When we talk about commercial real estate leases, you are probably already familiar with the two types of leases: a gross lease and a net lease.
These leases serve as an agreement between the parties involved (a commercial tenant and the landlord). They cover the basic details of which party will be responsible for the maintenance and upkeep of the property (basically, all the expenses).
While a gross lease burdens the landlord with all the expenses, a net lease is the complete opposite. The commercial tenant is responsible for covering all or some of the costs.
If you’re looking for something in between a gross lease and a net lease, then a modified gross lease (also known as a service-type modified gross lease) is what you may be looking for.
What is a modified gross lease? This lease helps tenants and landlords meet halfway by dividing the responsibility and expenses. Read on to find out more about it and all the benefits and drawbacks you need to know.
What Is A Modified Gross Lease? Key Questions Answered & Nuances Explained
A modified gross lease is a blessing for every commercial landlord because they can share the property’s operating expenses with their tenant while still controlling their property. It ensures that one party does not have to cover all the operating costs, which can be overwhelming.
Under this lease, the commercial real estate tenant covers expenses like the base rent, utilities, and interior maintenance, while the landlord covers other operating expenses, including property taxes and insurance.
This lease is popular among multi-tenanted commercial spaces because of its flexibility. For example, if a commercial building has five tenants and the annual electricity bill is $10,000, this can be divided among the tenants, and each tenant can pay $2,000. Another option is to split the bill according to the size of the area the tenants are leasing.
A modified gross lease provides another beneficial feature for landlords: an expense stop. This means that landlords will cover expenses up to a certain amount. After that, tenants will be responsible for the costs incurred. For example, let’s say a landlord puts an expense stop of $10,000 a year on infrastructure. If the $10,000 has already been utilized throughout the year for maintaining the property, then any other infrastructure costs after that will be the tenants’ responsibility.
More Benefits of Modified Gross Leases
This is a very appealing lease to landlords because it allows them to control their property while sharing the expenses with their tenants.
For example, because the upkeep of the commercial building infrastructure remains the landlord’s responsibility, they will be proactive in ensuring that the infrastructure is well maintained according to their standards. This is a massive relief for landlords because tenants can be unreliable.
Another benefit of having a certain amount of control is that the landlord can enjoy peace of mind knowing that their tax and insurance will be paid on time.
Tenants enjoy this lease because they can put more of their money into their business and focus on their operations, knowing that the landlord will take care of the exterior maintenance.
Potential Disadvantages of Modified Gross Leases
One of the most significant downsides of this type of lease occurs when landlords underestimate the operating costs of their property.
For example, let’s say a landlord wants to beat their competition by all means and offers lower rental rates to secure tenants faster without considering the cost of maintaining that space. This screams disaster! The landlord will be left with additional expenses and a poorly maintained building interior.
But this is easily preventable. The landlord needs to first calculate the upkeep of the space before deciding on the rental rate.
Another thing to consider is that modified gross leases are a little unstable because the costs fluctuate. Thus, there is no set cash flow for landlords; for example, if the maintenance price decreases, then the landlord benefits, but if the cost of maintenance increases, then the tenant benefits.
A disadvantage for tenants with the modified gross lease is the fear of having a lazy landlord who will prolong the maintenance of the building, resulting in the tenant losing out on business.
But this too can be prevented. Landlords need to up their game to make sure that their building is attractive and well maintained at all times.
What Does “Modified Gross” Mean?
A service-type modified gross lease is the third category of commercial rental lease that comprises characteristics from gross leases and net leases; it’s the best of both worlds!
An important thing to remember is that no modified gross lease is the same; they differ according to the rental agreements between parties, so each lease needs to be evaluated on a case-by-case basis.
These leases are particular when stating the responsibilities of each party involved. For example, a modified lease could note that a tenant must cover the cost of painting the building and cleaning services.
Because of the flexibility that comes with this lease, there is a lot of going back and forth and negotiations that can prove time-consuming. This is very important because both parties need to be happy and understand what expenses they are responsible for before finalizing and signing the lease.
Unlike other leases, the modified gross lease has no standard cost-distribution structure; this decision lies entirely with the landlord and tenant.
In most cases, tenants are responsible for covering all costs directly related to their unit(s). This includes unit maintenance, repairs, utilities, and janitorial costs, while the landlord covers the general operating expenses of the property.
The modified gross lease also creates a more flexible and more accessible relationship between the landlord and their tenants, as it favors both of them.
Modified Gross vs. Triple Net (NNN) Leases
A triple net lease is a detailed agreement in which the tenant bears all of the property’s operating expenses. These operating expenses are divided into three areas (net-net-net): real estate taxes, insurance, and maintenance. It has a fixed cost-distribution structure, unlike the modified gross lease, which varies on a case-to-case basis.
The modified gross lease allows for the tenants and landlords to share the expenses. In most cases, tenants usually cover the utility and janitor services costs, whereas the landlords cover the operating and maintenance costs.
The triple net lease is well suited for more complex or more extensive structures like chain-store spaces, whereas the modified gross lease is best for office-suite complexes or multi-tenanted buildings.
Modified Gross Vs. Triple Net Leases: Pros and Cons
With a triple net lease, landlords have to rely on and trust their tenants to make payments on time, like depending on their tenants to pay the property insurance when it’s due, for example. But with a modified gross lease, landlords can decide and choose what they would like to control, like managing the insurance costs themselves and making payments on time.
A small business may find a triple net lease more attractive because they can directly invest in their business without having to invest in construction costs. Tenants enjoy having control of the maintenance and appearance of the property. The triple net lease is also outstanding for landlords who have other things to focus on, like their primary job, because it saves them time and deals with property management costs.
Conversely, tenants may be put off the triple net lease because of increasing property tax and insurance costs which they are liable for. They are also held responsible for any personal injuries that may occur on their property; for example, if a customer trips on a mannequin and breaks their leg, the tenant will have to pay up.
Tenants may also be wary of the modified gross lease because the landlord’s interior design may not be of their taste. Landlords need to be careful of underestimating and even overestimating rental costs with this lease.
Industrial Gross Leases Explained
An industrial gross lease is a type of modified gross lease. It is a commercial real estate contract that serves to benefit the landlord and tenant on an industrial or warehouse property.
In the industrial gross lease, tenants must pay the landlord a monthly rental fee that covers the management, property expenses, and standard area maintenance (CAM) of the property. Terms of this lease include a mixture of industrial gross lease and triple net lease terms, and they vary depending on the industrial space and how the tenant will occupy the space.
The major downfall of the industrial gross lease for investors is that they have to be liable for most of the financial and other responsibilities. It can be very time-consuming for investors and even drain their resources because they have to take on the financial risk of unexpected costs, such as sudden repairs of the warehouse.
Some industrial gross lease tips for investors:
- Use gross industrial rent to cover expected expenses through this lease and minimize financial risks.
- Get in touch with a leasing broker to avoid common mistakes. Using a real estate broker helps make the negotiation process smooth and gives the investor the upper hand when bargaining.
- Investors should spread out the months of free rent to prevent being stuck in a situation where they receive no financial return.
In terms of commercial property leases, modified gross leases are a hit! While there are pros and cons to this lease, it’s the best option if you are indecisive between gross and net leases. Modified gross leases favor both the landlord and the tenant.
Tenants can enjoy control over their costs and focus on the core of their businesses, while landlords maintain control over their property and specific responsibilities such as CAM.
Modified gross leases are an excellent passive income generator; start building your wealth now by browsing our leases on for-sale retail spaces.