By and large, commercial tenants are savvy when it comes to rental rates and the games landlords play with rates to entice tenants into their buildings. Unfortunately, even the savvy get burned every now and then. That said, it doesn’t hurt – and in fact may save thousands of dollars – to review the basics of commercial leasing structures prior to evaluating your market options.

Gross v. Net Leases

The leasing structure spectrum runs from “gross” leases on one end to “triple-net” leases on the opposite end, and everything in between. Landlords typically market their buildings by quoting either a monthly or annual square foot rental rate. On rare occasion, the quoted rental rate will be the tenant’s only monetary obligation. Such an arrangement would truly qualify as a gross lease. In contrast, under a traditional net or NNN lease, in addition to the tenant’s rental obligation, the tenant will take on nearly all of the burdens (risk) of ownership, including: real estate taxes, insurance, utilities, and building maintenance and repairs.

The vast majority of leases will not fall squarely on either end of the spectrum. Thus, when comparing options, it is a mistake to simply compare the landlord’s quoted rental rates.

Pass-throughs

The tenant’s additional monetary exposures are commonly referred to as “pass-throughs”. As a tenant, it is important to identify and quantify this additional exposure prior to focusing exclusively on one building. To do so requires the tenant simultaneously vet each of their options thoroughly to ensure their financial comparisons are both accurate and consistent across buildings.

Apples v. Oranges

When evaluating building options, it is critical that the tenant ensure that they are comparing apples to apples. A $1.25/sf “full service” rate can be significantly different than a $1.25/sf “modified gross” rate. So what is the difference? The difference is the lease structure.

No two leases are the same; however, the use of the terms such as “full service” or “modified gross” is the first indication of the lease structure. Below is a general description of typical terms used to describe the lease types:

1. 1. Full Service: A full service lease is similar to the true gross lease described above. Under a full service rate, the building operating costs (utilities, common area maintenance, insurance, janitorial, real property taxes, etc…) are included in the rent. But unlike the fixed rent of a true gross lease, under a full-service rate the tenant will be responsible for any escalations in the landlord’s building operating cost above their base year (The base year is typically the first calendar year of the lease). For example, if the landlord’s building operating cost in the base year of the lease was $10/sf, and the subsequent years operating cost are $12/sf, then the tenant would be responsible for the $2 escalation in operating costs.
2. 2. Modified Gross: A modified gross rate is exactly what it sounds like. It is a gross rate that has been modified by the landlord to exclude some portion of the landlord’s operating expense. For example, a modified gross rate may be a fixed rental rate; however, the tenant is responsible for the utilities cost. A modified gross quoted rate alerts the tenant of additional cost above the quoted rental rate.
3. 3. Full Service plus/or net of “____”: This rate is similar to a full service rate; however, a specific operating cost is being excluded from the rent. For example, a “full-service plus/or net of electric” is a full service rate except that tenant is also responsible for the full cost of electricity (as opposed to only the escalated cost of electricity above the base year).
4. 4. Triple-net or NNN: Under a traditional NNN rate, the building operating costs are not included in the rent. Thus, under a NNN rate, in addition to rent the tenant will also be responsible for operating costs such as utilities, maintenance and repair, real property taxes, and insurance.

To construct an effective financial comparison of space options, a tenant has to identify the costs in addition to rent that the landlord intends to pass-through to its tenants. Understanding the above listed lease structures should help a tenant identify pass-throughs, or at least alert them to the possibility of a pass-through.

The Devil is in the Details (A Real-Life Example)

Landlords play games with their quoted rates and even the savvy get burned.

For background purposes, generally a “plus electric” rate is an indication that the electricity to the tenant’s space is separately metered. Depending upon the business, electricity should run between $.10/sf and $.20/sf.

Recently, we received a call from a tenant in a “full-service plus electric” lease in a multi-tenant office building, whose electric bills were running between $.40/sf and $.50/sf. Prior to entering into their lease, they conducted their financial comparison of multiple buildings using the lower rates listed in the paragraph above in their comparison. What they did not realize was the “plus electric” rate for their current building was not limited to separately metered electricity. Instead, per the fine print in their lease, the landlord is permitted to pass through the cost of electricity for the entire building. In addition to their own electrical consumption, the tenant is paying their proportionate share of electrical consumption for the entire building. Such cost is typically included in the base rent in a full-service lease; but this landlord has successfully obtained an above market rental rate by eliminating the cost from their quoted rental rate.

Reminder: An effective financial comparison includes a thorough review of the lease document itself. A tenant should be aware and comfortable with the permitted pass-throughs in their lease. Don’t get burned!