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Significance of Lease Structures

 

From the desk of Edward Botti, BC Compliance Group

April, 2018

Financial Significance of Lease Structures

For all intents and purposes, property owners and investors are in the business of creating revenue from their tenants’ occupancy of their real estate holdings. An age old business model with a long proud history of success. The legal documents that secure the mutual rights of the landlord and tenant that define the terms of the business arrangement are the leases that are negotiated and executed.

There are numerous types of leases that can be used in a commercial real estate deal. Determining the proper structure of a commercial real estate lease is critical for both parties.

Understanding what form of lease(s) to enter into and having a comprehensive understanding of the terms of the deal will make a substantial difference in the economic performance of the transaction, and define the relationships. The deal has to make sense for both parties. Remember, both parties are in the deal to make money, and they should.

Moreover, understanding all the risks that come into play are just as significant, but often overlooked.

Principally, a lease is a negotiated business arrangement in which the tenant consents to pay the landlord an agreed upon amount of rent, subject to certain escalation provisions for a defined period of time, for the use of real property.

The operating cash flow and marketability of the property is significantly impacted by the structure of a lease, which can potentially transform the valuation of a property if and when it is put on the market, notwithstanding the tenant’s indifference to that fact.

There are effectively three fundamental categories of commercial real estate leases, all structured around two rent calculation methods known as “net” and “gross.”

The gross lease structure traditionally refers to a system whereas the tenant pays a set amount for rent, which covers the landlord for all expenses. The net lease structure obligates the tenant to a reduced base rent, but contains conditions and terms for the tenant to reimburse the landlord for a proportionate share of the overall expenses, subject to certain inclusions and exclusions. The modified gross lease is a hybrid version of the Net and Gross leases.

Gross Lease/Full Service Lease

In a gross lease, the tenant’s rent is all-encompassing. The cash flow stream generated by the basic rent payments enables the landlord to pay all or most expenses related to the property. These expenses include items such as property taxes, insurance, and operating expenses. It makes it straightforward for a tenant because expenses such as utilities, security and cleaning costs are included in one monthly payment. This structure makes budget forecasting easier on the tenant, but does contain certain risk. One being that the tenant pays the same rental rate despite whether or not operating expenses end up being higher or lower than estimated.

A distinct advantage that a landlord has in this structure of a lease is because the rent is based off of an estimate of the supplementary expenses (which are determined exclusively by the landlord), it is conceivable that for one reason or another the landlord may overvalue the costs, resulting in a higher rate for the tenant. By doing so it generates potential benefits for the owner in a situation where operating expenses end up being lower than originally budgeted. Adversely, the risk is that the owner will theoretically be accountable for the cost of any unforeseen increases in property expenses above the budgeted amount. From a tenant’s standpoint, the full service gross lease is appealing because they can budget on an anticipated stream of rent payments. Nevertheless, since there is motivation for landlords to overvalue operating expenses, many tenants view full service gross leases as an arrangement in which they are paying a premium rent for the ability to budget expenses.

Net Lease

In a net lease structure, the landlord charges a reduced base rent, in addition to many or all of the operating expenses. Operating expenses include real estate taxes; property insurance; common area maintenance (CAM), cleaning services, property management fees, sewer, water, security, waste removal, landscaping, parking lot maintenance, fire sprinklers, and many others, depending on the specific geographical location of the property.

The Net lease has many different forms and versions. It’s important to understand which version best suites the tenant’s needs.

Single Net Lease “N”

In this lease structure, the tenant is obligated to pay for base rent and their proportionate share of the building’s property tax, while the landlord is obligated to pay for all other building operating expenses. The tenant is however obligated to pay for their own utilities and cleaning services.

 

 

Double Net Lease “NN”

In this lease structure the tenant is obligated to pay for base rent and their proportionate share of the building’s property tax and property insurance. In this structure the landlord is obligated to pay for any structural repairs and common area maintenance. Just like the “N” lease the tenant is obligated to pay for their own utilities and cleaning services.

Triple Net Lease “NNN”

The NNN lease is the most common structure of the net lease for commercial buildings, lifestyle centers, outlets, malls, and retail strip center properties. In this lease structure the tenant is obligated to pay all or part of the property taxes, insurance, and CAM, in addition to their agreed upon basic monthly rent. Additionally, the tenant would pay the costs of their own occupancy expenses such as cleaning services, security, utilities, as well as their own insurance.

Landlords usually estimate expenses and charge tenants a portion of these expenses based on their proportionate share of the building’s rentable square footage, on a monthly basis, and reconcile the expenses in the first quarter of the following year.

In many cases a NNN lease can be more beneficial to the landlord. Tenants should be diligent and carefully examine the building’s expenses over the prior 3 year period. If above normal rates of increase are experienced, tenants should attempt to negotiate limits on the rate of escalation the expenses experience on an annual basis (referred to as “Caps”). Many types of expenses can be “capped”, and there are several different methods to do so. Two of the more common variations are known as Cumulative and Compounded, each with unique characteristics and variations. It is also more difficult for a tenant to budget in a NNN, as certain expenses can vary and are subject to volatility, which creates a certain degree of exposure for a tenant.

The structure of “capping” the expenses is a topic I will address at some point, as there are many variations and conditions to consider. If you have a question on this matter, please feel free to reach out to me.

However, there are benefits that a tenant can reap in a NNN Lease structure. As previously mentioned, basic rent is lower and cost savings in operating expenses are passed on to the tenant, as opposed to the landlord.

Absolute Triple Net Lease

This structure of a lease is not very common because it more inflexible and obligatory than the NNN lease. In this structure of a lease the tenants are obligated for every possible real estate related risk. Conceivably, a tenant would be liable for construction expenses to rebuild the facility after a disaster and would even be obligated to continue paying rent after the building has been condemned. Appropriately called the “hell-or-high-water lease,” tenants have final responsibility for the building regardless of any unforeseen events. This is not something I would recommend, but in some instances, it is the only way for a tenant to secure a lease on a specific type of property.

Modified Gross Lease

A very equitable structure of a lease is the modified gross lease (which can also be referred as the modified net lease).The modified gross lease is very common in large office space transactions They are very comparable to a gross lease with respect to the rent being one set amount, which can include any or all of the expense we find in the net leases, such as property taxes, insurance, management fees, operating expenses & security.

The modified gross lease structure enables the landlord to recover increases in expenses that exceed a baseline or “base year” amount. The base year establishes a foundation for which to measure any increases in comparable years, which will be charged to the tenant. Typically during the first quarter of the ensuing lease year, the landlord reconciles the expenses and either bills the tenant for their share of the overage, or issues a credit to the tenant if the expenses are below the baseline amount.

Baseline amounts can be reflected at a total expense amount, such as $10,000,000, or a as an “expense stop” such as $3.75 psf. I have found the “expense stop” method to be less tenant friendly because the details and make-up of the expenses are basically hidden in a vail of secrecy.

The modified gross lease is more appealing to tenants because the first full year of expenses are built into rent, and the tenant only pays their proportionate share of the inflationary increases in the expenses going forward, allowing tenants to better manage how much they spend in comparison to a gross lease.

Utilities and even the cleaning services are usually excluded from the rent, and are directly paid for by the tenant. Tenants and landlords will negotiate which expenses are included in the baseline expenses.

One of the risks associated with this type of lease structure is that the baseline expenses can be undervalued, which would result in the tenant paying a premium for operating expense and even property taxes. Factors such as occupancy levels and rent abatement periods can impact the calculation of the baseline amount. The process of “grossing up” has been a source of undervaluing the baseline for quite some time. In many cases different levels of services are applied in comparison years that were not applied in the baseline year. We witnessed this dynamic in building security post 9-11.  All of these matters needed to be iron out to ensure an equitable distribution of expense.

When a perspective tenant evaluates options for an office space lease, it is critical for them to compare the different types of lease structures and to evaluate the economic impact of each version.

Many people will say that market conditions will usually even out rental rates for comparable properties, regardless of the structure of the lease. I do not necessarily agree with that notion. As you can see, deciding on the structure is critical, and becomes a strategic maneuver if the proper due diligence is applied.

Prior to entering into a commercial real estate lease, the tenant needs to carefully analyze the proposed lease to gain an understanding of exactly what expenses they will be responsible for paying, what expenses are excluded, how capital expenditures are treated, how they are calculated, and how that can change. Situations in which additional charges may occur should be identified and addressed. The only way to determine these variables is to analyze at least three years’ worth of operating statements, property tax records, amortization schedules and occupancy levels of the building.

Effect on Income for Landlord

From a landlord’s perspective the structure of the leasing portfolio at a building or facility can alter the property’s financial performance significantly. In a conventional office building facility, the cost variance on a gross lease vs. a NNN lease can be as great as $6 to $11 per square foot, in certain markets. Here in the New York City metropolitan area, a variance like that is not uncommon at all.

We do quite a bit of diverse projects and recently a real estate investor was considering an investment, and narrowed it down to two different projects. The purchase price on each property was very similar. The first property was an office building outside of Cleveland, Ohio, with a signature tenant who recently signed a 10 year extension of the current lease, paying $30 per square foot (psf) annually on a 150,000 square foot space for a total rent obligation of $4,500,000 per annum (subject to inflationary increase).

The other opportunity being considered was an office building in Edison, NJ, which had a new tenant that recently entered into a 10 year lease also paying $30.00 psf. Most other aspects of the buildings were essentially uniform, giving the perception that the two buildings appeared comparable from a financial stand point.

A pecuniary study was launched by our team, and we concluded that the Cleveland tenancy was based on a modified gross lease structure. Obligating the tenant to pay their own electric expense via a sub metering arrangement. The study showed us that the current landlord was paying for the majority of the building operating expenses, including the property taxes. The tenant’s proportionate share of those property costs was approximately $750,000 per year, essentially decreasing the NNN-equivalent rent to $25 psf.

The study of the Edison property illustrated that the tenant entered into a NNN lease structure that obligated the tenant to pay for all of the building operating expenses. Accordingly, the $30 psf rent ($4,500,000) per annum in overall rental income falls almost entirely to net operating income, with the exclusion of minor expenses that are not included in a NNN lease structure, that are historically no more than $1.00 psf.

A model to examine the performance of the two buildings showed us that the operating income for the Edison property was nearly $750,000 over and above that of the Cleveland property.

In another example, an investor group purchased a multi-tenant office building in San Francisco. The anchor tenant occupied over 55% of the building. The investor group did not do comprehensive due diligence of the leases, and assumed that when the proposition 13 tax appraisal was completed, all escape tax escalations would be passed along to the tenants. The anchor tenant anticipated this event, and negotiated with the original landlord protection from the proposition 13 re-assessment. As a result, the new ownership group had to absorb more than $700,000 in escape tax, due to the provision of the anchor tenant’s modified gross lease. Had they understood the leases, they could have negotiated contingencies with the prior ownership group of the building.

These two transactions are only two examples of the multiple factors that show us why properties can differ greatly in marketable value, when at first glance, they give the impression of being comparable, and how the economic impact of leases can effect a transaction.

Diverse structures of gross and net leases are extensively utilized commonly in the commercial real estate industry, to the point where those lease structures dominate the industry. Occasionally, the dominance of utilizing a particular structure of lease can be prejudiced by commonplace procedures in a specific region or market tendency. Twenty years ago, for instance, office building landlords in downtown Chicago principally applied the full-service gross lease structure on a very consistent basis. As the leasing market expanded to include industries that had a much larger energy demand, we see that today numerous office buildings changed the structure of leases as to make the escalating and variable cost of energy the tenants’ obligations, and therefore making the performance of the property more predictable, from a landlord’s standpoint.

Each lease structure has many different aspects, features and costs. No two leases really are comparable. It is critical for both landlord and tenant to completely understand the structure of a lease, especially so for an investor when evaluating investment opportunities and understanding how a specific lease can influence property performance.

Ultimately, the structure of a lease or lease portfolio in position must become a critical component in the elements of an examination on a property’s income and expenses.