User:Leases101/Draft of Commercial Real Estate Leases

--Leases101 (talk) 17:37, 30 October 2012 (UTC)

Commercial Real Estate Leases

Definition

The American Heritage Dictionary defines a lease as "A contract granting use or occupation of property during a specified period in exchange for a specified rent or other form of payment; The term or duration of such a contract." In commercial real estate, there are three basic types of tenant leases, which in turn have multiple variations. While each type of lease contains the basic components of term, rent to be paid, security deposits, definition of Premises, conditions of default, right of the parties, etc., the primary difference between them relates to which party pays for the various expenses of the premises and of the property/building to which the premises belongs, as well as which party has the responsibility to contract for the maintenance and services related to those expenses. Enforceability of these lease contracts is predicated on the following elements -

1. The names of the parties or a clear identification of the parties.
2. The term of the agreement, that is, how long the lease will run.
3. The precise description of the premises.
4. Signatures of the parties.

Types of Commercial Real Estates Leases

There are two contrasting types of commercial real estate leases, net and gross. In a true net lease a tenant is intended to assume all the burdens of ownership, while a true gross lease would have the tenant paying only rent and the landlord retains all other burdens of ownership. In practice however, the expenses can be allocated in a number of different ways.

INDUSTRIAL NET LEASE

There are three generic types of Industrial Net Leases each defining a differing framework as to who (i.e., the tenant or the property owner / landlord) has the responsibility for contracting for the maintenance and repair of the premises and/or property/building, as well as what the tenant is required to pay, in addition to rent, for the expenses of the property/building such as real estate taxes, insurance, maintenance, repairs, utilities, and other items.

Industrial Triple Net Lease

Under a Triple Net Lease (sometimes shortened to “Net-Net-Net” or “NNN”), the tenant is typically fully and solely responsible to contract directly with, and therefore pay all charges incurred under such contracts directly to, the maintenance, utility, and service providers (e.g., “vendors”) for a property/building. The landlord is not to incur any expenses, including property insurance and taxes, for the property/building, and there are, therefore, no property/building expenses or Common Area Maintenance / Operating Expense (“CAM/OE”) Escalations billed by the landlord to the tenant. At times, however, the landlord may choose to take over the responsibility to contract directly with, and pay all charges incurred under such contracts directly to, the maintenance, utility, and service providers (e.g., “vendors”) for a property/building so as to ensure that their investment (i.e., their property/building) is being adequately and correctly maintained, but they will then in turn bill the tenant in full for all expenses incurred.

Industrial Double Net Lease

Under a Double Net Lease (sometimes shortened to “Net-Net” or “NN”), the tenant is only responsible to pay for the property taxes and insurance, in addition to rent. Such payments could be directly to the tax assessor and insurance company, or in the form of a reimbursement to the landlord who would have initially paid the expenses. Because the tenant is not responsible to pay for the maintenance, repair, utilities, and other items related to the property/building, the landlord is responsible to contract directly with, and pay all charges incurred under such contracts directly to, the maintenance, utility, and service providers (e.g., “vendors”) for the property/building.

Industrial Single Net Lease

Under a Single Net Lease (sometimes shortened to “Net” or “N”), the tenant is responsible for paying the property taxes as well as the base rent. Such payments could be directly to the tax assessor, or in the form of a reimbursement to the landlord who would have initially paid the expenses. Because the tenant is not responsible to pay for the insurance, maintenance, repair, utilities, and other items related to the property/building, the landlord is responsible to contract directly with, and pay all charges incurred under such contracts directly to, the maintenance, utility, and service providers (e.g., “vendors”) for the property/building.

The terms above are not always consistently used. For example, any one of the three Net Lease versions above may leave the tenant responsible for directly contracting for its own utilities, or reimbursing the landlord for contracting the same. Therefore, the lease contract must be read in its entirety to properly distinguish the correct allocation of responsibilities.

GROSS LEASE

A true gross lease requires the landlord to pay all operating expenses from the gross rent it receives. There are variant hybrids of this methodology as discussed below, however the basic definition of a full-service gross lease is "A lease requiring the landlord to provide and pay for all maintenance, upkeep, repairs, janitorial services, waste removal, utilities, insurance, taxes, and other operating expenses for a property in return for a fixed periodic rent from the tenant."

Full Service Gross Lease

Under this type of lease, the landlord is fully and solely responsible to contract directly with, and pay all charges incurred under such contracts directly to, the maintenance, utility, and service providers (e.g., “vendors”) for a property/building without any subsequent charge to the tenant (i.e., CAM/OE Escalations). Under a true Full Service Gross Lease there are no operating expenses escalated (also referred to as “passed through”) by the landlord to the tenant since such costs are “included in” the tenant’s rent. Landlords, however, are now seldom using this type of lease, because these leases require the landlord to assume all of the risk of rising costs to operate and maintain the property/building.

Modified Gross Lease

Under this type of lease, the landlord contracts directly with and pays all of the vendors for the services they provide to the property/building, but they then pass those costs to (i.e., bill) the tenant for reimbursement of their share as stated in their lease. This billed reimbursement amount is separate from the Base Rent amount, and its calculation depends upon which version of Modified Gross Lease has been entered into: Base Year Lease, Expense Stop Lease, Stipulated Base Amount Lease, or Office Triple Net Lease.

Modified Gross – Base Year Lease

The intent and objective of a Base Year Lease is to confine the tenant’s operating expense obligation to the type of increases experienced by a fully occupied building over a base level of expenses established at the beginning of the lease term consisting of the same type of cost items. After the base year, the tenant is billed its pro rata share of the difference between the actual operating costs for that year and the base year operating costs. Unique to a Base Year lease is the ability to adjust each comparison year’s expenses to consist of the same (i.e., matching) type and quantity of expense component items as in the Base Year. In addition, when the Base Year Lease is coupled with a “Gross Up” provision, the intent is to have the tenant only pay for its share of (and therefore share in the risk of) any increases in the property’s/building’s expenses resulting from wage increases, contract increases, other cost-of-living type increases, etc., and not due to occupancy changes nor the addition of extra services. For example, if the Base Year’s expenses totaled $1 million and the following Comparison Year’s expenses rose because of inflationary, cost-of-living increases to $1.25 million, a tenant with a Base Year Lease would be responsible to pay for its percentage of the excess $250,000. From the tenant's perspective, this is the fairest method of calculting its operating expense obligation. Unlike the Expense Stop Lease method described below, in which calculations are performed on a dollar-per-rentable square foot basis and may not correlate at all to any actual expenses of the property/building, the Base Year Lease method utilizes actual expense information. The Base Year Lease methodology is not broken down to dollars-per-rentable square foot, a calculation method that frequently creates rounding errors detrimental to both parties.

For a particular calendar year’s expense escalations to be computed correctly under such “Base Year Concept”, the following tests are required:

• Equipment/service free maintenance warranties must be accounted for as if payments had actually been made. This must be complied with – any services or maintenance on any property/building equipment that were subject to a “free maintenance period warranty” (e.g., in the case of newly constructed building or the installation of new equipment, the property/building may not be not required to pay during the free maintenance period the normal maintenance costs that would typically have been incurred if the warranty didn’t exist) must have a compatible expense amount imputed into the expense escalations for all calendar years covered by the warranty period, including any Base Year or Comparison Year.

• Free Rent must be adjusted out. This must be complied with – in order to correctly compute escalatable “Management Fees” for any calendar year, all free rent or reduced rent given to tenants must be fully reversed, effectively resulting in the addition of the full amount of missing rent to the bottom line of “Revenues/Income”. When this is done, “Management Fees” will correctly and more accurately reflect what they would/should have been for a “fully occupied and fully built-out property/building”, and will not distort the escalations in either a Base Year (to the disadvantage of the tenant and to the advantage of the landlord) or a Comparison Year (to the advantage of the tenant and to the disadvantage of the landlord).

• Consistency in types and levels of services. This must be complied with – each expense account in the property’s/building’s year-end general ledger must also be reviewed in detail, item-by-item, to ascertain whether the same type and level of services had been provided to the property/building (and its tenants) during the subject Comparison Year as were provided in the tenant's “Base Year” (i.e., there must always be an “apples to apples” consistency). If there is a difference, “adjustments” such as the following are required to either the tenants’ Base Year amounts or to the subject Comparison Year’s expense amounts. Note that such adjustments are required and especially important to do following the sale of a property because new owners typically operate the property differently (e.g., different level of staffing, different insurance coverages, etc.), thus mandating multiple adjustments to whatever was contained in a tenant's Base Year.

Services must be consistent between periods. However those services are represented (whether monthly, quarterly, etc.), they must reflect the same period of expense in both the Base Year and the Comparison Year. If they do not, the Comparison Year should be adjusted. It is also common for the Base Year itself to be adjusted, if it is likely a changed service level will affect all remaining Comparison Years.

• If the scope of a particular service is added or increased in a Comparison Year that will continue forward for many years but it was not present in the Base Year, the Base Year Amount must be “adjusted” (i.e., increased) by an appropriate amount (this is the more correct and easier process than the only other correct alternative – that of having to instead continually exclude the particular expense in the escalation of the future Comparison Year expenses). This “Base Year Adjustment” will ensure that the tenant is not paying an unfair amount for a new/increased service expense item that was not included in their Base Year, and it will also ensure that the future cost increases of this new/increased service are treated the same as all the others are being treated so that the tenant fairly and equitably shares in future rate increases (as is the intent of the Base Year Concept).

• Likewise, if the scope of a particular service is deleted or reduced in a Comparison Year and that reduced service level will continue forward for many years but it was present at the originally higher level in the Base Year, the Base Year Amount must be “adjusted” (i.e., decreased here) by an appropriate amount (again, this is the more correct and easier process than the only other correct alternative – that of having to instead continually add an inflated amount of the particular deleted/reduced expense into the escalation of the future Comparison Year expenses). This, likewise, ensures that the tenant is paying its fair share of the costs of the property’s/building’s services and that the landlord is not having to absorb an unfair portion of the costs of the property’s/building’s services.

In short, this above-mentioned adjustment process is done simply to maintain equity and fairness for both parties in the “escalation of the property’s/building’s expenses” process, as was originally intended when both parties negotiated and executed this particular type of lease document. Additionally, landlords and their property managers are “ethically” required (per their moral responsibilities and their licensing requirements) to perform such adjustments so that neither party is over-paying for what it contractually agreed to pay.

Also fundamental to the fair application of the Base Year method is the Gross Up concept, also known as extrapolation. Under this provision, if the property’s/building’s occupancy is less than 95% (or whatever percentage the tenant’s lease stipulates), then all categories of operating expenses that are affected by changes in occupancy are to be adjusted to reflect such costs as if property’s/building’s occupancy were 95%. This will give the tenant the cost base of a “fully occupied” building and protect it from large increases in operating expenses due to increases in building occupancy, yet at the same time it ensures that the tenant and the landlord are each paying their fair share of the property’s/building’s overall expenses.

When applied to both the Base Year and all future Comparison Years, and correctly calculated, “grossing up” will ensure that the only increases in operating expenses chargeable to the tenant are those attributable to increases in wage rates, utility rates, contract rates and the like, but not occupancy. Expense categories that are typically grossed up include nightly janitorial cleaning (tenant-occupied areas only), utilities, management fees, and possibly such other costs as trash removal, lighting supplies, and elevator maintenance depending upon the circumstances. In addition, property taxes should be based upon a “fully assessed and built-out” property/building.

There are several methods of performing the “Gross Up”. Whichever method is used, it is important that a consistent application to the same categories of expenses be maintained throughout the tenant’s lease term and that a reality check is continually performed to determine if the methodology has a sound basis.

Modified Gross – Expense Stop Lease

Under the Expense Stop Lease, the tenant receives an offset against actual operating expenses, both of which are expressed in terms of “dollars-per-rentable square foot”. According to this method of calculation, actual expenses are figured on a per rentable square foot basis and then reduced or offset by the assigned Expense Stop amount, and the excess is then multiplied by the number of rentable square feet within the tenant’s premises to arrive at the tenant’s operating expense obligation.

For example, if actual expenses of a 420,000 rentable square foot building totaled $5 million, then the per rentable square foot equivalent would be $11.9047, or $11.91 rounded (i.e., $5 million divided by 420,000). If a 100,000 rentable square foot tenant had a $10.00 Expense Stop, then its operating expense obligation would total $191,000.00 (i.e., the $1.91 difference between the actual expense amount of $11.91 and the assigned Expense Stop of $10.00, multiplied by the 100,000 square foot size of the tenant’s premises).

This method is attractive from a landlord’s perspective but not so attractive from the tenant’s perspective because the assigned Expense Stop is often an arbitrary amount that may not be tied to actual expense levels experienced in the property/building. Since it is expressed in terms of dollars-per-rentable square foot, it can also result in rounding errors that often accrue to the benefit of the landlord. Unlike the Base Year Lease, once the Expense Stop amount has been designated, it is unlikely that it can be changed or adjusted to accommodate the addition of new escalatable services in later years.

It should be pointed out that this type of lease is becoming less frequently used because the Stop amounts and therefore the escalated expense amounts can be too easily manipulated to the detriment of the tenant.

Modified Gross – Stipulated Base Amount Lease

The Stipulated Base Amount Lease is a hybrid of the Base Year Lease and the Expense Stop Lease methods of calculating operating expenses. Like an Expense Stop, the Stipulated Base Amount is usually an arbitrary amount that may not be tied to actual conditions; furthermore, once agreed upon and written into the lease, it is usually not subject to change or adjustment. However, like a Base Year, it is expressed as a whole dollar amount and not broken down into dollars-per-rentable square foot.

As a example, assume that the Stipulated Base Amount assigned to a new lease is an arbitrary $750,000, although actual expenses for the year totaled $1.2 million. The tenant’s operating expense obligation will be based on its percentage share of the difference between property’s/building’s actual expenses and the Stipulated Base Amount. If new escalatable services are added to the property/building in later years, no adjustment of the Stipulated Base Amount can be made; rather, it remains fixed, regardless of changes in escalatable services, over the entire term of the lease. However, since the Stipulated Base Amount is not susceptible to rounding errors, it is preferred over an Expense Stop.

It should be pointed out that this type of lease is also becoming less frequently used because the Stipulated Base Amount and therefore the escalated expense amounts can be too easily manipulated to the detriment of the tenant.

Office Triple Net Lease

An Office Triple Net Lease, like an Industrial Triple Net Lease, offers the tenant no offset against operating expenses (i.e., essentially, its Base Amount is $0). Unlike an Industrial Triple Net Lease, however, services are contracted and expenses are incurred by the landlord, rather than by the tenant, and “passed through” (i.e., billed) to the tenant for reimbursement. Since there is no expense offset, tenants pay their percentage share of expenses on a dollar-for-dollar basis. Because this type of lease essentially transfers all risk of expense increases to the tenant, landlords in the office leasing market are now increasingly using it instead of the other types of leases.

External links

• example.com