There are two types of real estate leases: gross and net leases. A gross lease places the majority of a property’s operating expenditures on the landlord, whereas a net lease places the majority of the operating expenses on the tenant.
The third sort of leasing arrangement is a modified gross lease. It enables a landlord and renter to share responsibility for the property’s operating expenditures. Here’s a more in-depth look at the differences between the primary lease types, what operating expenses are involved, and how a modified gross lease might function.
What is a Modified Gross Lease?
A modified gross lease is a lease form in which both the landlord and the tenant are responsible for paying the operational expenditures of a property. Under a modified gross lease, the particular operational expenses paid by a tenant or landlord can and do vary greatly. This fluctuation is attributable to market conditions and tenant-landlord discussions. As a result, reading the lease agreement thoroughly is the only way to understand who is accountable for paying specific charges.
How Does a Modified Gross Lease Work
Commercial real estate leases are classified into two types based on rent calculation methods: gross and net. The modified gross lease, sometimes known as a modified net lease, is a hybrid of a gross lease and a net lease.
Modified gross leases are a cross between these two types of leases in that operating expenditures are shared by both the landlord and the tenant. With a modified gross lease, the tenant assumes responsibility for expenses directly related to his or her unit, such as unit maintenance and repairs, utilities, and janitorial charges, but the owner/landlord continues to bear responsibility for the remaining operational expenses.
The amount to which each party is responsible is negotiated in the lease terms. The expenses for which the tenant is accountable can vary greatly from property to property. Therefore a potential tenant must confirm that a modified gross lease clearly outlines which expenses are the tenant’s responsibility. A modified gross lease, for example, may force tenants to pay their proportionate share of an office tower’s total heating expense.
Obtaining a Modified Gross Lease
The tenant may agree to pay his or her pro-rata share of all running expenditures under a standard modified gross lease arrangement. As an example, suppose a tenant leases a 10,000-square-foot unit in a 100,000-square-foot structure. As a result, the pro-rata share of expenses for the tenant is 10%. If the total construction expenses are $1 million, the tenant’s 10% contribution is $100,000. The tenant may also have to pay $1 per square foot for structural repairs.
There are, however, much more complicated lease provisions for expenses known as an expense stop on specific expenses or groupings of charges. In these agreements, the property owner is liable for a single or group of expenses (for example, common area maintenance charges) up to a certain sum or the stop amount. If the expense stop is $2 per square foot, the landlord will cover these charges up to that amount. The tenant will pay anything above that amount.
There are numerous examples of recovery structures, which are modified gross lease agreements between property owners and tenants. Reimbursement arrangements can vary greatly. Other terms or rules, such as caps, floors, administrative fees, responsibilities for peripheral tenants to return an expense after an anchor tenant pays a flat fee first, and how building areas are assessed for reimbursement reasons, can be included in recovery structures.
Advantages of a Modified Gross Lease
#1. Greater Budgetary Control
Because the landlord is responsible for the upkeep, the corporate renter has more budgeting control over expenses that directly affect their business operations, such as salaries, rent, business taxes, and so on.
Furthermore, it allows you to cut expenditures and save money. You can, for example, pay for your own utility usage and make it more efficient.
#2. Less responsibility for office construction
Corporate tenants prefer modified gross leases since they are not liable for building maintenance. This enables corporate renters to concentrate on the most important aspects of their business operations. Because the landlord will be accountable for paying the CAM, they will become more concerned about the building’s condition. This is beneficial since it helps you to focus on the most important issues of your company.
Examples of Modified Gross Leases
The term “modified gross lease” refers to a lease in which both the landlord and the tenant share the expenses. While every expense between the landlord and renter is negotiable, often negotiated expenses include property taxes, property insurance, common area maintenance (CAM), utilities, and structural repairs.
There are several recovery mechanisms that are used to determine which of these expenses are reimbursed by the renter to the landlord.
The tenant could simply pay its pro-rata share of all running expenses in a basic lease agreement. Assume a tenant occupies a 10,000 square foot space in a 100,000 square foot building. This means that the tenants’ pro-rata share is 10,000/100,000, or 10%. If the entire building expenses were $1,000,000 and the tenant reimbursed its pro-rata portion of all building expenses, the tenant would owe 10% x $1,000,000, or $100,000.
The renter may sometimes pay a pro-rata portion of some expenses while paying a flat dollar amount per square foot for others. The tenant, for example, may pay its pro-rata share of property taxes and insurance, as well as contribute $1/SF every year toward structural repairs.
In more complex reimbursement schemes, tenants may have an expense stop on individual or collective spending. The landlord will pay for the expense up to a specific amount (the “stop” amount) with an expense stop. For example, if the expense stop is set at $2.00/SF, the landlord will pay up to $2.00/SF of the expense. Anything above $2.00/SF would then be the tenant’s responsibility.
This is rather simple for individual expenses. Expense stops, on the other hand, are frequently applied to entire categories of spending rather than to individual expenses. This distinction is critical, and it is frequently misunderstood. This is because the amount payable by the tenant in each circumstance may differ.
Read Also: PERCENTAGE LEASE: Guide To Leases in Commercial Real Estate
For example, if a $1/SF expense stop is applied to an entire group of charges (say, common area maintenance expenses), the reimbursement will begin as soon as the total of all expenses in that group exceeds the stop value. If the same $1/SF expense stop was applied to each individual item, the expense stop would be triggered for each individual expense rather than the sum of all expenses.
Let’s have a look at an example. Assume we have a 100,000-square-foot structure with the following expenses:
- $100,000 in property taxes
- $25,000 in insurance
If both of these expenses were included in an expense group and a $1/SF expense stop was applied to our expense group, the tenant would be reimbursed for its pro-rata portion of the amount above the expense stop. The entire expenses, in this case, are $125,000, and the building space is 100,000 square feet, hence the total expenses per square foot are $1.25. That means the tenant would pay the difference above the $1/SF limit, which in this example is $0.25/SF or $25,000 in total.
If we applied the $1/SF expense stop to each individual expense (rather than the full group), we would receive the following per square foot expense amounts:
- Property taxes – $100,000 / 100,000 = $1 per square foot.
- Insurance – $25,000 x 100,000 = $0.25 per square foot.
Because neither individual item exceeded the $1/SF expense cap, the tenant would receive no compensation.
As you can see, it is critical to establish whether or not expenses are bundled together for reimbursement purposes. This is why, if you want to completely understand the reimbursement structure for a lease, you must read the contract.
Read Also: GRADUATED LEASE: Definition & Guide To Commercial Leases
These are only a few instances of gross lease recovery schemes that have been modified. Structures of reimbursement can and do vary greatly. Other aspects of recovery structures could include limitations, floors, administration fees, ancillary tenant reimbursement requirements after an anchor tenant pays a flat fee initially, convoluted procedures for how building sections are calculated for reimbursement reasons, and so on.
Disadvantages of a Modified Gross Lease
#1. Less Power
If the landlord is careless with building maintenance, it might have an impact on the building’s aesthetic. If the aesthetic of the building is important to your firm, it may have an impact on how it operates. There have been multiple incidents when landlords have neglected building care, resulting in unkempt common areas that may discourage customers and embarrass corporate tenants.
#2. Variation
In contrast to a standard gross lease, costs in a modified gross lease might be expected to fluctuate. This can have an impact on your financial planning, particularly for startups and small firms. Furthermore, the landlord may exaggerate their running costs. This may have an impact on the rental rate. Also, you may wind up paying too much for some of the charges. As a result, it is critical to consult with a tenant representative to determine which lease choice is ideal for you.
While there are apparent benefits and drawbacks to choosing a modified gross lease, it can be a great option if you can’t decide between the two commercial real estate extremes of gross and net leases. A modified gross lease is often a good choice for both tenants and landlords. It allows tenants to pay for costs over which they have authority, while also giving landlords control over certain duties, such as CAM charges.
Base Year vs. Modified Gross Lease
In the preceding cases, we discussed a reimbursement structure that featured a cost stop. Expense stops may employ a particular amount, such as a dollar per square foot figure, at times. Occasionally, expense stops will employ a base year amount and are referred to as base year stops.
The base year stop operates in the same manner as our expense stop examples above, with one important exception. The distinction between an expenditure stop and a base year stop is that a base year stop simply uses the expense amount in the lease’s base year. For example, if our base year expenses were $100,000 and our entire building was 10,000 square feet, our base year expense figure would simply be $100,000 or $10/SF. The tenant would be liable for paying its share of expenses beyond this base year amount in all subsequent years.
What is the definition of the base year? This is dependent on the lease, and the only way to tell for sure is to read it. The base year, on the other hand, usually follows the calendar year in which the lease begins. For example, if a lease begins in June 2020, the base year would be the 2020 calendar year, which runs from January 1st to December 31st.
The base year is sometimes described as the first year of the tenant’s lease. In this scenario, the dates are June 1st, 2020 – May 31st, 2021. However, with multi-tenant buildings, this becomes difficult to track, hence landlords frequently use a calendar base year.
Triple Net (NNN) Lease vs. Modified Gross Lease
A triple net lease is a lease form in which the tenant is responsible for all property running expenses. Triple net leases are widespread in big single-tenant facilities, such as national restaurant chains, and are desirable because they provide a turn-key investment.
The modified gross lease, as we’ve seen throughout this text, is a lease structure in which the landlord and tenant divide the cost of operational expenses. A modified gross lease is far more involved than a triple net lease. This is partly due to the fact that reimbursement mechanisms under a modified gross lease can vary greatly and might be difficult to understand.
Gross Lease vs. Modified Gross Lease
The full service or gross lease is a lease form in which the landlord pays for all property operational expenditures. Because the tenant is not responsible for any running expenses, gross leases are the easiest lease type for the tenant to grasp.
In contrast, in a modified gross lease, both the tenant and the landlord share responsibility for paying the property’s operational expenses. As previously stated, the reimbursement mechanisms that describe how and when the renter reimburses the landlord can quickly become intricate and difficult to grasp.
The market conditions will determine whether a commercial real estate lease is a gross lease or a modified gross lease. Of course, reading the lease agreement is the only way to understand what type of lease you have and, more crucially, who pays for what (and when).
Conclusion
In short, while there are certainly advantages and disadvantages to employing a modified gross lease, it can be a good compromise between the two commercial real estate extremes of gross and net leases for both landlords and tenants. As a result, in the commercial real estate market, a modified gross lease is a rather frequent sort of leasing contract.
However, due to the significant difference between gross leases and net leases, it’s crucial to understand that modified gross leases might have quite diverse terms. Thus modified gross leases should be evaluated on a case-by-case basis.
Modified Gross Lease FAQs
What is the difference between triple net and modified gross lease?
A tenant must pay rent as well as all property operating costs under the provisions of a triple net lease. A business tenant pays some, but not all, of the running costs under the conditions of a gross modified lease.
What is a modified gross lease base year?
A base year lease, often known as a modified gross lease, requires the landlord to pay existing expenses while tenants bear any annual increases in expenses. A base-year lease falls between a NNN lease and a gross lease.
