Unlike residential real estate, commercial properties are leased to tenants for 3 to 10 years and investors are required to operate those properties according to those lease terms till the leases expire. So if you are thinking about investing in commercial real estate, you should earn first about commercial real estate leases.
When reviewing a commercial lease the investor should pay close attention to the following four important components of a lease document:
Rent rate and future escalations
While the first three points are more or less easy to understand, Expense Reimbursements are more complicated. Landlords use three major lease types that determine how the landlord is reimbursed for property expenses:
Gross or Full Service Gross Lease (FSG)
Net Lease (NNN)
Modified Gross Lease (MG)
Gross Lease/ Full Service Gross Lease
The landlord pays for all property expenses: utilities, real estate tax, insurance, and other common area maintenance expenses up to the amount specified in the lease. Usually, the specified amount is equal to the property expense amount in the base year, i.e the year when the lease is signed. Anything above that base amount will be paid by the tenant. Full Service or Gross Leases are widely used in office leasing.
The investor should watch out if there is any maximum cap language in the lease regarding annual expense increases. Tenants use maximum cap language in a lease to protect themselves from future expense increases. In California real estate taxes are set as a percentage of real estate purchase price. If the property did not trade for a long time the new owner’s property tax bills possibly will be much higher compared to the one prior to the acquisition. The real estate investor can recover the full amount of real estate tax increase if there is no maximum cap language in the lease related to real estate tax taxes.
Net Lease / Triple Net Lease
The tenant pays for all property operating expenses based on its share of the space. First, the landlord provides tenants with an annual expense budget before the beginning of each year. The tenant pays that amount as an additional rent during that year and once the year is over the tenant receives a final expense statement showing actual expenses. If the tenant overpaid, the landlord will pay it back in the form of a rent credit, and if the tenant underpaid the landlord will cover the difference. Net Leases are more commonly used for single-tenant and multi-tenant retail buildings.
In most cases when buying a net leased building, the landlord is still responsible for the roof and structure. So when acquiring a triple net leased property real estate investor should still pay close attention to the physical condition of the building.
Modified Gross Lease
This lease type is somewhere in between triple net and gross lease. In this case both tenant and Landlord agree to pay certain expenses based on the pre negotiated lease language. Modified gross lease is used very often in industrial leasing, where the landlord pays only for property tax and property insurance while the rest is paid by the tenant.
During the due diligence period, one of the best things that the investor can do is to request a Common Area Maintenance (CAM) Reconciliation Report from the property manager. The report shows all the charges and reimbursements to the Tenants. If you are planning to make your first commercial property acquisition you should consider hiring a real estate acquisition advisor, who will review all the leases and will provide you with a detailed cash flow analysis.