Types of Commercial Real Estate Leases

Commercial real estate investing heavily relies on understanding the different types of commercial leases. These leases, along with the varying responsibilities they place on tenants and landlords, are pivotal in assessing a property’s value.

What Is a Commercial Real Estate Lease?

A commercial real estate lease is an agreement between a property owner and a tenant. The terms of these leases vary significantly, but they generally fall into two categories: gross leases and net leases. In gross leases, the landlord handles operating expenses. In contrast, net leases require the tenant to cover these costs. Residential properties like multifamily units often have gross leases, while commercial spaces are more likely to have net leases. For example, a tenant in a residential building may pay utilities but not property taxes or common area maintenance, which is a typical responsibility for commercial tenants. Moreover, tenants in residential buildings usually aren’t liable for the building’s overall insurance or major repairs.

Commercial leases also encompass terms for lease termination and penalties for early exit.

5 Types of Commercial Real Estate Leases

Now that you have a basic understanding of commercial real estate leases, let’s delve into the five types of commercial real estate leases commonly encountered in property investments.

1) Gross Lease/Full Service Lease

 Under a gross lease, the tenant’s rent covers all operating expenses, including property taxes, utilities, and maintenance. The landlord uses the rent to offset these costs, leading to a generally higher base rent but no additional costs for the tenant. This lease type, preferred by tenants for its simplicity and fixed cost, is prevalent in industrial, retail, and office freestanding properties.

To account for fluctuating expenses, landlords may incorporate “escalation clauses” in the lease. These clauses cover increases in insurance or taxes and can also allow landlords to adjust the rent temporarily based on variable costs, like increased electricity usage during summer months.

2) Net Lease

The net lease represents a flexible option within the types of commercial real estate leases. This lease typically has a lower base rent compared to a gross lease, but includes additional responsibilities for the tenant, such as property taxes, insurance, and common area maintenance (CAM). There are four primary variations of net leases:

• Single Net Lease: In this format, tenants pay both the rent and a portion of the property tax, as negotiated with the landlord. The landlord covers building expenses, while the tenant is responsible for utilities and other services.
• Double Net Lease: Extending the single net lease, tenants also cover a part of the property insurance along with the property tax. Maintenance of common areas falls under the landlord’s responsibilities, but utilities and garbage services are the tenant’s responsibility.
• Triple Net Lease: A popular choice among types of commercial real estate leases, the triple net lease includes property taxes, insurance, and CAM costs. Tenants may pay some or all of these costs on top of their base rent. This structure is typically more favorable to landlords, but tenants benefit from the ability to review operating expenses, with any savings reverting to them.
• Absolute Triple Net Lease: An intensified version of the triple net lease, where the tenant assumes all costs, effectively taking on the full responsibility of the building. This lease is akin to owning a building without the actual purchase, but it comes with the risk of being solely responsible in the event of a disaster. It’s the least common among commercial real estate leases.

3) Modified Gross Lease/Modified Net Lease

As the third major type of commercial real estate lease, the modified gross (or modified net) lease offers a compromise for both tenants and landlords. It allows more flexibility in negotiating operating expenses. The base rent is set according to mutually agreed terms, like in a gross lease, but the lease rate remains constant regardless of fluctuating costs.

4) Variable Lease

• Index Lease: This lease links the rent to an index, typically the Consumer Price Index, though it can also correlate with local rental market trends. For instance, a tenant in a major city might have their rent annually adjusted based on the average office rent in that area.
• Graduated Lease: Here, rent escalates according to a preset schedule. A tenant might agree to an annual rent increase of 3% every August. Seasonal variations are also common, especially for businesses in tourist areas, where rent might be higher during peak seasons and lower in off-peak periods.

 Within the types of commercial real estate leases, a variable lease stands out for its adaptability, adjusting based on specific conditions. There are two main subtypes: index leases and graduated leases.

5) Percentage Lease 

The percentage lease is another significant type of commercial real estate lease. Under this arrangement, the tenant pays a portion of their gross income to the landlord, in addition to the base rent and other expenses. The percentage, often around 7%, is negotiable and varies between leases. The method for calculating this percentage isn’t always straightforward and can differ widely.

Percentage leases are frequently used in malls, shopping centers, and are popular with restaurants and retail stores. They are particularly suitable for start-up businesses with uncertain sales projections. In such cases, the base rent is kept low, providing an opportunity for the landlord to earn more if the business thrives.

Navigating the Landscape of Commercial Real Estate Leases

In the realm of commercial real estate, understanding the various types of leases is fundamental to making informed decisions, whether you’re a landlord, tenant, or investor. From the straightforward structure of a gross lease to the more complex arrangements of net leases, each type offers unique benefits and responsibilities. The flexibility of variable leases, such as index and graduated leases, caters to dynamic market conditions and specific tenant needs. Meanwhile, percentage leases align the interests of landlords and tenants, particularly in retail settings, by linking rent to business performance.

As you embark on your commercial real estate journey, remember that the choice of lease type can significantly impact the financial and operational aspects of your investment or business venture. It’s essential to consider not just the immediate costs, but also the long-term implications of these leasing agreements. Seeking professional advice and conducting thorough market research will guide you towards the lease option that best suits your objectives and circumstances.

Ultimately, the types of commercial real estate leases serve as a critical tool in your arsenal, enabling you to navigate the commercial real estate market with confidence and strategic insight.