Gross vs Net Leases Explained – Commercial Real Estate Accounting

Gross vs Net Leases Explained - Commercial Real Estate Accounting

NOTE: This is the first in a series of articles we will be releasing in the coming weeks on commercial real estate and the unique accounting aspects that are associated with it.

Do you ever get confused when your commercial real estate broker friends (or clients) are talking about gross and net leases and you don’t know what it all means? I’m asking for a friend 🙂. If that is you today and you’d like to change that, then this article is for you.

As an accountant I’ve been saying this for many years – the best accountants I know are not only great technical accountants but also KNOW THE INDUSTRY THEY ARE WORKING IN COLD. It’s one thing to read a lease – it’s quite another to have context on the terms, understand if the terms are market or not, tenant versus landlord friendly, etc.

In this article, we are going to define gross, modified gross, and net leases, including the pros and cons of each for both owners and tenants.

Definitions and Pros/Cons:

  • Gross Lease
    • Also known as a full-service lease, a gross lease is a type of commercial lease where the tenant pays a fixed rental amount, and the landlord is responsible for covering the Big Three operating expenses (property taxes, property insurance, and repair and maintenance (“R&M”). In this case, the monthly payments include both base rent AND the landlord’s estimate of the Big 3.
    • From the tenant’s perspective, the primary pro is that they have a predictable monthly payment for years to come as they don’t have to worry about fluctuating property taxes and insurance. Conversely, the primary con is that the property taxes, insurance, and R&M ‘estimated and included’ in their monthly lease payment may be more than the actual expense paid by the landlord, resulting in a potential net gain for the Landlord, and resulting net loss for the tenant.
    • From the landlord’s perspective, the primary pro is the stable income and the control over maintaining the property in good condition since they are responsible for R&M. And of course the most significant con for landlords under this lease structure is the fluctuations in property tax and insurance costs which they are solely responsible for (e.g. actual Big Three expenses are higher than the estimate being paid by the tenant).
  • Modified Gross Leases:
    • Modified gross leases are the same as gross leases, with the main difference being that real estate taxes and insurance are generally trued up annually for the difference between actual expenses and the estimated ‘base year plus increase’ that is defined in the lease.
    • The pro from a tenant’s perspective is that if the base year + increase is LESS than the estimate, then the tenant will receive a rent credit – alternatively, the con is that if the base year calc is higher than the estimate, the tenant will have to pay more in rent after the true up.
    • The pro for the landlord is that they no longer have to accept property tax or insurance fluctuation risk, as that is passed on to the tenant. For that reason, this lease is generally considered more landlord friendly.
  • Net Leases:
    • For net leases, conversely, some or all of the operating expenses are passed on to the tenant, meaning the tenant is responsible for making the payments. The different types of net leases include single net leases (where the tenant pays property taxes directly), double net leases (tenant pays property taxes AND insurance directly), and triple net leases (tenant covers property taxes, insurance, AND maintenance directly).
    • From the tenant’s perspective, the main pro is often a lower monthly payment given taxes and insurance are not paid monthly but rather annually or semi-annually. The con is that the tenant is now accepting tax and insurance risk, PLUS they have the extra burden of doing the property maintenance.
    • From the owner’s perspective, this lease structure is likely the most beneficial if they don’t want to take on tax and insurance risk, want predictable cash flow, and don’t want to handle property maintenance.

Accounting Implications:

Now that we have explained the different business terms of these leases, we have to talk about the accounting from both the tenant’s and owner’s perspectives:

  • Tenants:
    • Gross leases – This is by far the simplest accounting for the tenant because they simply record one payment of rent each month (e.g. rent expense).
    • Modified Gross – In this lease, the tenant is likely recording four different expenses (e.g. four different line items) per payment per month: base rent, property tax estimate, insurance estimate, and R&M estimate. And then at year-end, the landlord will deliver a true up that will need to be recorded.
    • Net leases – These would likely be considered the most intensive from an accounting perspective (assuming accrual accounting) given you’re accruing for taxes, prepaying and amortizing insurance, and then entering and processing R&M bills as they come in.
  • Owners:
    • For owners, net leases are by far the easiest from an accounting perspective because the tenant is responsible for paying taxes and insurance. In this case, the landlord simply collects one check per month recorded as rent income.
    • After net leases, gross leases would be next in terms of complexity, because while the owner is responsible for R&M, taxes, and insurance, there is no true up at year-end.
    • Modified gross leases have the most accounting complexity for owners because not only do they make the payments throughout the year and handle the maintenance, but they also must true-up the bill annually with the tenant (actual vs base year-estimate).

 

If you have any further questions and/or need help with your accounting for gross and net leases, please book a call to speak with us here

NOTE: Another aspect of gross and net leases that we haven’t covered in this article is common area maintenance (CAM) charges. These are additional charges often included in modified gross and net leases. We will cover accounting for CAMs in a subsequent article given it is an in -depth topic in and of itself.