Finally, even though net leases shift certain expenses to the tenant, they are generally paid through the landlord to ensure that things like property taxes don’t fall into delinquency. This is the same idea as your mortgage servicer requiring you to pay taxes and insurance as part of your monthly payment -- this way, they don’t have to track you down when the bills come.
Net leases are most common among commercial properties that are occupied by a single tenant, although they aren’t unheard of in situations where there are a few tenants in a building. Warehouses, freestanding retail properties, entertainment properties, and medical buildings are examples of property types that generally use net leases.
Advantages of gross leases
For a landlord, a gross lease generally represents the highest overall profit potential. Because the landlord is taking all the risk in terms of variable expenses, they tend to charge tenants more than a comparable net leasing arrangement would, even when factoring in taxes, insurance, and maintenance. Plus, in multi-tenant properties, gross leases are by far the simpler of the two arrangements.
For tenants, gross leases keep the rental process simple. The tenant simply writes one check for a predetermined amount. The tenant doesn’t have to do much maintenance work on the property, and if a repair is needed, all they have to do is alert the landlord.
Advantages of net leases
Net leases have advantages for both the landlord and the tenant.
From the landlord’s perspective, the most obvious advantage is that it shifts the variable costs of property ownership to the tenants. For example, I own a residential rental property, and if the property taxes increase by $1,000 next year, I’ll have to cover that cost. On the other hand, if I were leasing a retail property to a tenant on a net lease basis, I wouldn’t have to pay an extra dime. In simple terms, a net lease reduces a landlord’s risk, and helps create predictable rental income.
From the tenant’s perspective, a net lease typically offers a lower rental rate than that of a comparable gross lease. This is true even when factoring in the taxes and other added expenses -- because the tenant is accepting a higher risk level, the trade-off is that the landlord accepts a slightly lower income in exchange for consistency.
What’s more, not only is rent often cheaper than it otherwise would be, but net leases typically come with long initial terms (usually 10 years or more) with annual rent increases built in. However, the rent in a net lease tends to increase at a slower pace than the overall rental market. For example, market rent has historically risen by about 3% per year on average, and a typical rent "escalator" in a net lease is commonly 1–2% annually.
Lease structure is a major component of real estate analysis
If you’re analyzing real estate investments, knowledge of lease structures is a key component of assessing risk and economic sensitivity. For example, when I’m looking at a real estate investment trust (REIT) that owns freestanding retail properties, I know that the tenants are locked in for long periods of time, and that the company’s rental income stream should be extremely predictable. On the other hand, if a REIT owns self-storage properties (gross leased), tenants can come and go easily, and rising tax or insurance expenses could significantly hurt profits.
Of course, this is just one piece of the analytical puzzle, but it’s an important one, and one that’s frequently overlooked by investors.