Who Pays for What? Understanding Key Differences in Triple Net, Gross and Modified Gross Commercial Leases

Commercial lease agreements for office, retail and industrial tenants are commonly structured differently with respect to how expenses are handled and collected between the landlord and the tenant. The most typical of these structures are triple net (NNN), gross and modified gross. These concepts are often confused and used interchangeably despite meaning very different things and result in a significant economic impact for all parties. It is important to understand and distinguish between each of these lease structures whether one represents landlords or tenants.

This Holland & Knight blog post explains what NNN, gross and modified gross leases are and highlights the key differences between them.

NNN Lease

A NNN lease is a lease where the landlord passes all expenses incurred by the landlord in connection with operating the property through to the tenant. Therefore, in addition to paying base rent for the premises, the tenant is also responsible for paying to landlord its proportionate share of the costs of three separate categories (nets): 1) operating expenses, 2) taxes and 3) insurance. NNN leases are most common in retail spaces and are more landlord-friendly. When drafting a NNN lease, it is important to understand the allocation of maintenance responsibilities and costs as between landlord and tenant and make sure that the definition of "common area maintenance" is very inclusive and is in sync with the actual costs incurred in the maintenance of the center.

Review Tip: Watch out for situations where insurance and/or taxes are included within the operating expenses definition.

Review Tip: Under an NNN lease, the landlord may still be required to repair major structural defects and/or be responsible for capital expenditures above a certain threshold.

Review Tip: What is included and specifically excluded in the definition of common area costs – tenants often provide a very detailed list of exclusions from common area costs such as services and items which are provided to other tenants for which the landlord is actually paid or reimbursed from such other tenant; fines or penalties incurred due to a violation of applicable law relating to the retail center; late fees and/or interest due to landlord's failure to timely pay expenses; salaries or other compensation paid to employees, etc.

Review Tip: Tenants often ask for a cap on annual increases in operating expenses payable under an NNN lease to limit the tenant's exposure to sudden increases in controllable operating expenses, such as management fees, maintenance and utilities.

Quick-Service Restaurant Example (NNN)

The tenant is a quick-service restaurant leasing a 5,000-square-foot space in a shopping center with the following agreed upon terms:

• Base Rent. $30 per square foot
• Annual Rent. $150,000
• Term. 20 years (with renewal options)

Gross Lease

A gross lease is a commercial lease that incorporates additional rent costs (e.g., operating expenses, taxes, insurance, maintenance costs) into a fixed monthly fee. Gross leases are viewed as more tenant-friendly because the fixed monthly amount allows the tenant to budget its expenses and forecast future liabilities. As a result of such fixed rent amounts, gross leases may increase a landlord's economic risk due to unpredictable increases in property expenses. While NNN or modified gross (defined below) leases are more popular than gross leases, it is common to see gross leases in shopping mall developments; provided, however, there are often carve outs to the "gross" nature of the lease such as requiring the tenant to pay merchant association/marketing fees, a percentage of gross sales, separately metered utilities (e.g. gas, electricity and water), after-hours utility charges and property insurance premiums.

Review Tip: Sometimes, a commercial lease will be described as "full-service gross," but that can be a misnomer and is often used to describe a modified gross lease (described below).

Review Tip: Though in gross leases the tenant should be responsible only for the gross rent amount, it is important to review the lease to confirm whether the tenant is responsible for any specific utilities or janitorial services serving the premises.

Quick-Service Restaurant Example (Gross)

Staying with the same quick-service restaurant tenant leasing a 5,000-square-foot space in a shopping center, but now with the following agreed upon terms:

• Base Rent. $45 per square foot (note higher base rent)
• Annual Rent. $225,000
• Term. 20 years (with renewal options)

Modified Gross Lease

A modified gross lease (sometimes referred to as a modified net lease) is commonly used in multi-tenant projects and is a hybrid between an NNN lease and a gross lease. This lease type offers the most flexibility between landlord and tenant, as the cost allocation of operating expenses is fully negotiable. The base rent is slightly higher than an NNN lease because the rent is intended to capture some of the operating expenses but is typically lower than rent in a gross lease because the tenant may not be responsible for all operating expenses. Modified gross leases typically incorporate a "base year" concept, in which costs and expenses for a certain year act as the floor in determining what, if any, of the operating expenses will be passed to the tenant in subsequent years of the lease term. Any costs exceeding the "base year" costs will then pass through to the tenant.

Review Tip: Another type of lease to recognize is a "double net (NN) lease," in which a tenant pays property taxes and insurance in addition to base rent, while the landlord carries the maintenance obligation of the premises.

Review Tip: It is crucial to review expense definitions and exclusions, caps and audit rights as part of an overall risk analysis.

Quick-Service Restaurant Example (Modified Gross)

Lastly, for the same quick-service restaurant tenant leasing a 5,000-square-foot space in a shopping center, but now with the following agreed upon terms:

• Base Rent. $38 per square foot (slightly higher than an NNN rent but lower than gross rent)
• Annual Rent. $190,000
• Term. 15 years (with renewal options)

Conclusion

Ultimately, lease structure matters for both landlords and tenants. Tenants need to consider cash flow, budgeting and long-term profitability, while landlords must consider property management responsibilities, risk allocations and investment returns. Though NNN, gross and modified gross leases are commonly used labels, the actual obligations are determined by the lease language itself, not the language used to describe the allocation. It can be common for parties to use the lease terms interchangeably and, sometimes, even incorrectly. Therefore, it is critical to review the lease document closely to understand which party is responsible for certain obligations and expenses and make sure that the actual allocation follows the intent of the parties.