A COMMERCIAL real estate project’s value is typically based on its net operating income, which equals rental income minus operating expenses. The allocation of operating expenses between the landlord and tenants is therefore an important factor in the project’s value. Most commercial leases use some variation of two basic operating expense allocation models:
Gross rent model: The landlord pays 100 percent of operating expenses from gross rent paid by the tenants.
Triple net rent model: The tenants pay all operating expenses, including property taxes, insurance and repairs and maintenance, either directly or by pass-through reimbursement to the landlord.
The choice between the two models is ultimately about how to allocate certain economic risks between the landlord and tenants. With the gross rent model, the landlord bears all the risk that actual operating expenses may exceed projected amounts. Of course, the tenant conversely bears all the risk that operating expenses may be less than anticipated, resulting in a higher than expected net operating income for the landlord. In other words, with the gross rent model, landlords and tenants make a bet on levels of future building operating expenses.
The longer the potential lease term, the greater the difficulty in projecting property operating expenses accurately over the life of the lease. Macroeconomic factors, such as inflation, as well as property-specific concerns, can be hard to predict over longer periods. Therefore, as the term of the lease increases, so does the risk under the gross rent model. That risk can be reduced or eliminated with the triple net model, under which all operating expenses are shifted to the tenants — although those expenses are sometimes subject to negotiated limitations.
Of course, triple net leases present their own kinds of risk to both parties. For example, a triple net lease under which the landlord performs all building maintenance and repair work at the expense of tenants represents a kind of cost-plus contract. Accordingly, tenants bear the risk that landlords will not work as hard as they should to control the building’s operating expenses because those are passed through to the tenants.
Landlords will counter that argument by pointing out that they have market incentives to minimize building costs, because a building that is expensive to operate is less attractive to potential tenants under triple net leases. However, those market incentives may not provide sufficient comfort to tenants that their landlord will be adequately incentivized to control costs over the entire term of the lease. Tenants may therefore seek to hedge this risk further by requesting caps or limits on operating expense pass-throughs, particularly for operating expenses that can be controlled (i.e., expenses other than taxes, utilities and, sometimes, insurance).
With multitenant buildings, the landlord typically performs building maintenance and repairs and collects a pass-through common area maintenance charge from the tenants, because it is impractical to have multiple tenants directly performing building repairs.
In contrast, with a single tenant building, a triple net lease may make the tenant responsible for directly performing building repairs and maintenance because the lone tenant uses 100 percent of the property. However, that situation presents another risk to landlords. Tenants who are directly responsible for building repairs may fail to perform necessary maintenance to reduce their occupancy costs, a choice that results in deferred maintenance problems at the end of their lease. In other words, tenants may try to reduce their effective rent by cutting corners on their maintenance and repair obligations. That effective rent reduction manifests itself in the form of reduced asset value for the landlord.
Landlords may address that risk by requiring tenants who are responsible for directly maintaining and repairing the leased property to carry preventive maintenance contracts with approved vendors for major building elements such as the HVAC system, elevators and roof. Landlords may also specify minimum acceptable maintenance standards for other aspects of the property, such as requiring parking lots to be repaved and restriped at specified intervals. Landlords can also address this concern by including provisions for robust return conditions in their leases. Those provisions typically require that tenants return the building in good condition and repair at the end of the lease term.
Of course, tenants often seek to limit their contractual obligations on return conditions, for example, through an ordinary wear-and-tear exception. Landlords must then be clear that any such ordinary wear-and-tear exceptions to the return-condition requirement will not eliminate the tenant’s obligation to keep up maintenance and repair throughout the term of the lease.
As with any real estate agreement, triple net leases have a variety of benefits and risks. Landlords must consider all of those factors when determining whether this model is best for their property and long-term plans.
Richard R. Spore III, member, Bass, Berry & Sims PLC, Memphis