What is a Modified Gross Lease?

What is the difference between a triple net lease and a modified gross lease?

What is a Modified Gross Lease?

A modified gross lease can be best understood through comparison, as it represents a middle ground between a full-service gross lease and a triple net (NNN) lease.

Before signing an industrial, retail, or commercial lease agreement, it’s crucial to learn about complex lease terminology to understand and budget for the price you will be paying per square foot.

Leases are often gross, modified gross, or triple net, representing three methods in how costs are divided between tenant and property owner. The kind of lease is often determined by the type of building or the property’s location. It’s crucial to know the difference between these leases before signing a contract. 

Gross Lease

Gross is a quite common square footage phrase and is popular with U.S. residential and class “A” office leases. In a gross lease, the property owner is financially responsible for the building and pays all the expenses associated with its operation (including taxes, insurance, and maintenance). To help recoup most of these costs, the property owner builds them into the monthly rent amount that a tenant pays for the use of the building. The property owner pays all of the expenses associated with the building, in exchange for a monthly, all-inclusive rent sum. These leases usually include an escalation clause on the gross or net rent amount.

Triple Net Lease

Triple net leases are typically used for larger and more complex structures, i.e., a strip center or a chain store such as 7-11 or McDonald’s. These leases are extremely popular with large single tenants’ properties such as restaurant chains and are popular because they provide a desirable and profitable investment. These properties tend to have more complicated leases as the tenant is responsible for rent along with all operating costs, which include three (net-net-net) types of expenses: real estate taxes, insurance, and maintenance and/or utilities, contingent on the category of building and unit the tenant is leasing. Thus, the tenant absorbs all of the operating expenses and property costs as part of their own business expenses in addition to monthly rent payments, including:

  • Property Taxes
  • Insurance Premiums
  • Maintenance, Repairs, and Upkeep

Modified Gross Lease

A modified gross lease falls somewhere in between the terms of a gross lease and a triple net lease. In a modified gross lease, the tenant is responsible for some (but not all) of the property’s operating expenses, but they still pay them as part of one monthly rent amount.

For example, in a modified gross lease, a tenant may be responsible for all the upkeep and maintenance costs and a certain portion of insurance premiums. At the same time, the property owner writes checks for taxes and remaining insurance costs. However, many expenses may be negotiated between landlords and tenants in modified gross leases, including property taxes, property insurance, common area maintenance (CAM), utilities, and structural repairs. Modified gross leases are commonly in place on office buildings or other stand-alone buildings.

Gross leases do not require renters to cover any expenses, taxes, or insurance associated with the building, as these will all fall under the responsibility of the property owner or investor. While you can certainly offset all of the building costs, taxes, and insurance by building them into the monthly rental cost, you’ll need to be prepared to handle any expenses that arise on the property, which can reduce your profit margin if large costs come up unexpectedly.

Negotiating a Modified Gross Lease

In a basic modified gross lease agreement, the tenant may consent to pay his or her pro-rata portion of all operating expenses. In a simple example, a tenant leases a 10,000 square-foot space in a 100,000 square-foot building. As a result, the tenant’s pro-rate share of expenses is 10%. If the building’s total expenses are $1 million, the tenant’s 10% share would equal $100,000. The tenant may also owe $1 per square foot towards structural repairs.

However, there are much more complex lease provisions for expenses called an expense stop on individual expenses or groups of costs. In these arrangements, the property owner is responsible for an individual expense or group of expenses (i.e., common area maintenance expenses) up to a specific amount or the stop amount. If the expense stop is $2 per square foot, the landlord takes care of these charges up to $2 per square foot. The tenant pays anything over that amount. 

There are many examples of modified gross lease agreements between property owners and the tenant called recovery structures. Reimbursement agreements can differ quite a bit. Recovery structures can consist of other terms or rules such as caps, floors, administration fees, obligations for ancillary tenants to refund an expense after an anchor tenant pays a flat fee first, and how building areas are measured for reimbursement purposes.

Advantages of a Modified Gross Lease

Modified gross leases contain details and parameters that are unique to each deal. In general, there’s no set collection of financial responsibilities and how they’re divvied up between the tenant and the property owner. This flexibility can bring advantages for both property owners and tenants.

  • For property owners, a modified gross lease can be attractive because the investor can maintain control of important elements of their commercial investment property that they don’t want to entrust fully to the tenants while recouping some of the expenses through tenant rent.
  • For tenants, a modified gross lease is advantageous because they have a location for their business but don’t have to assume all the expenses and responsibilities of being a property owner.
  • With these leases, most tenants can audit lease expenses, and nearly all landlords must refund the over-collection of operating expenses if the lease is structured equitably and properly.

Drawbacks of a Modified Gross Lease

The terms of a modified gross lease can vary wildly from one deal to another; both property owners and tenants need to understand the intricacies and details of any modified gross lease they consider. While modified gross leases have tenant and investor benefits, there are also several drawbacks to consider on each side of the deal.

One of the main drawbacks of a modified gross lease for property owners is that they must assume some to most of the responsibilities (financial and otherwise) of being a landlord. A property with a modified gross lease in place will require more of an investor’s time and resources to manage. They will also have to assume more financial risk due to unknown or unexpected costs that come up when the property needs repairs or work. In contrast, a triple NNN provides the property owner a low-touch, low-risk investment with regular profits over the long term through rent payments and pass-through of taxes, insurance, and upkeep costs.

For tenants, a modified gross lease can have a few drawbacks as well. A tenant will have to share the responsibility of the building as dictated by the deal, which could expose them to financial vulnerabilities and losses to their businesses if they have to pay for unexpected costs. Additionally, the tenant will have less control over a number of aspects of the building that may impact their business in a modified gross lease. For example, if the property owner is responsible for all of the repairs, upgrades, and maintenance of the building. In that case, the tenant doesn’t have a say over how their place of business looks and functions, which may create some issues if they don’t agree with changes made by the investor.

While a gross lease can be attractive to renters, it can also present more layers of risk and uncertainty for commercial real estate owners and investors, including:

  • Short-term leases
  • Profits lost to building vacancies between tenants
  • Uninvested tenants
  • Unpredictable income streams
  • Unexpected tax increases or fees related to the property

Differences Between Triple Net Lease and Modified Gross Lease

The triple net lease has several advantages for property owners and tenants. Instead of the tenant spending valuable capital on real estate and construction costs, it can focus its investments on the core business. The tenant also maintains control over the upkeep and look of the property to their standards. For the landlord, the NNN lease allows them to concentrate on their primary business rather than property management expenses and issues. 

Another difference is the leases on a triple net property can typically be transferred. That allows the landlord to sell his or her interest in the property, even the property has a tenant with a lease in place. As the property owner, you will be able to move on with your investment strategy when it’s the right time for you and not have to worry about structuring a sale at the lease’s end. 

Finally, triple net leases can last up to 25 years or more. In a few cases, ground leases can last for up to 99 years in total. A longer lease term helps property owners because there’s less turnover and also fewer opportunities for a vacancy. Even though the leases tend to be long, they are typically structured with either flat rent or with a fixed increase in the lease payment to account for inflation. In fact, triple net leases often include a 3% rent increase included in the agreement. As a result, a property owner can anticipate some profit growth, even with a long-term lease term.

A modified gross lease is attractive to some small businesses because it requires the landlord to maintain the building. It also gives the tenant direct control over their expenses, such as electricity. For property owners, a modified gross lease lets them retain control over their property. This can ensure that the building is adequately looked after and avoid maintenance conflicts with careless tenants.

Disadvantages for Tenants and Landlords

For a tenant, a triple net lease has certain potential disadvantages. The tenant shoulders the possibility of property tax and insurance increases covering all building maintenance and may be liable for most personal injuries that occur on the property, such as a customer slipping and falling on the sidewalk.

Under a modified gross lease, the landlord might miscalculate his or her operating costs when setting the rental rate, which may lead to a tenant overpaying for specific costs. The tenant also runs the risk that the property owner does not maintain the property to the tenant’s standards, which could negatively impact the tenant’s business.

Sands Investment Group is knowledgeable in all types of triple net leases (including highly sought-after locations like Starbucks). We are the fastest-growing net lease investment company in the United States, with over 3,000 transactions in 48 states (worth $5.9 billion) since 2010, and we have the expertise to advise you on all the key factors you should be considering in your NNN investments. 

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