2. Net lease
Renting space in a commercial building isn’t as simple as it seems. It’s more than signing an agreement and moving in. It requires attention to details within the lease, like negotiating property tax payments, utilities, maintenance, and more.
Before signing a lease, the lessee needs to be aware of the type of commercial lease to which they are agreeing. Many different types of commercial real estate leases are used by landlords. Understanding the various commercial lease types will lead to improved negotiations and help determine monthly expenses.
In addition, the new lease accounting standards are making an impact on lessors and lessees by changing the accounting treatment of operating leases. This article breaks down the different types of commercial leases and provides resources to help you understand how ASC 842 is impacting the accounting for commercial real estate.
A full-service lease, or a gross lease, is a lease where the lessee is responsible for paying the base rent. The lessor generally handles any other building expenses, such as maintenance costs, taxes, and insurance. This type of arrangement typically results in higher rental rates, but the lessee only receives one bill to cover all of the necessary expenses and isn’t involved with the day-to-day expenses.
However, some full-service leases require tenants to pay additional expenses beyond their base rent after their first year of renting the space. It’s important to double-check the details of the lease before signing.
A net lease is a commercial lease that specifies the lessee pays a proportionate share of the operating expenses of the building. That means they have to pay part of things like maintenance costs, property taxes, and insurance. In a net lease agreement, each lessee’s share of expenses is generally allocated based on the percentage of the property the lessee occupies.
There are different categories of net leases:
- Triple Net Leases (NNN)
- Double Net Leases (NN)
- Single Net Leases (N)
A triple net lease is the opposite of a gross lease. The lessee agrees to pay rent, utilities, and all of the property’s operating expenses. This includes maintenance costs such as common area maintenance (CAM), insurance, and property taxes (represented by “NNN”).
Typically, these leases are longer-term and have a lower base rent because the tenant agrees to pay for all operating expenses. This is a common commercial lease type.
A double net lease requires the lessee to pay for rent, utilities, property taxes, and insurance (represented by “NN”). In this type of net lease, however, the lessor pays for the building’s maintenance expenses. This results in lower base rent because the tenant is paying more of the expenses.
A single net lease specifies the lessee pays for rent and utilities, as well as property taxes (represented by “N”). The lessor pays for building insurance and maintenance costs. While this type of lease is really similar to a full-service/gross lease, it’s not the same.
A modified gross lease falls between a full-service/gross lease and a triple net lease. The lessee pays rent, utilities, and part of the operating costs. Every contract is different depending on the lessor.
For example, some modified gross leases only require lessees to pay a portion of operating costs after their first year renting the space.
While it may seem like an absolute NNN lease is interchangeable for a triple net lease, they’re different. With an absolute NNN lease, the lessee is responsible for all payments. The lessor is absolved from all financial obligations.
In other words, the tenant pays for all building costs, including all repairs and maintenance. It’s as though they own the building without having to purchase it. The base rent is typically lower in this type of arrangement.
A percentage lease specifies the lessees pay base rent plus a percentage of their gross business sales over a defined threshold. The lessor takes care of property taxes, maintenance, and insurance fees. This type of lease usually involves a retail space.
Typically, lessors ask for around 7% of gross sales in these types of arrangements. Comparatively, an agreement requiring a percentage of 10% or higher is uncommon and should be closely examined.
Regardless of the commercial lease type, the way we account for leases is changing. FASB’s new standard, ASC 842, impacts any lessee entering into a lease. The way leases are classified is shifting. At a high level, lessees will now record most of their leases on the balance sheet.
A few of the differences between ASC 840 and ASC 842 need to be considered. Under ASC 840, the previous standard, leases were categorized as either capital or operating leases. ASC 842, however, categorizes a lessee lease as either finance or operating. Under both lease types, a lease asset is recognized as a right-of-use (ROU) asses and future lease payments are recognized as lease liabilities on the balance sheet.
To assist with accounting for these changes, make sure you are working with an accountant with a good grasp of the new FASB rules. Understanding how the new standard affects lessors and lessees involved in commercial leases is imperative.
This article reviews the commercial lease categories. While these categories don’t represent all of the rules surrounding commercial leases, they provide a general overview of what a lessee can expect to encounter with each type. Every individual contract is different and should be reviewed thoroughly.