When you purchase an investment real estate property, you have to make many decisions. One important decision is whether you will charge a flat rate to tenants and cover all operating expenses yourself, or whether you will charge tenants a lower rent and bill them for expenses.
The first option is usually referred to as a full-service lease. It’s also called a gross lease. It means the landlord pays all expenses, including operating costs, maintenance, property insurance, property taxes, utilities, and management fees. The tenant only pays rent.
The second option is often referred to as a NNN lease, or a triple-net lease. The tenant pays rent and all other expenses.
Those sound pretty simple, right? But you can also set up a lease with any number of in-between options, which is sometimes called a modified gross lease. One special arrangement is called an expense stop. In that situation, you’ll offer a full-service lease that covers all expenses and tenant utilities up to the amount established as normal during the first year. For any future years, if expenses exceed the base year, the tenant will pay the difference.
No matter what arrangement you choose, you must make sure that your lease clearly defines each kind of expense and lists whose responsibility it is to pay, and what limits (if any) there are on those responsibilities. For example, how will you handle non-recurring expenses, or big capital expenditures like repaving the parking lot? Does the landlord charge a monthly fee that goes into a reserve fund, or is it pay-as-you-go?
In some markets, tenants expect a newer building to be offered as a NNN lease, while older buildings will be leased full-service. But the norms differ from market to market, so make sure you understand your market.
Your decision can have a big impact on your success as an investor. If you plan to sell your investment property, you should aim to negotiate all leases as NNN leases. Investors are much more interested in purchasing net lease buildings than gross or modified gross, because the cash flows — and thus the return on investment — are much more predictable with a NNN lease than a full-service lease.
To improve resale value and to mitigate your risks as a landlord, your best option is a NNN lease. But the downside of a NNN lease is that you have to do a lot of accounting and billing, and sometimes you’ll get pushback from tenants about the expenses you bill them for. That’s why it’s so important to define all of the possible expenses in the lease.
At Culmen Real Estate Services, our consultants can help you make this important decision.
We can help you figure out what your cost of operations are, and help you negotiate the lease language. We can help you anticipate unusual situations and we know what special clauses to include in your lease to protect you from unexpected operating costs.