If you’re in commercial property, you’ve probably at least heard the term net lease, but if you haven’t dealt with it firsthand, you may not know what it means—yet. Chances are, you will need to become familiar with the concept at some point, and that’s what we’re here for. In this article, our brokers answer the question, "What is a net lease?" and they explain the different types and financial structures as well as the strategic considerations for both tenants and landlords.
What is a Net Lease?
In commercial real estate, net leases are a type of lease agreement that shifts certain financial responsibilities from landlords to tenants. As Pickett Sprouse Commercial Real Estate Broker Brad Gregory explains, "In addition to rent, it's where the tenant is also responsible for paying a portion of or all operating costs for the property." Operating costs for commercial real estate typically include property taxes, building insurance fees, and maintenance costs. By having the tenant to pay part or all of these expenses, net leases essentially take away some level of risk and hassle from the property owner.
In return, Pickett Sprouse Broker Vernon Averett, CCIM notes, "Landlords may offer lower rent payments in net lease agreements to account for the additional expenses borne by tenants." This trade-off is a key financial characteristic of net leases, distinguishing them from gross leases or full service leases, where the landlord absorbs all property-related expenses in exchange for a higher rent.
Types of Net Lease
There are four different types of net leases. You can have a single net lease (N lease), a double net lease (NN lease), a triple net lease (NNN lease), or an absolute net lease (absolute NNN lease). Brad and Vernon lay out the differences between each.
Single net lease (Net lease)
- Tenant Responsibilities: Rent + Property Taxes
- Landlord Responsibilities: Insurance, Maintenance, and Repairs
- Notable Characteristics: Tenants pay a lower base rent due to the additional expense of having to pay property taxes
Double net lease (Net-Net lease)
- Tenant Responsibilities: Rent + Property Taxes + Insurance Premiums
- Landlord Responsibilities: Maintenance Costs
- Notable Characteristics: The rent amount considers the tenant’s burden of paying for both property taxes and insurance premiums
Triple net lease (Net-Net-Net lease)
- Tenant Responsibilities: Rent + Property Taxes + Insurance Premiums + Maintenance Expenses (often expressed as TICAM, which stands for taxes, insurance, and common area maintenance)
- Landlord Responsibilities: Possibly the roof, structure, and sometimes the parking lot1.
- Notable Characteristics: This lease places all costs related to the property on the tenant, including structural maintenance and repairs. Triple net leases are often long-term agreements, typically 10 years or more, involving a single tenant leasing the entire building.
Absolute net lease (absolute Net-Net-Net lease)
- Tenant Responsibilities: All imaginable real estate costs associated with the property
- Landlord Responsibilities: Limited to none
- Notable Characteristics: The lease usually cannot be terminated before its expiration, and the rent amount usually cannot be altered, but as COVID showed us, this isn’t always the case. Many of the strong national chains that need a specific type of space, such as Dollar General and Walgreens, do an absolute lease.
Multiple Tenants and Net Lease
When multiple tenants are involved, the amount of taxes, insurance, and maintenance costs that each pays depends on the type of net lease. Brad offers the following example. "If there are four tenants with each tenant using 25 percent of the building, a $4,000 property tax bill would cost each tenant $1,000."
In most cases, if there are multiple tenants, the owner probably has a property manager who oversees and collects all of the different payments. In some cases, the building owner may serve as the property manager.
Pros and Cons of Net Lease for Tenants
As with anything, there are pros and cons of signing a net lease for tenants. Brad outlines what those are.
Pros
- Possible lower base rent: Tenants may pay a reduced base rent, making prime locations more affordable.
- Control over property: Tenants have more control over their space and can make property improvements and select their own contractors as they see fit.
Cons
- Risk of higher variable costs: While property taxes and insurance premiums are usually known ahead of time, maintenance costs can fluctuate depending on the building's condition and other unexpected factors.
- Responsibility for tax-related liabilities: If a tenant is responsible for paying taxes, they will also be responsible for any tax-related fines and penalties.
Pros and Cons of Net Lease for Landlords and Investors
Net leases also present both benefits and drawbacks for landlords and investors. Vernon offers this look at what some of those are.
Pros
- Stable income and lower management responsibilities: Net leases offer a stable income stream with minimal landlord responsibilities.
- Often longer term leases: Longer lease terms mean that landlords don't have to worry about a high tenant turnover rate and having to frequently find new quality tenants.
Cons
- If the tenant breaks the lease, the landlord is left with a large expense they weren't planning on. This is particularly true with triple net leases and is why many landlords only lease to credit-rated or credit-worthy tenants. These are tenants who have "an investment-grade rating based on size and financial strength from major credit rating agencies such as Moody’s and Standard & Poor’s2.
- Infrequent rate increases. Since net lease agreements are usually for longer periods of time, landlords will not be able to implement many, if any, rate increases during that time.
Key Terms and Clauses in Net Lease Agreements
No matter the type of net lease, both Brad and Vernon agree that there are a number of key terms and clauses that should be spelled out for both the tenant and the landlord.
- Lease Term: The length of time the lease agreement is in effect, typically expressed in years or months.
- Rent Escalation Clause: This clause outlines how and when rent will be increased over the term of the lease agreement, typically based on a fixed percentage or linked to an index such as the Consumer Price Index.
- Renewal Options: This clause gives the tenant the right to renew the lease for an additional term, usually at a pre-determined rent amount.
- Assignment and Subletting: This clause outlines the tenant's ability to assign or sublease the property to another party, subject to landlord approval.
- Improvements: Specifies who is responsible for making improvements or alterations to the property, and how these costs will be allocated.
- Maintenance and Repairs: Details the responsibilities of the landlord and tenant for maintaining the property, including who is responsible for repairs and upgrades.
- Insurance Requirements: Specifies the types and amounts of insurance coverage required by the landlord and tenant, including liability insurance and property insurance.
- Default and Remedies: Outlines the events that constitute a default under the lease agreement and the remedies available to the landlord in the event of default.
- Lease Termination: Specifies the conditions under which the lease agreement can be terminated prior to the expiration of the lease term, and any associated penalties or fees
The Bottom Line on Net Lease Agreements
The bottom line is that a net lease is a type of commercial real estate lease in which the tenant is responsible for paying not only the base rent but also a portion or all of the property's operating expenses, such as property taxes, insurance, and maintenance costs. This arrangement shifts some of the financial burden from the landlord to the tenant in exchange for a lower base rent for the tenant. This makes it a popular option for both parties.
Understanding the nuances of net leases is crucial for both landlords and tenants to make informed decisions and negotiate favorable terms. That’s why it is important to have knowledgeable and experienced net lease advisors like the Pickett Sprouse brokers working for you.
If you have a question about potential net lease properties in central and eastern North Carolina, contact us at marketing@pickettsprouse.com.