One of the essential real estate concepts that investors need to know is the lease structure. Many people may be aware of residential leases. However, commercial property leases are entirely different.
When it comes to commercial real estate, a popular type of lease is the triple net lease. This applies especially for properties with single tenants. The following is an overview of the different kinds of leases that commercial tenants may sign and the information that investors should become familiar with when it comes to triple net leases.
The Main Types of Leases in Real Estate
There are two fundamental types of real estate leases: gross leases and net leases. The expenses that tenants are expected to pay is the main difference between the two.
What Is a Gross Lease?
When it comes to gross lease terms, the tenant needs to pay a rental rate previously agreed upon with the landlord. This rate depends on the property. Aside from this, the tenant may be responsible for different utilities.
Many Americans are likely familiar with the gross lease. That’s because these are used by residential landlords when leasing houses and apartments to tenants. They are also common in other types of consumer-facing real estate. Examples include hotel rooms and self-storage units.
What Is a Net Lease?
A net lease is one that shifts specific financial obligations over to the tenant. The amount that the tenant pays will depend on the kind of net lease, but financial responsibilities may include insurance, utilities, taxes, and more.
Net leases have four main categories:
- Absolute Net Lease
Here, it is the responsibility of each tenant to take care of every payment possible, including potential major repairs. There may be just a few limitations related to maintenance. One examples is when a building experiences structural issues because it is old. Under the triple net lease, the landlord should be responsible for this. But if it is under the absolute net lease, the tenant is the one who should be responsible for it.
- Single Net Lease
Aside from utilities and rent, when it comes to the payment of the property taxes of the building, tenants are the ones who should be responsible for it.
- Double Net Lease
Aside from utilities and rent, when it comes to the payment of the property taxes as well as the insurance of the building, tenants are the ones who should be responsible for it.
- Triple Net Lease
Aside from utilities and rent, when it comes to the payment of the property taxes, insurance of the building, as well as most of the common area and structural maintenance expenses, tenants are the ones who should be responsible for it.
The most common of these four is the triple net lease. Because of this, “net lease” and “triple net lease” are usually used interchangeably.
It’s not very common to encounter single net leases. Absolute net leases are not common, either. What often occurs in properties for multiple tenants, like office buildings and shopping malls, are double net leases.
Even if the expenses eventually become the tenant’s responsibility, a lot of landlords prefer payment to pass through them so they can ensure expenses are being paid.
Generally, triple net leases have initial terms that are long. It’s not uncommon for the triple net lease to be with an initial term that is more than 10 years, with options allowing the tenant to extend. Oftentimes, they have gradual rent increases that are built in, as well. These are what they call “escalators.”
When Are Triple Net Leases Used?
People may use the triple net lease for any kind of commercial real estate, but they are highly practical for freestanding or single-tenant properties. A triple net lease could end up being a logistical nightmare if maintenance and insurance expenses are split among numerous tenants.
Triple net leases are commonly seen on retail properties that are freestanding, such as clubs, warehouses, convenience stores, etc. (i.e., Walgreens, McDonald’s, Costco, or a large industrial warehouse). They’re also common on bigger single-tenant properties, such as industrial properties and medical offices.
How Do Triple Net Leases Benefit Landlords?
Landlords may want to use the triple net lease so the property owner’s variable costs would shift away from the landlord and transfer to the tenant.
Here’s an example. Let’s say you own a single family home that eventually gets rented out to tenants. One year, your property taxes increase by $500. You will have to take care of that expense.
However, if I purchase a building and have it leased to another business on a triple net basis, every cost will become the responsibility of the tenant. An increase in taxes would not affect your cash flow.
Aside from that, the nature of the triple net lease in the long-term can lessen re-leasing and vacancy risk. Plus nowadays, there is steady growth in the income stream of built-in escalators in rent.
Basically, a triple net lease allows the landlord to minimize risk. Tenants lock in for a long time, which keeps landlord expenses predictable.
But use of a triple net lease isn’t entirely without risk. One example is maintenance. It is still the responsibility of the landlord to have this done in a timely manner. Property owners often do this so they can protect their investment. Tenants, on the other hand, are not that interested in spending cash on routine maintenance.
How Do Triple Net Leases Benefit Tenants?
It may appear that triple net leases could only be advantageous to the landlord. However, they often require lower payments compared to gross leases. It can also be viable as the tenant is agreeing to a long lease and takes care of the risk of any variable costs like maintenance, insurance, and taxes. Even after they factor out the added responsibilities in cost, tenants often have a better deal.
Most of the time, a triple net lease has an initial rental rate that is favorable. It also has an escalator that is generally less compared to the expected rise in market rental rates. Historically, there is an annual 3 to 4 percent increase in the annual rate of commercial market rentals.
Aside from this, it is common for annual rent escalators to increase by 1 to 2 percent. Because of this, leases often have a cost structure that is favorable and tenants are aware of what they need to pay in rent yearly for the whole term.
Triple net leases can be beneficial to both the tenant and the landlord. For those reasons, it’s not surprising that it is a common lease structure.
Now that you are aware of the ways the triple net lease works, you can be confident when analyzing any triple net property you would like to invest in.
Do you have any questions about lease types that were not addressed above?
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