Lease Structure Deep Dive: The Triple Net Lease
In commercial real estate, the stability of cash flows received from a property can play a big part in determining the value of a property. Revenue ultimately comes from leases and understanding that revenue stream is extremely important. Read more about revenue and leases from this recent article. One common structure of commercial real estate leases is the triple net lease. The rest of this article will explain what a triple net lease is, describe the specifics in more detail, and then cover some advantages and disadvantages for both owners and tenants.
Types of Leases
Before we get into the specifics of the triple net lease, we need to define the different types of leases that are common in the industry. Then we can differentiate a triple-net lease from other types of leases.
All tenants pay a base rent. Much like the rent a tenant pays on an apartment per month, the base rent is a set amount a tenant will pay each month/year to the landlord. There are several different types of leases that the analyst should be aware of, ranging from a “gross lease” to a “triple net lease” (also known as a “NNN lease”).
- Gross lease – the tenant pays a base amount of rent and the landlord pays all expenses associated with operating the property
- Percentage rent – the tenant pays a certain amount of their sales in addition to base rent (mostly with retail properties)
- Single net lease – the tenant pays a base rent plus a pro-rata share of the property tax on the property, along with utilities and janitorial services associated with their specific space
- Double net lease – the tenant pays a base rent plus a pro-rata share of the property tax and insurance on the property, along with the utilities and janitorial services associated with their specific space
- Triple net lease – the tenant pays a base rent plus a pro-rata share of the property tax, insurance, and other common operating expenses on the property
A simplistic way of explaining this is that under a gross lease a tenant pays a higher base rent, but no additional expenses. Under a triple net lease, a tenant pays a lower base rent, but is also responsible for paying operational expenses on top of the base rent. There are some who believe triple net leases have an overall lower cost to the tenant due to increased risk on the tenant and others who believe market forces tend to even out the total cost of both triple net and gross leases. While it’s often difficult to determine the equality of the two structures, there shouldn’t be a significant difference in the overall cost between the two.
Characteristics of a triple-net lease
Theoretically, any lease can be a triple net lease. In practice, though, it’s much more common for commercial tenants than for residential. Triple net leases can also exist in both multi-tenant properties and single-tenant properties, with some differences in the two. For all triple net leases, tenants pay other expenses that the property incurs above the base rent for the space, such as property taxes, insurance, and any maintenance on the property. It’s important to note that the maintenance can cover both ordinary maintenance and other maintenance, such as storm damage or other major damages.
In a multi-tenant property, a tenant under a triple net lease would typically pay a pro-rata share of the properties tax, insurance, and maintenance expenses, in addition to any contractual obligations for reimbursement of common area expenses and rent. For a single-tenant property, the tenant covers all the expenses in addition to base rent on their own.
There are two major considerations when determining what type of lease is right for a given situation. The first is risk and the second is management. Triple net leases shift both risk and the management to fall more heavily on the tenant. As a result, rental rates for triple net leases are often lower than that for gross leases. We’ll discuss how these considerations shift in the next section.
Advantages and disadvantages
Just like anything else, there are trade-offs that owners and tenants will experience with a triple net lease at one end of the spectrum versus a gross lease on the other end of the spectrum (reminder: in a gross lease the tenant pays a single amount in rent and the owner pays all expenses out of that amount).
Below we’ll cover some of the advantages and disadvantages from both the owner and the tenant perspective. Each of these should be considered when determining which lease structure is best for your respective situations.
As discussed above, a triple net lease shifts the risk of expenses and the burden of management to the tenant in exchange for a lower base rental rate. So an owner looking for stability of cash flow and passive management would probably be more attracted to a triple net lease structure than a gross lease structure, all else being equal.
Because tenants are responsible for the operation and maintenance of the property under a triple net lease, owners have very little responsibility. For example, if a window breaks or a roof needs to be repaired, the owner doesn’t have to spend time getting contractors, estimates, etc. The tenant has the responsibility to operate the property on a day-to-day basis and also incurs the costs of maintaining the property.
In terms of revenue stability, owners of a property under a triple net lease have much higher certainty of cash flow than they would under a gross lease. The reason for this is that under a gross lease an owner would collect a base rental amount and then be responsible for all expenses the property incurs. These expenses could be variable over time (higher electric expenses during summer and winter months) and the owner could face major maintenance or damage expenses that would cause their cash flow to fluctuate. Under a triple net lease, however, all of the additional costs (above base rent) to operate and maintain the property are the obligation of the tenant and will not affect the owners cash flow.
This hands-off approach doesn’t come without disadvantages though. If a tenant fails to keep the property properly maintained or doesn’t have the funds to repair major damages, the owner could incur the costs of bringing the property back up to a marketable condition. There are usually contractual stipulations as to the property condition that must be maintained by the tenant, but in the case of a tenant going out of business or otherwise becoming insolvent, the owner may have to take financial responsibility.
Tenants have the reciprocal advantages/disadvantages of owners. In addition to running whatever business they’re in, the shifting of expenses and the burden of property management now fall on the tenant to deal with.
The responsibility of tenants to cover expenses under a triple net lease have two major advantages: transparency and control. Transparency is due to the fact that the tenant sees every expense that is incurred by the property and knows exactly where their money is going. Because of that transparency, tenants have the control to ensure the property is operating as efficiently as possible. Any savings the tenant can achieve due to better expense or property management is passed on to the tenant rather than the owner.
As discussed above in the “Advantages” section for owners, there could be wide variations in expenses from month-to-month or year, especially in the case of major repairs or damage to the property. These fluctuations could make it difficult for businesses to budget for the future.
As mentioned, each lease structure has its own benefits and detriments. Each owner and tenant should thoroughly understand the specific characteristics of the property and the lease and then carefully decide which structure is best for them. This “best” decision requires balancing the individual goals of the owner (more or less hands-on, importance of cash flow stability, etc.) with the risks the tenant is willing to incur (responsibility for management and fluctuating expenses).