Gross Lease vs. Net Lease -- What Investors Need to Know

Commercial properties can be leased in different ways, and this can have an effect on the financial risk you take on. Read on to find out what you need to know.

Large Office Building

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Large commercial office building

When you make a real estate investment, do you pay attention to the lease structure? If not, you should. There are two main types of real estate leases, gross and net, and their very different characteristics can have big implications for you as an investor.

With that in mind, here’s a rundown of the key differences between gross leases and net leases, and what real estate investors need to know about each.

A gross lease is what most Americans are familiar with

When most Americans think of real estate leases, they’re thinking about a gross lease. This is the type of lease that is used for residential real estate leases like those of apartments, and it is also used for certain types of commercial properties -- especially consumer-facing types like self-storage and hotels.

In simple terms, a gross lease simply requires a tenant to pay an agreed-upon amount of rent at regular intervals in exchange for the use of a property. For example, if an apartment rents for $1,000 per month, or a hotel room charges $119 per night, that’s all the renter has to pay to the landlord (although with properties like hotels and self-storage units, there’s likely to be a sales tax involved).

To take it a bit further, a gross lease leaves most of the expenses of owning and operating the building as the landlord’s responsibility. Specifically, gross leases always require the property owner to pay property taxes, building insurance, and routine maintenance and repair expenses.

I mentioned that gross leases are the most common lease type among consumer-facing types of real estate, but they are often used for other property types, for which buildings are shared among multiple tenants.

A gross lease is often referred to as a full-service lease in commercial applications. For example, office buildings often use full-service leases, because it would be impractical to charge tenants a proportional share of expenses like building maintenance.

A net lease shifts more expenses to the tenant

On the other hand, a net lease means that the tenant is responsible for rent and certain other expenses of owning, operating, and/or maintaining the property.

There are four main types of net leases, and the main differences among them are determined by which specific expenses are shifted to tenants:

  • Single net leases require tenants to pay the building’s property taxes in addition to the agreed-upon rent.
  • Double net leases add the building’s insurance expense to the tenant’s responsibility, as well as property taxes.
  • Triple net leases require tenants to pay property taxes, building insurance, and most maintenance expenses. These are by far the most common type of net lease in practice.
  • Absolute net leases pass virtually every possible property expense to the tenant, including major repairs, which are generally not included in triple net leases. Major structural issues are an example of something a landlord may still be responsible for under the terms of a triple net lease, but an absolute net lease would make it the tenant’s responsibility.

As I mentioned, triple net leases are the most common type of net lease -- so much so that the term "net lease" is often used to refer to a triple net lease. Double net leases aren’t quite as common, but still make up a significant portion of the net lease market. Single and absolute net leases aren’t often seen in practice, unless there are special circumstances that make them a natural best option.

Finally, even though net leases shift certain expenses to the tenant, they are generally paid through the landlord to ensure that things like property taxes don’t fall into delinquency. This is the same idea as your mortgage servicer requiring you to pay taxes and insurance as part of your monthly payment -- this way, they don’t have to track you down when the bills come.

Net leases are most common among commercial properties that are occupied by a single tenant, although they aren’t unheard of in situations where there are a few tenants in a building. Warehouses, freestanding retail properties, entertainment properties, and medical buildings are examples of property types that generally use net leases.

Advantages of gross leases

For a landlord, a gross lease generally represents the highest overall profit potential. Because the landlord is taking all the risk in terms of variable expenses, they tend to charge tenants more than a comparable net leasing arrangement would, even when factoring in taxes, insurance, and maintenance. Plus, in multi-tenant properties, gross leases are by far the simpler of the two arrangements.

For tenants, gross leases keep the rental process simple. The tenant simply writes one check for a predetermined amount. The tenant doesn’t have to do much maintenance work on the property, and if a repair is needed, all they have to do is alert the landlord.

Advantages of net leases

Net leases have advantages for both the landlord and the tenant.

From the landlord’s perspective, the most obvious advantage is that it shifts the variable costs of property ownership to the tenants. For example, I own a residential rental property, and if the property taxes increase by $1,000 next year, I’ll have to cover that cost. On the other hand, if I were leasing a retail property to a tenant on a net lease basis, I wouldn’t have to pay an extra dime. In simple terms, a net lease reduces a landlord’s risk, and helps create predictable rental income.

From the tenant’s perspective, a net lease typically offers a lower rental rate than that of a comparable gross lease. This is true even when factoring in the taxes and other added expenses -- because the tenant is accepting a higher risk level, the trade-off is that the landlord accepts a slightly lower income in exchange for consistency.

What’s more, not only is rent often cheaper than it otherwise would be, but net leases typically come with long initial terms (usually 10 years or more) with annual rent increases built in. However, the rent in a net lease tends to increase at a slower pace than the overall rental market. For example, market rent has historically risen by about 3% per year on average, and a typical rent "escalator" in a net lease is commonly 1–2% annually.

Lease structure is a major component of real estate analysis

If you’re analyzing real estate investments, knowledge of lease structures is a key component of assessing risk and economic sensitivity. For example, when I’m looking at a real estate investment trust (REIT) that owns freestanding retail properties, I know that the tenants are locked in for long periods of time, and that the company’s rental income stream should be extremely predictable. On the other hand, if a REIT owns self-storage properties (gross leased), tenants can come and go easily, and rising tax or insurance expenses could significantly hurt profits.

Of course, this is just one piece of the analytical puzzle, but it’s an important one, and one that’s frequently overlooked by investors.

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