'NNN' might be right, but so could a 'gross lease' or 'full service'
I’ve been approached by several business owners over the past several weeks looking for an interpretation of their current lease document and trying to determine what financial exposure they have over and above what the basic lease rate requires.
I thought it would be helpful for everyone involved in looking for commercial space to understand basic lease forms and to be aware of some specific, commonly misunderstood clauses included in most lease documents. This will provide an understanding of what to look for before you sign on the dotted line and potentially save you money and unnecessary financial stress in the future.
Let’s start with reviewing the standard basic lease forms that are typically used in commercial leasing:
A triple-net, or NNN, lease
Gross lease or modified gross lease
Full-service leaseThe NNN lease document
This agreement typically obligates the tenant to pay a pro-rata share of all the operating expenses over and above the initial rental rate. These expenses fall into three categories: property taxes, insurance costs and common-area expenses (CAMs). A NNN lease document is typically used in retail leases and in retail centers, but I’ve found more and more landlords suggesting this lease form for both office and industrial products.
One of the biggest pitfalls to be aware of in obligating yourself to a NNN lease is the exposure to a new tax assessment should the property sell while you are the tenant. Proposition 13 requires all properties sold in California to be re-assessed at the new sales price. This can be significant if the property has been owned for a long time or if there is a significant increase in the price over what the current owner paid.
Another area of common ambiguity is the replacement/repair costs associated with the HVAC system (heating, ventilation and air conditioning). For instance, a lease clause may obligate the tenant to repair the existing unit and require the landlord to replace the unit should the entire unit fail. However, what if a compressor needs to be replaced? This can be a significant expense and could be interpreted as a tenant obligation because it’s not a complete replacement of the unit, much like replacing an engine in an automobile.
Gross lease or modified gross lease
This lease form typically has the landlord absorbing the expenses for property taxes and insurance but obligates the tenant to pay for common-area maintenance expenses and their own utilities. There are numerous hybrids associated with this lease form: gross lease, modified gross lease, standard industrial gross lease, etc. The key here is to identify what specific expenses the tenant is actually responsible for in writing.
One commonly misunderstood lease clause is the impact of base-year expenses. Many commercial leases will have a factor in the lease that allows for lease rate increases to the tenant for expense increases to the landlord over base-year expense.
As a tenant, it is imperative to actually review the landlord’s budget before you sign the lease and make the necessary anticipated adjustments to your own budget. One suggestion here would be to lock in your current expense exposure for a minimum of 12 months or to request that the base year be projected to a year in advance. This is important if your lease begins in the last six months of the year. Who wants a rent increase three months after the lease begins? I’ve seen it happen, and it’s important to protect yourself.