Lease structure is one of the most important concepts for real estate investors to understand. Most people are familiar with residential leases, but commercial properties are leased differently.
The triple net lease is a popular lease type in commercial real estate, especially among single-tenant properties. Here’s an overview of the types of leases commercial tenants could potentially sign and what investors need to know about triple net leases.
Two main types of real estate leases
When it comes to real estate leases, there are two basic types: gross leases and net leases. The main difference is what expenses the tenants are expected to pay.
Gross lease definition:
Under the terms of a gross lease, a tenant pays the landlord an agreed-upon rental rate for the property. Depending on the property, the tenant may also be responsible for various utilities, but that’s the extent of the financial obligation.
A gross lease is what most Americans are familiar with. These are the leases that residential landlords use when leasing apartments to tenants. They're also common in other consumer-facing types of real estate. You might see them on self-storage units and hotel rooms, for example.
Now let's look at the other option.
Net lease definition:
A net lease shifts some financial obligations to the tenant. Exactly what the tenant pays for depends on the type of net lease, but it could include utilities, taxes, insurance, and more.
There are four main categories of net leases:
- Single net lease: In addition to rent and utilities, tenants are responsible for paying the building’s property taxes.
- Double net lease: In addition to rent and utilities, tenants are responsible for paying the building’s property taxes and for building insurance.
- Triple net lease: In addition to rent and utilities, tenants are responsible for paying property taxes, building insurance, and most structural and common area maintenance expenses.
- Absolute net leases: Tenants are responsible for virtually every possible payment, including major repairs. Triple net leases generally have a few maintenance-related limitations. For example, if a building has structural issues because of its age, that may still fall to the landlord under a triple net lease. Under an absolute net lease, it would be the tenant’s responsibility.
Triple net leases are by far the most common. They're so common that the terms "triple net lease" and "net lease" are often used interchangeably.
Single net leases are very uncommon. Absolute net leases aren’t terribly common, either. Double net leases are a bit more common in multi-tenant properties such as shopping centers and office buildings.
Even though these expenses become the responsibility of the tenant, most landlords insist that the payment pass through them. That way they know the expenses get paid. This is like a common residential mortgage. You probably pay a monthly portion of your annual property taxes and hazard insurance on your home mortgage. The same concept applies here.
Triple net leases generally have long initial terms. It’s not uncommon for a triple net lease to have an initial term well in excess of 10 years with several options for the tenant to extend. And they often have gradual rent increases built in. These are known as "escalators."
When are triple net leases used?
A triple net lease can be used for any type of commercial real estate, but they're most practical for single-tenant (freestanding) properties. Splitting insurance and maintenance expenses among dozens of tenants would be a logistical nightmare.
You’ll commonly see triple net leases on freestanding retail properties, like convenience stores, warehouses, clubs, and so on. They’re also quite common on larger single-tenant properties, like medical offices and industrial properties with a single tenant.
Why would a landlord want to use a triple net lease?
Because it shifts most of the variable costs of property ownership away from the landlord and onto the tenant.
Think of it this way: I own a single-family home as an investment and it's rented out to tenants. If the property taxes jump by $500 next year, I have to absorb that expense. If my insurance cost rises by $500, I’m paying. And, if unexpected maintenance items arise ... you guessed it, I’m paying.
Meanwhile, if I buy a building and lease it to a convenience store business on a triple net basis, all of those costs would be absorbed by the tenant. My cash flow wouldn’t be affected at all.
In addition, the long-term nature of a triple net lease lets a landlord minimize vacancy and re-leasing risk. And the built-in rent escalators create a steadily growing income stream.
In a nutshell, a triple net lease lets a landlord minimize risk. It keeps expenses predictable and locks a tenant in for a long time.
This isn’t to say that there aren’t any risks to a landlord who uses triple net leases. For example, if maintenance is the responsibility of the landlord, you can bet that it’ll get done in a timely manner, as the property owner wants to protect their investment. On the other hand, a tenant doesn’t have as much of an incentive to spend money on routine maintenance.
Why would a tenant agree to a triple net lease?
It may seem like triple net leases are only advantageous to the landlord. But they generally come with lower payments than comparable gross leases. This is viable because the tenant agrees to a long lease and absorbs the risk of variable costs (taxes, insurance, and maintenance). Even after factoring in the additional cost responsibilities, tenants get a better deal.
Triple net leases often have a favorable initial rental rate and the escalator is also generally less than the expected rise in market rental rates. Commercial market rental rates have historically risen at a 3–4% annualized rate. Meanwhile, annual rent escalators in the 1–2% range are common. These leases have a favorable cost structure and tenants know exactly what they’ll be paying in rent every year for the entire term.
Common for a reason
There are lots of benefits to triple net leases -- both to the landlord and the tenant. It's not surprising that it's such a common lease structure. And now that you know how a triple net lease works, you can feel confident in your analysis of any triple net property you consider investing in.