Gross or Net and who pays for what?

A PRIME CONSIDERATION, for landlords and tenants alike, when negotiating the terms and conditions of a lease is the allocation of the financial responsibility to maintain, repair and oversee the daily operations of the property.

In general those costs that are directly related to ownership fall to the landlord and the costs attributable to the building’s operations are passed through to the tenant. These “pass-through” costs, depending on the type of lease negotiated, can be either included in the base rent paid to the landlord (known as a Gross lease) or the landlord may charge these expenses on a pro rated basis directly to the tenant. This latter type lease is commonly called a Net lease.

A Gross lease provides a landlord with a fixed amount of monthly rent out of which he must extract funds to pay for the building’s taxes, insurance and operating costs. In this type lease the landlord will typically negotiate annual or periodic base rent escalations (usually pegged to a standard index such as the Consumer Price Index (CPI), a fixed percentage or a combination of both) to help cover the probable annual cost increases in operating the property.

In a Net lease the tenant is responsible to pay the landlord a base rent that is “net of” (excludes) the building’s operating expenses. In addition to this base rent the property’s operating costs, either all or a portion, are also paid to the landlord as “additional rent” - calculated on a pro rated (pro-rata) basis - a number that is derived by dividing the tenant’s space square footage by the total square footage of the entire building. (Example: the tenant occupies 10,000 SF; the building is 50,000 SF; hence the pro-rata share would be 10,000 SF/50,000 SF or 20%).

It is important to note, however, that all Net leases are not the same and the definitions of what constitutes a Net (N), double Net (NN), triple Net (NNN) or even “pure Net” varies from state to state and region to region and hence cannot be used to categorize what is included in the “additional rent” charged to the tenant. The only way for a tenant (or landlord) to know what expense items can and cannot be charged to the tenant is to understand what was negotiated and included in the language of the lease contract.

These ‘additional rent” or “pass-through” charges are typically broken down into three basic categories - a) property taxes, b) property insurance and c) common area maintenance charges or CAM charges. These latter CAM charges are an amalgam of various costs associated with operating the building and usually include common area utilities, janitorial, lawn and landscape services, snow and trash removal and in some larger facilities in-house management and security services.

Operating Costs vs Capital Improvements

One would think that defining what is or is not an expense attributable to the operation of the building - hence allowable as a “pass-through” item to be paid by the tenant would be a rather cut and dry issue - not so. Landlords quite often will argue that any capital improvement, no matter how large or small the cost (e.g. the replacement of the HVAC, lighting or even the windows/doors with new more energy efficient systems or products), that results in a reduction of the daily operating expenses in the building should be considered an expense shared by the tenants - who derive a benefit from the improvement. Conversely, tenants will press the issue that all such capital improvements are directly beneficial to the landlord who “recovers” those capital costs through the property’s increased value and marketability to better quality tenants at higher rental rates.

As with any debate surrounding the variety of Net leases, here too there are no hard and fast rules that can be universally applied to define the differences of opinion. Savvy tenants and landlords alike can however defend their arguments by treating the improvement as it would be defined under our tax laws. If the law states that the improvement must be capitalized and amortized over a period of time then it should be classified as a “capital improvement” and therefore not a cost to be borne by the tenant. If the landlord however, is allowed by law to deduct the improvement cost during the year in which it is incurred then it can be considered an operating expense and allowable as a “pass-through” to the tenant as an additional rent charge - a part of the “Nets”.

In the final analysis the results of who pays for what charges will depend in large measure on three points; a) the specifics of the lease document language that was originally negotiated; b) the bargaining power of each party - a landlord may make concessions if the tenant is a quality client he wants to keep or the tenant may compromise if they want to remain in a well located and run property and c) the general strength or weakness in the commercial real estate market (supply and demand) - especially if the lease is coming up for renewal.

H. Pearce Commercial Real Estate specializes in Connecticut’s central, south-central, and Shoreline markets, with offices in North Haven and Rocky Hill. Commercial property offerings can be found in color on the web at www.HPearceCommercial.com.