Understanding Commercial Real Estate Leases

When you list a property to sell or to lease you need to understand the type of lease that you are dealing with. There are definite differences in leases at all levels and hence a lease must be read fully before proceeding.

Leases are the foundation of property performance. The best salespeople understand the leasing process and the high value that it brings to the future sale. A good lease can enhance a sale price when the time comes.

As mentioned, there are many different types of leases, but there are some rules and common basic elements which will allow you to understand the lease or the potential lease that you can apply to a property. It’s all about interpretation of the lease document and that means that you must read the document.

Professional Property Services

After many years of working in the industry, I have seen the best people set the foundations of success around the leasing process. This means that they have grounded themselves with investment skills and knowledge by leasing property for a few years. So let’s now look at how you can move down this path of skill development regards leasing.

The better you negotiate and the more fully that you interpret a lease, the more professional you are and you appear to the people that you work with or serve.

You can and should add strategic value in the client in every lease that you negotiate. A lease is not just a document to allow a tenant to occupy premises; it is a tactical cash flow that can attract to or detract from the property.

The way that leases work for the property investor will solidly impact on the property and its performance for the duration of the lease. As you work with tenants or buyers for the property, the type of lease that applies will also impact on the negotiations. Let’s look at the main lease types and expand on some of the most relevant issues for you.

Gross Lease:

Under a gross lease the tenant pays a full rent that includes a component for outgoings and the building owner will pay all building operating costs (also known as outgoings). This means that the lease itself will have rent review provisions that escalate the gross rent only.

In a lease of this type the landlord needs to know that they can maintain the building outgoings to predictable levels over the lease term as the landlord holds all the risk of paying the outgoings. The levels of rent review escalations in the lease must be expected to cover or exceed the escalations in the level of outgoings over future years otherwise the landlord will loose money.

Gross leases are common in retail and office property. Your choice in using this rent and lease type should be balanced against the predicted levels of outgoings costs and future changes for the subject property.

Obviously an older building will have steady escalations in outgoings above that of a building that is younger. As a building ages and deteriorates, the gross lease method becomes less attractive and more risky for the landlord.

Semi Gross Lease:

In this type of lease the landlord is initially setting a gross rent which is paid by the tenant and is reviewed over the term of the lease, however the landlord also gets paid some regular money for outgoings that increase under a specific calculation. This is how it is done:

The landlord specifically recovers the escalation in outgoings above a nominated outgoings base year. This base year is selected at the start of the lease and is usually the last reconciled outgoings year prior to lease commencement, which is usually the previous financial year to the start of the lease (because it is fully reconciled and known as a set value).

As the new semi gross lease proceeds through its term, the tenant has to pay the escalation of the outgoings above the nominated base year. For example, if in a lease the base year for outgoings purposes was set as the financial year 08/09 and the known level of outgoings for that year was $85m2 pa, then in the financial year 09/10 when the outgoings escalate to $97m2, the tenant will have to pay outgoings of $12m2pa. As the lease ages and in the financial year 12/13, the outgoings could be $108m2, and in that case the tenant will need to pay $23m2.

In this type of lease the base year is set and the outgoings ‘gap’ will likely increase significantly as the lease gets older. This type of lease is good for the landlord with younger properties, in that it protects the landlord against the escalation of the outgoings above the base year yet still allowing the landlord to use a gross rent as the foundation for rent charge and collection.

It is common in this type of lease for the base year of outgoings to be updated at the time of any market rent review during the lease. Market reviews in this type of lease would be undertaken if the lease was lengthy (over 3 years) and so the market rent review would occur say each 3 or 4 years.

It is not necessary to do a market rent review at any particular time in a lease as the matter is negotiable at lease commencement, however be aware of the fact of re-setting the base for outgoings and the impact it will have on the landlord.

As a further interpretation of this type of lease you should look at the type of outgoings that are recovered in the calculation. It is not unusual for ‘lease savvy tenants’ such as the government or large corporations to nominate the type of outgoings to which the base year escalations will apply.

Naturally it is better for the landlord to recover the escalation in all outgoings in a building above the base year, however the government and corporate tenants are well known for limiting the calculation to rates and taxes escalations.

Clearly a lease is a product of a negotiation, but you need to understand what can be done and then get the best lease deal possible for your client.

Net leases:

The term net lease is firstly generic; hence you should be aware that there are 3 types of net leases within the category. So let’s look at them.

Net lease: In this lease the tenant pays some or all of the rates and taxes for the property or premises.

Net-Net lease: In this lease the tenant pays the rates and taxes as nominated in the ‘net lease’ method but they then also pay for insurance premiums for the property and premises.

Net-Net-Net lease: In this lease the tenant will pay for the rates and taxes, the insurance of the premises, and they will then also pay for repair and maintenance costs associated with the premises.

So what lease type is the best for the landlord? In most cases the Net-Net-Net Lease is the way to go, however it is a matter of if the tenant will accept and sign that type of lease.

As a point of negotiation it would be wise in any Net Lease, or a Net-Net Lease to have a higher start rent for the landlord and better rent review provisions that offset the lesser outgoings recovery for the landlord.

Net-Net-Net leases are common on properties that are fully occupied by one tenant. This is method of lease structure is widespread in industrial property and office property.

Percentage lease:

This type of lease is more commonly seen in retail property as the calculation of rent is linked to the trading figures for the tenant. In most leases of this type the tenant firstly pays a fixed base rent that is geared to some rent review method, and then the tenant also pays additional rent that is calculated from their turnover or sales. As the tenant improves its trading, then the rent escalates.

An essential part of this lease structure is to obligate the tenant to give you accurate and regular audited turnover figures. The lease has to support and enforce the audit process for the landlord. Monthly turnover figures are the best way to go in this, with the tenant providing the audited figures to the landlord by say the 7th of the next month. The landlord then charges the turnover rent to the tenant based on the audited figures.

This type of lease is also seen in new shopping centres as new tenants stabilize levels of custom and sales, in supermarkets for the same reasons, and in hotels or motels. The basic strategy with turnover rent is to give the landlord some cash flow from the establishment of a base rent from the start of the lease, and then to collect additional rent as the property and the tenancy becomes more successful in generating sales and customers.

Spell it out

In all leases, the recovery of rent and outgoings must be clearly set out to avoid debate and disagreement with the tenant. As you can now see, the selection of the lease type that you are to use on a property will significantly impact on the future for the landlord. It will also impact on any sales situation.

It pays to know what is going on in the market regards lease and rent types so that you do lease deals that are similar to or better than the rest of the market. The right lease structure, document, and rent will help sell properties at better prices.