Lease structures & their strategic impact
As with any contract, leases can vary significantly and have particular case by case nuances; however, they will generally fall into one of three categories for the treatment of rent and operating expenses – namely, gross, modified gross, and NNN (aka triple net). The differentiating factor among the three types centers on the definition of rent and the treatment of operating expenses. As we will discuss in an upcomming post on due diligence, the lease structure plays a crucial role in forming and implementing your asset strategy plan.
The following is a summary of each of the main structures:
Gross Lease: A lease in which, for a specified rent, the landlord provides all services and repairs and pays for taxes, insurance, and maintenance.
Modified Gross: A lease in which, in addition to base rent, the tenant must reimburse the landlord for the increases in operating costs over a predetermined base year, base amount, or stop. Very common with office properties.
Triple Net (NNN): A lease type in which the landlord turns the Premises over to the tenant, and in addition to base rent, the tenant is responsible for all expenses – OpEx, taxes, and insurance – as if the tenant were the owner of the premises (in terms of maintenance, the landlord will often remain responsible for the roof and structure). Common with single-tenant occupancies and industrial properties, but also frequently seen in office and retail, with expenses paid on a pro-rata basis.
Some markets will be a mixture of modified gross and net, such as having common area electric paid on a net basis and other expenses as modified gross over a base year – you’ll see these spaces marketed as base rent + e (where e represents electric).
It is essential to understand a few other definitions and concepts before discussing strategy:
While there are nuances between each, Common Area Maintenance (aka CAM)/Pass-thru expense/ and operating expenses are often used interchangeably when discussing the costs that tenants pay (reimburse the landlord) for building level expenses as additional in the modified gross and NNN lease scenarios. Generally, these are above the line expenses (i.e., above NOI) -meaning they do not include capital expenses, leasing costs, and partnership level professional expenses. These operating expenses relate to the operation and maintenance of the property. Examples include maintenance contracts such as landscaping and security, general repair costs (non-capitalized) for items such as the HVAC and plumbing systems, property management fees, property level payroll, property manager, chief engineer, etc.
You also need to be aware of Caps, which establish limitations on pass-through expenses. While not an exhaustive list, common cap scenarios include: (i) limitations on year over year (YoY) increases in total operating expense pass-throughs; for example, a 3% cap would limit pass-throughs to a 3% increase even if YoY increase were 5%. You will need to determine if this cap is cumulative because you may be able to defer the excess to the following year if the cap is not reached; or (ii) Controllable vs. non-controllable Caps – in this scenario, the caps only apply to expenses that are within the control of management. While there can be a debate on which expenses are controllable, the lease will often provide some clarity. For example, insurance, real estate taxes, snow removal, and some utilities are typically deemed non-controllable; and (iii) Line item caps – such as capping property management fees to 3% of gross revenues, even though that particular market may allow for management fees up to 4%.
One other concept to remember is the Base Year, which establishes the dollar threshold over which the tenant pays their pro-rata share of expenses. Base Years are commonly the first full calendar year of the lease term and are frequently adjusted at the time of a lease renewal. Additionally, it is important to note whether there is a gross-up (e.g., to 95% occupancy) for buildings with some vacancy.
The intricacies of rent, recoveries, and other forms of additional rent could easily fill a book. This article’s point is to raise a handful of critical factors so that some of the strategic opportunities and potential roadblocks are top of mind when underwriting a new acquisition or building a strategy for an existing portfolio asset.
Value Add Scenarios and Impact of Lease Structure
Addressing Deferred Maintenance can significantly impact a property, such as reputational improvement, justifying rent increases, and reducing operating costs over time. However, you cannot assume that these YR1 maintenance costs will be recoverable as additional rent without clarifying several points: (i) are these repairs treated as capital expenses or operating expenses? Capital expenses are generally not recoverable, with few exceptions – such as improvements that show a verifiable reduction in operating expenses and sometimes costs that are due to compliance with law – regardless, these expenses are generally amortized over a certain period. Alternatively, if you assume that capital expense or compliance with law costs are not recoverable, you may be leaving money on the table; (ii) will these deferred costs exceed the YoY increase allowed per the Caps established in the lease? If so, you cannot include the entire amount as recoverable in your underwriting; and (iii) if you are conducting a lease-up program while addressing your deferred maintenance, you may create artificially high base years given the temporary increase in operating expenses – negatively impacting your recoveries in subsequent years. There are multiple ways to address this, including negotiating a base year stop instead, assuming a stabilized figure instead of actuals.
Increasing rents to market rents is a typical value add opportunity. In order to understand the actual value received from these adjustments, you need to take the impact of adjusted base years into account. If you are dealing with a building with old long-term leases or a heavy upcoming roll, you’ll need to figure in the impact on historical recovery income once the base years are adjusted. By no means is the preceding meant to imply that increasing rents to the market is negative; however, you’ll need to look at the full impact across all revenue lines to understand the value add from a cash flow perspective.
Generating fees as the operating partner in a JV is a common method to generate company level cash flow while building sweat equity. The equity partners are much more likely to be open to particular fee structures if the fees (i.e., management fees) are recoverable from the tenants. Many larger tenants negotiate clauses that require management fees to be comparable to fees for that given market and create a Cap as a not to exceed the threshold. The tenants with the leverage to add such clauses are usually the larger tenants and therefore have a higher pro-rata share of the property and can significantly impact recoveries.
These lease provisions are not necessarily good or bad on their face; instead, understanding them provides the purchaser with the best opportunity to generate value and returns. Previous posts have covered the importance of understanding objectives and aligning the appropriate strategies - understanding the nuances of the lease agreements is an extension of getting comfortable with executing your key strategy.
This article is for general information, educational, and entertainment purposes only. Establishing and implementing a strategy for a particular property encompasses many unique factors, and professional advice/services should be sought for that specific transaction or investment. CRE Vertical Partners, LLC is a real estate investment firm, heavily focuses on implementing a comprehensive & consistent strategy across all aspects of the real estate vertical to best achieve our investment objectives.