Industrial real estate lease agreements typically exist in two standard forms: net and gross. Most industrial buildings, owned by large professional or institutional landlords, are structured as net leases. This trend may not continue for much longer. We have begun to hear talk about larger institutional landlords transitioning to gross leases.
This transition may seem innocuous because objectively a net lease and a gross lease could be two sides of the same coin: the tenant pays for all expenses in both structures. The reality is that this pending sea change could significantly impact industrial tenants. Landlords are progressively becoming more skilled at increasing their profits, often on the backs of tenants.
This could be an attempt by landlords to reduce transparency and benefit from their ability to dictate terms.
Before we get to that, let’s discuss the difference between net and gross leases.
A true net lease describes a lease in which the tenant pays rent to the landlord as well as all other associated real estate costs (e.g. taxes and maintenance costs). Effectively, the landlord collects a rent that is net of expenses. Many landlords are reluctant to relinquish control of their building’s maintenance but still want the tenant to cover maintenance costs. So, leases are frequently structured in such a way that tax and maintenance costs are paid for by the landlord and then “passed through” to the tenant on a monthly estimated basis.
A gross lease is a lease in which the rent and all associated real estate costs (real estate taxes and maintenance expenses) are rolled up into one lump rent charge. This lease can be structured one of two ways.
- In a true gross lease, the tenant pays the gross rent and that’s it. In this structure, the landlord is taking on the risk of any increases in taxes or operating expenses.
- In a modified gross lease the landlord agrees to cover a base expense rate for taxes and operating expenses. The tenant is then responsible for any additional costs. This protects the landlord from potential increases in expenses, which would be passed to the tenant.
What do pending changes mean for tenants?
In both gross lease structures, tenants may be at risk for increased spending. Conversely, landlords can benefit from a “double dip” on taxes and operating expenses. Most gross leases will have an annual escalator, which automatically increases rent each year. So, the landlord collects an increase in the gross rent, plus – in the case of a modified gross lease – is able to pass through any increase in expenses to the tenant.
Gross leases provide several benefits to landlords. The motivation behind a move to a new gross lease form will likely be justified as a way to reduce administrative costs; landlords will no longer have to itemize, report, or reconciliate expenses with tenants.
Although this may seem like a sensible way to remove a layer of costs, it will only increase the landlord’s profits; the tenant will not benefit. The lack of transparency may also provide landlords with new opportunities to profit from tenants:
- Landlords may be motivated to reduce maintenance costs, especially in areas that do not have long-term material affect to their buildings, such as landscaping and snow removal.
- The fixed lease escalators will almost certainly increase at rates that far exceed the actual annual increase in tax and maintenance costs. This will allow landlords to contract with management companies who will compete for highly lucrative management contracts.
Ultimately, if institutional landlords trend toward gross leases tenants will have limited ability to dictate the lease structure. However, as we have always stressed, the more you understand about what is at stake and the motivation of the landlord, the better positioned you will be for success in negotiations.
Stay tuned! Next week we will dive into some of the hidden ways that your landlord may be padding profits by means of maintenance and operating expense charges.