Preparing a Letter of Intent (LOI) or Memorandum of Understanding (MOU) to document the “deal points” of a lease requires the real estate practitioner to clearly define the type of lease contemplated in the transaction; however, many practitioners rely on the general description “Gross” or “Net” to define the lease terms. Such descriptions are not universally applied. As a result, the parties (landlord and tenant) do not necessary have a “meeting of the minds” at the outset as to the mechanics and cost implications involved in the transaction.
Failing to be specific in the LOI as to how operating expenses are handled (above and beyond describing the lease as “Gross” or “Net”) can be deleterious to a lease transaction. At the very least, delays may occur in documenting the transaction and unnecessary costs may be expended for the legal teams to flush-out these critical “deal points”. More importantly, it may ultimately be discovered (after the delays and expenditures) that the parties had a fundamentally different understanding of the lease terms at the outset, and the transaction may die.
Real estate practitioners should seek to avoid this result by clearly defining the operating expense impacts under the lease so that the parties are in agreement on the fundamental terms before the definitive lease agreement is drafted.
This article discusses the two (2) basic types of leases, and how the variation of operating expense calculations on such leases warrant the parties making an extra effort to define the expense structure during initial negotiations.
Types of Leases
There are generally two (2) types of leases: Gross and Net leases. The following is a discussion of these two basic types of leases and some of the variations that the real estate practitioner should consider in drafting LOIs and MOUs for the lease transaction.
- Gross: “Full Service Gross Lease” or “Full Gross Lease”; “Gross Lease with Base Year” or “Industrial Gross Lease”; “Modified Gross Lease”
- Net: “Triple-Net (NNN or Net-Net-Net) Lease”; “Modified Net Lease”
“Full Service Gross Lease” or “Full Gross Lease”
A “Full Service Gross” or “Full Gross” lease is a lease wherein all services are included in the rent, including utilities, janitorial service, building maintenance, operating expenses, taxes and insurance. Essentially, the tenant pays a set “rent” (and no other payments) for the space. The lease is “full service”, including utilities. There may, however, be an exception for excessive use of utilities, parking charges or special services provided exclusively to the tenant, which would be an extra cost to the tenant.
“Gross Lease with Base Year” or “Industrial Gross Lease”
In a “Gross Lease with Base Year” or “Industrial Gross Lease”, the tenant pays a “base rent” which includes a base amount of expenses and taxes. The base amount is factored into the rent payment equal to the amount incurred by landlord during the Base Year set by the parties (i.e. Base Year = 2008).
Market Rent: $21.00 sq.ft.
Expenses/Taxes during Base Year (2008): $9.00 sq.ft
Base Rent: $30.00 sq. ft.
Thus, in subsequent years, tenant pays any increase in expenses/taxes over the amount incurred during the set Base Year.
Market Rent: $21.00 sq.ft.
Expenses/Taxes during Base Year (2008): $9.00 sq.ft
Expenses/Taxes during 2009: $10.00 sq.ft
Effective Rent in 2009: $31.00 sq. ft.
A Base Year lease is advantageous to a tenant in that it gives the tenant a fixed rent for the first year of the lease. However, care should be taken in setting the Base Year. The tenant is disadvantaged if expenses were artificially low in a Base Year, because tenant would pay a disproportionate “increase” in subsequent years. Conversely, an artificially high Base Year expense would generally favor the tenant.
The following should be considered in determining the Base Year:
Tenants typically favor a later year because tenant does not have to pay operating expenses until the Base Year ends.
Example : Rent Commencement Date of 11/1/08 and 2008 Base Year – only 60 days of rent without an operating expense payment.
A later year also typically favors the tenant because expenses generally increase over time, so a later Base Year often equates to a higher threshold upon which increases in expenses will be calculated in subsequent years.
With new construction, a tenant who accepts the first year of a building’s operation as the Base Year might be exposed to an artificially low inclusion of expenses, with the result that the tenant will pay an artificially high burden of such costs in later years once the building is fully operational.
Example : Repairs during the first year may be covered by contractor or equipment warranties. In such case, normal periodic repair costs would not be included in the operating expenses for the base year, making the base year expenses artificially low.
Example : In new construction, the property is typically less than fully occupied during the first year of operation so recurring expenses will likely be artificially low during the first year, and will increase as new tenants are added. In such case, the tenant should include a “gross-up” provision in the lease so that operating expenses will be “grossed-up” to amount equivalent to an amount that would have been expended had the building been fully (or 95%) occupied. Without this adjustment, the landlord will likely make a profit on the expense pass-throughs in subsequent years.
Operating Expenses vs. Taxes:
Tenants generally desire taxes to be part of the Operating Expenses, and not separately assessed by the landlord. Why? A tenant pays the “increase” in expenses over the Base Year, but does not receive a credit for any decrease. Thus, if taxes significantly decrease in a given year, a tenant would not be able to utilize that deficit to offset other expenses to lower the overall net “increase”.
“Modified Gross Lease”
A “Modified Gross Lease” is a hybrid of the Gross Lease. It is not “fully service” in that certain services may not be included in the rent, such as certain utilities, property taxes or insurance. A “Modified Gross Lease” is not standard, and may include any exclusions agreed to by the parties.
“Triple-Net (NNN or Net-Net-Net) Lease”
A “Triple-Net (NNN or Net-Net-Net) Lease” is the antithesis of a “Gross” lease. Under a Triple-Net (NNN or Net-Net-Net) lease, the tenant assumes payment of all utilities, maintenance, operating expenses, taxes and insurance. From an accounting perspective, if there are multiple tenants in the building, the tenant pays a pro-rata share based on the percentage of space occupied by the tenant vis-à-vis the total space within the building. Separately metered utilities, however, would not be paid on a pro-rata basis because the tenant would consuming the entire utility usage for the installation and thus should bear the entire cost of the usage.
“Modified Net Lease”
A “Modified Net Lease” is a Triple-Net (NNN) lease with certain services included in the rent. For example, the landlord may include property taxes or insurance within the rental payment, and not separately charge the tenant for this cost. As with the “Modified Gross Lease”, the “Modified Net Lease” is not standard, and may include any inclusions agreed to by the parties.
The foregoing highlights some of the variations in Gross and Net leases. However, in practice, few leases are purely “Gross” or “Net”, and these terms are not universally applied. Thus, what one party may consider to be “Gross” or “Net” may be materially different than another party’s understanding of “Gross” or “Net”. Accordingly, the real estate practitioner should be careful to include in a LOI or MOU how operating expenses are to be allocated, rather than simply stating that the lease is “Gross” or “Net”.
Operating Costs, Taxes and Insurance
The following may be used as a guide in defining how operating expenses are to be allocated between the landlord and tenant. The real estate practitioner should include, to the extent possible, detail in the LOI or MOU on how operating expenses will be calculated. In doing so, consider:
- What should be charged as an operating expense
- When should the expense be charged
- How to measure the accuracy of the charges
What should be charged?
A typical “Operating Expense” clause will require the tenant to pay all expenses and costs incurred by the landlord in connection with the ownership, operation and management of the property. This, of course, is very broad and may require the tenant to pay costs that the tenant (and possibility the landlord) never contemplated would be chargeable to tenant’s account. Accordingly, to the extent possible, the parties should list those items that the parties agree to exclude from expense pass-throughs to the tenant, so that the landlord and tenant have a “meeting of the minds” as to the charges for which tenant will be responsible.
Below is a discussion of some of the exclusions the parties may consider.
Efficiency: Consider requiring the efficient and economical ownership, operation and management of the property.
Cap: Consider capping the expense pass-through to avoid payments that are financially crippling to the tenant, while giving landlord the ability to broadly pass-through operation costs to the tenant without significant limitation.
Lender Costs: Consider excluding depreciation, amortization, interest, principal, attorney fees, costs of environmental investigations or reports, points, fees, and other lender costs and closing costs on any mortgage on the property.
Ground Lease: Consider excluding ground lease payments, if any.
Tenant Improvement Costs: Consider excluding the cost of initial improvements or alterations to tenant spaces, and costs incurred in renovating vacant space.
Tenant Services: Consider excluding the cost of landlord providing any service directly to and paid directly by any tenant.
Reimbursed Costs: Consider excluding the cost of any items for which landlord receives reimbursement or refunds from insurance proceeds or a third party.
Capital Costs: Consider excluding the cost of capital improvements. An exception may be where the improvements are intended as a labor-saving device or to effect other economies in the maintenance or operation of the property or which are required under any governmental law. Also, the costs of capital expenditures may be amortized in equal annual installments over the useful life of the improvement, so that the entire cost is not payable in the year in which the capital improvement was put in place.
Earthquake Insurance: Consider addressing the cost of earthquake insurance premiums.
Bad Debt: Consider excluding any bad debt loss, rent loss or reserves for bad debt or rent loss.
Other Services: Consider excluding landlord’s cost of electricity and other utilities provided to other tenants or occupants but that are not offered or provided to tenant.
Landlord Defaults: Consider excluding interest or penalties resulting from late payments to third parties.
Excessive Management Fees: Consider addressing or limiting the cost of management fees, if any, to a reasonable amount.
Business Costs: Consider excluding landlord’s costs of operating its business of the ownership of the property, including matters such as property management, lawsuits, sales, entity costs, wages (other than possibly a building manager), income taxes and the like.
Leasing Costs: Consider excluding the cost of advertising and promotional expenses directed toward leasing tenant space in the building, as well as leasing costs and commissions.
Excessive Costs: Consider excluding costs of goods or services paid to any related person or entity of the landlord in excess of fair market value of such goods and services.
Negligence: Consider excluding costs necessitated by or resulting from the negligence or willful misconduct of the landlord or its employees, agents or contractor or any tenant or other users of the property.
Reserves: Consider addressing the amount of reserves that may be passed-through, if any, for anticipated or future expenses.
Hazardous Materials: Consider addressing costs arising from the presence of any hazardous material in or about the property.
Existing code violations: Consider excluding costs incurred because the building violates any applicable building code or on account of construction defects.
Developer Fees: Consider excluding the cost of any fees under an applicable development agreement for the property, such as costs made in connection with any child-care facilities, traffic demand management programs, transportation impact mitigation fees, off-site improvements, infrastructure or transportation assessments, or art programs.
Property Tax Increases: Consider addressing increases or supplemental property taxes assessed by reason of a sale of the property.
Miscellaneous Expenses: Consider excluding charitable and political contributions, entertainment, dining, gifts or travel expenses.
When should it be charged?
The LOI or MOU should address when operating expense payments will be made. Typically, operating expenses payments are either paid annually, in arrears, or estimated payments are made during the lease year and reconciled at year end.
How to measure the accuracy of the charges
A tenant that is being charged operating expenses will typically require of landlord the ability to audit landlord’s records to determine the accuracy of the operating expense charge. Audit provisions are often a “hot button” for landlords, and accordingly, the general terms of the audit provision should be included in the LOI or MOU when possible. Issues that may be addressed are:
- Who may audit
- Manner of audit
- Penalty if over-charged
Who may audit?
The parties should agree on who may audit landlord’s records. Landlord will typically require a Certified Public Accountant to audit its records, and consideration should be made as to how such accountant is selected (and what happens if the parties disagree). Some landlords will also prohibit contingency fee auditors from auditing landlord’s records.
Manner of Audit? Typically, the audit would occur at landlord’s office during normal business hours, and landlords often give a tenant only a limited time within which to request an audit. Some landlords provide as little as 60 days following the issuance of an invoice for operating expenses. Others allow several years. Also, consider how and when base year expenses may be audited.
Penalty if over charged
Consider imposing a penalty (such as the cost of the auditor) if the audit shows that the operating expenses were overstated by a certain percentage. This incentivizes the landlord to take measures to accurately account for its expenses.
Landlords typical require that the results of any audit be kept confidential from the other tenants, while a tenant will want to benefit from other tenant’s audits. The confidentiality of the audit should be included in the audit if it is a material deal term for either party.
A well drafted LOI or MOU will not only identify the type of lease, but will highlight the variances in operating expense allocations to better define the business deal between the landlord and tenant. Unless the landlord and tenant have done significant business in the past, and have a mutual understanding as to what constitutes a “Gross” or “Net” lease when applied between them, identifying the type of lease in a LOI or MOU without explaining the economic considerations of operating expense impacts may not give rise to a “meeting of the minds” between the landlord and tenant. These issues may be flushed-out during the negotiation process, but not without increased costs, delays and the risk that the parties may never reach agreement on the basic deal points upon which the transaction may be consummated.
This article does not communicate advice. It provides general information only, and may not be applicable to every situation.