In most cases, agreements called “leases” govern the relationships between the landlord and tenants. Therefore, a lease can be defined as an agreement between the landlord and tenant for the rental of the landlord’s premises to the tenant for specified terms and conditions. There are four most common leasing arrangements in real business practices.
They are as follows:
- Gross lease
- Net lease
- Fixed base lease
- Base-year lease
Each of these lease arrangements determines which party bears the risk of future operating cost increases and to what extent which are discussed in this post.
1. Gross Lease Arrangement
A gross lease is a type of lease arrangement in which the tenant pays a specified amount that covers the rental of the premises, including the operating expenses and real estate taxes of the property.
In this type of lease, the tenant’s future total rental payments are known from day 1, and the landlord bears the risk of future operating expenses and real estate tax increases.
Some tenants prefer this type of lease arrangement because it helps them manage the risk of future cost increases and planning.
Gross Lease Arrangement Example
ABC Plaza LLC, the owner of Lie Dharma Plaza, a 45-story office building in Orlando, rents a 10,000-square-foot space to XYZ Services (‘‘tenant’’). The lease is for five years, and tenant will pay the landlord the following rental to cover rental of the premises, which includes all operating expenses and real estate taxes of the premises:
- Year 1; $100,000
- Year 2; $100,000
- Year 3; $105,000
- Year 4; $110,000
- Year 5; $115,000
Under this simplified example, the listed amounts are the full and only rental payments due to the landlord from this tenant during the lease period.
The tenant does not pay any additional amount in respect to operating expenses and taxes. Whether the cost of operating the building goes up or down in the future will not have an impact on the amounts noted.
2. Net Lease (Triple Net Lease) Arrangement
In a net lease arrangement, the tenant pays a minimum base rent in addition to the tenant’s proportionate share of operating expenses and real estate taxes.
In this type of lease, the landlord recovers from the tenant operating costs and real estate taxes. This arrangement is also referred to as “triple net” or “net net net lease.”
Net Lease (Triple Net) Arrangement Example
Eastern Tower LLC, the owner of a property located at 465 Tower Lane in Boston, is leasing the whole fifteenth floor of the 25-story property to Lie Dharma Partners LLC (‘‘tenant’’), a prestigious hedge fund that is currently located two blocks from the property.
The lease specifies that for the 10-year lease, Lie Dharma would pay a minimum base rent as indicated in addition to its pro rata share of the property. The minimum base rents are:
Years Rent per Square Foot
The fifteenth-floor space to be leased to Lie Dharma has a total net rentable area (NRA) of 30,000 square feet. The entire building has a total NRA of 600,000 square feet.
The parties re-measured the space and agreed on the sizes listed, noting that the tenant’s pro rata share is 5 percent of the building. This amount would be used in determining the tenant’s share of operating expenses and real estate taxes.
In determining the tenant’s share of operating expenses and real estate taxes, let us assume that the total operating expenses in year 1 are $15,247,000 and real estate taxes are $4,435,000.
Therefore, the additional rent would be:
Operating expenses $15,247,000
Real estate taxes $ 4,425,000
Lie Dharma pro rata share x 5%
Lie Dharma additional rent—Yr 1 $ 983,600
Note that in most cases, the parties would agree that the tenant would pay monthly the minimum base rent plus its estimated monthly pro rata share of operating expenses.
For real estate taxes, the tenant would pay its share of the taxes based on when they are due to the government taxing authority. (Tax due dates vary depending on the municipality.)
Therefore, excluding the real estate taxes, the tenant’s total monthly payment for the first year of the lease would be determined in this way:
Step 1. Calculate the monthly minimum base rent.
Monthly Minimum Base Rent:
Minimum annual base rent-
(80 per square foot 30,000) $2,400,000
Number of months x 12%
Monthly minimum base rent $200,000
Step 2. Calculate the estimated monthly operating expenses.
Estimated Monthly Operating Expenses:
Estimated year 1 annual Operating-
Tenant pro rata share percent x 5%
Tenant pro rata annual share $ 762,350
Estimated monthly operating-
expenses $ 63,529
Step 3. Add the monthly minimum base rent and the estimated monthly operating expenses.
Monthly minimum base rent $200,000
Estimated monthly operating expenses $ 63,529
Tenant’s total monthly rent payment $263,529
Since the operating expenses paid by the tenant each month is an estimated amount, at the end of each year, the landlord would have to perform a reconciliation of the actual operating expenses incurred in running the property and compare that to the estimate paid by the tenants during the course of the year to determine if additional rent is due from the tenant or if a refund is due to the tenants.
The lease normally would indicate the timeframe when this reconciliation would need to be finalized by the landlord and communicated to the tenant.
Some leases also give the tenants an audit right. An audit right is the tenant’s right under the lease to review the books and records of the landlord to ensure that the amounts are appropriately included or excluded as operating expenses of the property.
3. Fixed Base Lease Arrangement
The fixed base lease is a hybrid of a gross lease and net lease. In a fixed base lease, the tenant pays a gross amount that covers the base rental of the premises plus operating expenses. However, the total amount that the tenant pays is broken down into the base rental and the operating expenses.
At the end of the year, if the tenant’s pro rata share of actual operating expenses is greater than the operating expenses portion of the amount included in the gross payments paid by the tenant over the course of the year, the landlord would bill the tenant for the additional amount.
If, however, the tenant’s pro rata share of the actual operating expenses is less than the operating expenses portion of the gross payment, the tenant does not get a credit or refund.
Fixed Base Lease Arrangement Example
A landlord and tenant agree that tenant pays $100.00 psf (per square foot) for 10,000 square feet of space of an office building under a fixed base lease arrangement.
The parties agree that $40.00 of the $100.00 represent the operating expenses of the property. At the end of year 1 of the lease, the landlord performed a reconciliation of the operating expenses incurred on the building.
The total expenses were determined to be $47.00 psf. In this case since actual operating expenses ($47.00) are greater than the amount of estimated operating expenses ($40.00) by $7.00, the landlord would bill the tenant for an additional rent of $70,000.
This additional rent is determined as:
Actual year 1 operating expenses $ 47.00
Operating expenses in estimated-
gross payment $ 40.00
Difference $ 7.00
Net rentable area (NRA) x 10,000
Additional rent due from tenant $70,000.00
If the actual operating expenses after the reconciliation show operating expenses as $38.00 psf, the total rent paid by the tenant would remain $100.00 psf without any year-end adjustments.
4. Base-Year Lease Arrangement
The year in which a lease started is called the base year of a base-year lease. During the base year, tenants pay a whole amount that represents the rental of the premises plus the tenants’ pro rata share of operating expenses during that year.
In subsequent years, if the operating expenses are greater than the operating expenses incurred during the base year, the landlord is entitled to bill tenants their pro rata share of the increase over the base-year operating expenses.
Base-Year Lease Arrangement Example
XYZ Realty is the owner of a 10-story, 100,000-square-foot office property of which 10,000 square feet was rented to Putra & Associates LLP under a base-year lease arrangement. The lease started in 2009 for a 5-year lease term.
The parties agreed to a total rent of $100.00 psf based on 2009 operating expenses of $2,300,000.
In 2010 the tenant continues to pay $100.00 psf as agreed to in the lease. However, the total operating expenses for 2010 were $3,050,000, which is an increase of ($3,050,000 – $2,300,000) $750,000 from the base-year operating expenses.
If XYZ Realty’s pro rata share of operating expenses is 10 percent of total operating expenses for each year of the lease, then XYZ Realty would have to pay the landlord an additional rent of $75,000.
This amount is calculated as:
Total 2010 operating expenses $3,050,000
Minus base-year operating expenses $2,300,000
Increase over base-year operating-
expenses $ 750,000
Multiply by tenant pro rata share x 10%
Additional rent due $75,000
Note, however, that if the 2010 operating expenses had been less than the base-year operating expenses, the tenant would not have been entitled to any refund or credit.