Gross Lease vs Net Lease

When you look at commercial real estate rental agreements you will come across two common types of commercial leases. These are gross and net. This article compares these commercial leases – Gross Lease vs Net Leases when leasing commercial premises.

What is a Net Lease?

Under net lease structures, the tenant pays a base or net rent. On top of this, they are then charged an additional amount for outgoings. It is essentially an agreed initial dollar amount when a tenant takes possession at the beginning of the period. In addition to this base rent, the tenant is responsible for paying the outgoings. This includes maintenance and repairs, real estate taxes and insurance costs for the commercial property, whether it is a commercial office, industrial or retail. 

This percentage is usually a percentage of the tenant’s gross lettable area related to the total lettable space in the building or centre.

The additional payments are a predetermined proportion of all maintenance and operating expenses, the property’s state taxes, and insurance costs. Although these may be excluded in certain circumstances, these are primarily compulsory charges that tenants have to pay. For example, if the tenant occupies 10% of the total lettable building area unless specified differently, the tenant will pay 10% of the total outgoings.

What is base year in a commercial lease video?

How to calculate net rent?

Let us give the example of John looking at leasing an office building space of 100m2 with a quoted rental of $300 per square metre. The commercial property leasing agent also quoted the total outgoings for the building being $100,000 per year. Since the total lettable area for the building was 1000 metres, John, the prospective lessee, was looking to lease 10% of the lettable area.

We can work out what John’s net effective rent would be payable from the above.

Area 100 square metres x $300 (price per square metre) = $30,000 pa (net rent)

Also, John would have to pay outgoings. Below is the calculation.

Outgoings/Property expenses quoted for whole building $100,000 x 10% (percentage leased)

Outgoings payable is therefore $100,000 x 10% = $10,000 per year

This would mean that if the final outgoings were the same as quoted, John would be liable to pay a total amount of $40,000 per year.

Calculated as $30,000 (rent) + $10,000 (outgoings) = $40,000

To put in a nutshell, the rent amount is broken up into two parts.

(1) The base rental, which usually increases annually at a fixed rate (CPI or market value) and

(2) a proportion of the outgoings increases at the same rate as the actual outgoings for the individual property.

What are the advantages of a net contract agreement?

These types of net leases are usually favoured by property owners and new real estate investors. They give more security of investment return if the percentage of outgoings increases faster than base rent. The tenant will have to absorb this increase in this real estate investment.

What is a Gross Lease? 

In summary, gross rent is the opposite of net rent. Under a gross lease, the tenant pays a whole rental amount and includes all common area maintenance in most cases. Other additional expenses include property taxes, insurance and maintenance costs, council rates for the entire term of the lease. The tenant has no obligation to pay rent other than the basic gross rental. The landlord usually calculates this and has the outgoings included in the total amount based upon the anticipated expenses. Sometimes, a tenant may pay a percentage of the increase in outgoings from the lease’s first (base) year. On other occasions, depending on economic factors, the landlord may choose to absorb some of the outgoings under a modified gross lease. This is usually more popular with tenants because it can avoid cost surprises.

What are the advantages of a gross contract agreement?

The main advantage is that it puts an upper limit on the maximum rent payable to the landlord. On the other hand, the landlord may choose this method to attract tenants in testing economic conditions. 

The landlord will have to absorb an accelerated increase in outgoings in this situation.

Gross rent calculator

The following example is from another office John was looking for in the same area. In this example, the landlord was looking at offering a gross lease agreement. 

The office size was of the same size (100m2) and similar position and quality. The quoted rent was $41,000 per annum. 

This gross rental was going to be more expensive for the first year than the $40,000 John was quoted in the net lease example.

Should the tenant take the Gross or Net rent agreement?

It looks like it is better to go for the cheaper net lease agreement on the surface. Whether it is better depends if the tenant thinks that outgoings will increase faster than the annual rent increases.

If the annual rent increase was 3%, and the outgoings grew to 6% per year, then the gross rental agreement would look better in the long term. On the other hand, it could be a better choice to go for a gross lease if you thought that outgoings would increase 1-2% per year with everything else being equal, including rent increases.

What is the average rent increase per year of a Commercial lease?

 

Commercial real estate lease increases can fluctuate, usually in line with the current inflation and interest rates. For example, in the late 1980s, it was common to see fixed rate increases by 10% or more. We see lower average increases with the consumer price index at record lows. The question is, what is the average rent increase per year at the moment?

 

Most lease agreements have annual commercial rent increase percentage increases. This varies depending on the type of commercial property and the current economic conditions.

The theory is that annual increases ensure that the return to the landlord reflects the increases in property value and operating costs. Whether this is a true reflection of the actual market rent is a topic for future discussion.

From the hundreds of leases that I have seen over the last few years, I estimate that around 90 per cent have increases of the consumer price index (CPI) or 3% per year from the base rent. The others are more common with the large shopping centre leases state rent reviews of 4 to 5% or CPI plus 1 or 2%.

These percentages of growth can vary in the options to renew the lease. For example with the recent growth of inflation figures I would not be surprised that landlords would be pushing for more CPI type increase and raising the more popular 3% increase to a higher one.

Some might argue whether the cumulative increases in rent over the long term lease could be more substantial than the individual revenue growth and profit.

In some states of Australia, the rent movement clause in terms of the lease for retail leases limits increases to CPI or a fixed percentage – not the greater of which has been allowed with many other commercial leases.

Commercial rent increases are a crucial clause in the lease. It would be good to get to know the current market rentals for your business area from an experienced commercial real estate agent. Also, ensure that you discuss this with your specialist commercial leasing lawyer. 

This is even more important when taking over an existing lease (assign the lease). Trying to work out annual rent reviews in some of the more recent lease (law society) contracts I have seen many times used by most solicitors is akin to playing snakes and ladders.

What is the difference between net & gross rent?

 

Which is better – Gross or Net leases?

As a landlord it depends on your own and general economic conditions and what is required to attract your ideal tenant. Generally, in better economic conditions most landlords feel more secure with net lease agreements. That way future rentals are more predictable. In addition, the risks of unforeseeable extra maintenance expenses are borne by the tenant.

Like to discuss further? Contact Con Tastzidis at CST Properties Commercial Real Estate Agents and Business Brokers on 9882 2221