What are the Types of Commercial Leases?
Real estate investors commonly need to rely on a commercial lease to create a legally binding contract with their clients. Understanding the types of leases available is a big part of ensuring the best long-term results.
Understanding Commercial Leases
A commercial lease may not seem like a complicated process and may seem to be much like a traditional residential lease. However, there are differences that can impact investor success and costs. Negotiating an agreement that meets the needs of the tenant and property owner is often the goal, but it can be a challenge when property owners do not know the extensive options and tools available to them in commercial real estate leases.
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What Are the Types of Commercial Real Estate Leases?
Several types of commercial real estate leases exist, each with different features and components, but all designed to create a legally binding agreement that fits the unique needs of any property. Consider these common options.
Perhaps the most commonly used commercial real estate lease, a gross lease, is a fixed fee paid for the space. The flat amount typically includes all agreed-upon costs, including rent itself, though the landlord also pays some utilities, insurance, and taxes. Tenants may pay some or all of the utility costs depending on the agreements made.
Two options exist here. If the property owner plans to cover any of the utilities, a modified gross lease is developed. If the tenant will pay none of these utilities, this is called a full-service lease.
Pros and Cons of Gross Lease
- Gross leases offer a straightforward relationship.
- They are a reliable source of income for tenants.
- Long-term leases may impact rental rate rises that could be obtained otherwise.
- Fixed service leases tend to be more expensive for tenants.
A net lease is an alternative option. In this situation, the renter pays the landlord a fixed rent and covers all additional costs, called incidentals. This is another commonly structured lease because it is more hands-off for property investors, requiring the tenant to manage the costs of the property.
Types of Net Leases
There are three types of commercial lease structures that fall under the umbrella of net lease. They are divided based on the number of categories the renter covers, with the three main categories including commercial real estate taxes, maintenance costs, and insurance costs.
- Single net leases: In this lease, the tenant is responsible for one expense category.
- Double net leases: The tenant is responsible for two of the expense categories.
- Triple net leases: The tenant is responsible for all three of the expense categories.
Pros and Cons of Net Leases
- Net leases make it clear that the tenant covers more of the costs of operating the business property.
- Net leases allow the owner to be more hands-off in their management of the property, not having to worry about costs for any specific area.
- In some markets, it may be difficult to find tenants willing to take on a triple-net lease.
- Net leases may not be ideal for property owners who want more management and oversight of the property’s use and condition.
Property owners may also wish to consider a percentage lease. This type of lease is unique in its structure. It has a fixed rental rate that is paid consistently. In addition to this, the tenant pays each property owner a percentage of the profits that they make using that property.
The benefit to the tenant is that by providing a percentage of profits, the fixed rate is lower, and there is less risk to the tenant in the long term.
Many of these leases are structured so that the percentage portion of the terms does not apply immediately but instead is applicable after a certain period of time elapses or when revenue for the business reaches a specific level, which is referred to as the breaking point. The owner of a competitive property has the incentive to maintain and upkeep it to encourage profit.
Pros and Cons of Percent Lease
- In tough markets where there is a lot of competition for business owners to establish a new company, this type of lease structure can make it less risky for the tenant, increasing the desirability to sign the lease.
- For property owners in high-value areas, having a profit margin enhances the lease’s financial benefit and may make the transaction more profitable if the right business is placed.
- The property owner doesn’t manage the business, and ultimately the tenant still needs to have a viable business managed in the right manner to achieve the best long-term outcome.
- There is risk involved if the fixed rate is significantly lower than the market competition and the business does not reach profitability goals.
A fourth option is a variable commercial real estate lease. This type of lease provides more unique features and enables all parties to structure the lease in a way that meets their goals and needs. Typically, there are two types of variable leases.
- Index Lease: This type of lease is structured to follow an index of some type, such as the Consumer Price Index or the region’s commercial rental market. The rental rate is reviewed and adjusted annually to accurately reflect market conditions.
- Graduated Lease: In this form, the rent amount increases to a pre-determined level over a specific amount of time. The landlord and tenant agree to specific increases at various intervals, such as a 2% increase each year.
Pros and Cons of Variable Lease
- Variable leases are ideal for environments when the area may be growing or going through a significant change, meaning right now, rates may need to remain low but, over time, should grow.
- Tenants may be more likely to consider the property if the initial rate is lower.
- There’s a risk that the tenant may leave before the property reaches the desirable rate, though some leases will include stipulations.
- Costs can be higher for businesses, making it harder for them to remain in that market.
5 Factors to Consider When Choosing the Right Type of Commercial Lease
Any type of commercial lease needs to fit the local needs and conditions and must be something that works for both parties. Consider:
- The base rent is needed to make the rental of the property profitable for the investor.
- Market conditions in the area and how they impact leasing demand.
- Consider changes in costs in the area, such as inflation, utility increases, and overall real estate value growth.
- Estimate the desirability of the region and expected changes to it over time.
- Factor in the type and amount of hands-on management the investor plans to have in managing costs associated with the property.
Wrapping Things Up
The structure of all commercial real estate leases must be carefully considered based on the financial goals of the property owner and investors, but it also must meet the local demand and tenant requirements. In some markets, property owners may need to be more flexible to secure highly desirable tenants for the property, while in others, a varied lease may be the best move forward for all parties involved in the transaction.