Gross Lease vs Net Lease
When you look at commercial real estate rental agreements you will come across two common types of leases. These are gross and net. In this article, we compare these commercial leases – Gross Lease vs Net Leases when leasing commercial premises.
What is a Net Lease?
Under a net lease, 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 at the beginning of the period when a tenant takes possession. In addition to this base rent, the tenant is responsible to pay the outgoings. This includes maintenance and repairs, real estate taxes and insurance costs for the commercial property whether it being a commercial office, industrial or retail.
This percentage is usually a percentage of the gross lettable area the tenant occupies as related to the total lettable area in the building or centre.
The additional payments are a predetermined proportion of all maintenance and operating expenses, the state taxes and insurance costs for the property. Although these may be excluded in certain circumstances, these are mostly 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.
How to calculate net rent?
Let us give the example of John looking at leasing an office space of 100m2 with a quoted rental of $300 per square metre. The commercial property leasing agent was also quoting the total outgoings for the building being $100,000 per year. Since the total lettable area for the building was 1000 metres the area John, the prospective lessee was looking to lease 10% of the lettable area.
From the above, we can work out what the rent would be payable by John.
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 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 which 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 lease are usually favoured by property owners and new real estate investors as they give more security of investment return if the percentage of outgoings increase at a faster rate than base rent. In this situation, the tenant will have to absorb this increase.
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 in most cases all common area maintenance. Other payments include property taxes and insurance as well as operating costs, council rates, property taxes and insurance costs for the entire term of the lease. Basically, the tenant has no obligation to pay rent other than the basic gross rental. This is usually calculated by the landlord and has the outgoings included in the total amount based upon the anticipated expenses. Sometimes a tenant may have to pay a percentage of the increase in outgoings from the first (base) year of the lease. On other occasions, depending on economic factors, under a modified gross lease the landlord may choose to absorb some of the outgoings. 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 to a tenant 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.
In this situation, the landlord will have to absorb an accelerated increase in outgoings.
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?
On the surface, it looks like it is better to go for the cheaper net lease agreement. Whether it is better, it depends if the tenant thinks that outgoings were going to increase at a faster rate than the annual rent increases.
If the annual rent increase was 3%, and the outgoings grew to say 6% per year, then in the long term, the gross rental agreement would look better. On the other hand, it could be a better choice to go for a gross lease if you thought that outgoings were going to increase 1-2% per year with everything else being equal, including rent increases.
Commercial rent increase percentage increases
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 a true reflection of the real market rent is a topic for future discussion.
From the hundreds of leases that I have seen over the last few years, I would estimate that around 90 per cent have increases of the consumer price index (CPI) or 3% per year from the base rent. The others 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.
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 a good idea to get to know what the current market rentals are 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 you are 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