It takes attention to detail to understand modified gross leases for commercial real estate. People often categorize the lease as a full-service (gross) or a triple net lease, but most of the agreements out there fall into the middle of the spectrum. Ultimately, the landlord and tenant share the operating expenses.
With such lease agreements, they are often called a modified gross lease. You should learn the difference between gross and net leases and why modified gross leases could be the best choice.
What Is a Modified Gross Lease?
A modified gross lease is typically a lease structure where the landlord and tenant are responsible for paying the property's operating expenses. The specific operating costs that a tenant pays or a landlord pays under the modified gross lease (MGL) can vary significantly. This variation is because of negotiations between the tenant/landlord and the market conditions. Therefore, the only way to know who is responsible for paying each expense is to read the lease agreement thoroughly.
The Spectrum for Commercial Real Estate Leases
Ultimately, there are two types of commercial real estate lease options - Absolute gross leases and the absolute net lease. With the absolute net lease, the operating expenses get paid by the tenant. However, with a gross lease, the landlord pays for all of the operating costs for the property.
Any other agreement falls in the middle, and they are often called modified gross leases.
Always Read the Lease Agreement
The most crucial part of understanding the commercial real estate lease agreement is to read it thoroughly. You may see descriptive terms, such as net lease, gross lease, and double net lease; they can be good starting points. However, to know if you have a modified gross lease, you must go through each point carefully.
Typically, property insurance and property tax are always handled by the landlord. Then, it's the tenant's responsibility to cover any property expenses lined up in the agreement.
Examples of Modified Gross Leases
A gross modified lease applies to leases where the expenses are the responsibility of the landlord and tenant, and this is often referred to as a modified gross lease. A modified gross lease usually has the operating expenses up for negotiation between the two people, such as maintenance costs or structural repairs, property taxes, and more.
When it comes to who pays what, there are many lease structure options available. In the basic lease agreement, the tenant pays a pro-rata share of the operating and maintenance costs. For example, a tenant occupies a space of 10,000 square feet within a 100,000 square-foot building. Therefore, the tenant's share is 10,000/100,000 (10 percent.) If the full expenses for the building were $1 million, then the tenant must pay $100,000.
The money can go for just about anything, including property taxes. It's up to the landlord as to how to handle real estate taxes and all the rest. Typically, the money doesn't have to be distributed in the lease structure agreement. Still, if the tenant isn't required to cover property taxes in the commercial lease, it is up to the landlord to cover remaining insurance costs and property taxes as needed.
Sometimes, the tenant might pay the pro-rata share of certain expenses and pay a flat-dollar amount for everything else. For example, a pro-rata share of the property taxes and/or insurance may mean that he or she pays $1 per square foot each year for structural repairs.
If it's a more complicated reimbursement structure, the tenant may have an expense stop on grouped expenses or individual ones. That means the landlord must pay for the expenses up to the stop amount, and the tenant covers the rest.
Individual expenses are often straightforward in the gross modified lease. However, expense stops can apply to groups of expenses, so it can get confusing very quickly.
For example, there's a $1/SF expense stop for the common area maintenance needs. Then, that reimbursement kicks in when all of the expenses add up to that stop amount. However, if the same expense stop is applied to the individual expenses, each one has to trigger the expense stop before the tenant stops paying.
What if you have a 100,000 square-foot office building with $25,000 in insurance and $100,000 in property taxes?
If those expenses were in the expense group with a $1/SF expense stop, the tenant must reimburse the pro-rata share of the amount over that expense stop. The total expenses in the example equal $125,000 with a 100,000 square foot building area. Therefore, the total expenses are $1.25/SF. Ultimately, the tenant pays excess over that $1/SF expense stop.
However, if the expense stop of $1/SF was applied to each expense, you see the following prices:
- Property Taxes - You pay $100,000 for 100,000SF, making it $1/SF
- Insurance - You pay $25,000 for 100,000 square feet, making it $0.25/SF.
Neither of the individual expenses goes over the $1/SF expense stop, so there are no reimbursements for the tenant.
Base Year vs. Modified Gross Lease
In the examples above, you learned about an expense stop. However, they can be used for specific amounts or are based on the year amount (called a base year stop).
With a base year stop, it works the same as the other examples with one difference. The base year stop uses the expense amount for the base year in the lease. For instance, if the expenses for the base year were $100,000 and the building was 10,000 SF, then the base year expense amount is $100,000 ($10/SF). The tenant is then responsible for paying the expenses above that base year price.
How is a base year defined? It ultimately depends, and you should read the lease to find out for sure. However, usually, the base year follows the calendar year when the lease began. If it started in June 2020, the base year is the 2020 calendar year from January to December.
However, the base year could be defined as the first year of the lease for the tenant. If you moved into the property on June 1, 2020, then that's the start, and the end date is May 31, 2021. Still, if there are multiple tenants, this can be quite confusing, so most landlords use the calendar base year to be safe.
Triple Net Lease vs. Modified Gross Lease
A triple net lease is a lease structure where a tenant must pay rent and all operating expenses for the property. Triple net leases are often common with single-tenant properties that are quite large, such as a national restaurant chain.
A modified gross lease means the landlord and tenant share the operating costs and expenses. Typically, a modified gross lease is invariably more complicated than a triple net lease because the reimbursement structure for a modified gross lease varies widely.
Ultimately, with a triple net lease, the person covers all property management costs, base rent, building insurance, janitorial services, and other building expenses for the commercial property.
Full-service Lease vs. Gross Lease vs. Modified Gross Lease
A full-service gross lease means that the landlord pays for the property's operating expenses. Gross leases are often the simplest structure for a tenant because they aren't responsible for covering operating costs at all.
This contrasts with the modified gross lease, where both the landlord and tenant pays for the operating costs based on the lease agreement. Ultimately, the reimbursement structures are complicated with a modified gross lease and can be hard to understand. This is where there needs to be a middle ground, and most commercial leases have specific rules in place.
Still, the tenant may not know what other costs are associated with the property other than the base rent. It might be wise to get legal help.
Whether a commercial real estate lease is a modified gross lease or gross lease depends on the market conditions. With that, you can only know what lease you have by reading it.
Deciding who pays the real estate taxes and other operating costs can be a bit confusing. However, most tenants don't like triple net leases because they're responsible for everything.
Essentially, modified gross leases are a good choice, but it's important to read through everything when determining if you require a modified gross lease or if it's right for your commercial spaces.
Generally, modified gross leases are designed to benefit both parties, but a triple net lease is there for the landlord above all else.
A modified gross lease puts the tenant in control to save a bit of money. However, the stipulations in place by the landlord determine who pays what and why. There are sure to be commercial real estate extremes throughout the nation, so it's best to read through the lease agreement and fully understand what you're getting into before signing.
Is the tenant responsible for business taxes, property taxes, and all the rest, or is it the landlord's responsibility? Only the lease agreement knows. Since many commercial properties use a modified gross lease, it's crucial to understand the term and figure out what the tenant is responsible for paying to use the retail space.