When thinking of renting a property, the type of lease you sign should have a significant impact on the property you choose. Knowing the type of lease you’re looking for also helps you negotiate rent or any other obligations that the landlord may request.
However, lease agreements rarely specify the type of lease agreement in the document. Instead, you’d have to deduce the type of lease from the terms and conditions, as well as the parties’ (lessee and lessor) rights and obligations to the property.
Here’s a guide to help you identify the various types of leases and the terms and conditions that come with them.
What is a Lease?
A lease is a contract in which a lessor rents real estate to a lessee. The agreement grants the lessee possession of the property in exchange for payment of rent or other obligations to the lessor by the lessee.
The rent is usually paid monthly for the duration of the lease.
The document conveying the property from the landlord to the tenant for the duration of the lease is referred to as a lease agreement. The lease agreement specifies details of the rights and obligations of both landlord and tenant.
The lease agreement must contain an adequate description of the property, spell out the rent, use of the property, security deposit, duration of the lease, address of the property, date of the agreement, and details of both the lessor and the lessee.
Parties to a Lease Agreement
Lessor
The lessor is the owner of the real estate. The lessor grants the lessee the possession, use, and occupation of the property. In return, the lessor periodically collects a fixed amount called rent from the lessee. The lessor is also known as the landlord.
Lessee
This is the tenant. The tenant pays rent to the landlord in return for being granted exclusive possession of the property throughout the lease.
Common Types of Leases
Lease types vary by jurisdiction, but there are broad categories that cover all of them. Full-service lease, percentage lease, absolute NNN lease, net lease, and modified gross lease are some of the most common types of lease.
It is important to note that the lease agreement may not explicitly state the type of lease; the best way to determine the type of lease is to review the contract’s terms.
1. Full-service lease
It’s also known as an operating lease. In this lease agreement, the landlord is solely responsible for the property’s maintenance and payment of operating expenses, while the tenant is only responsible for the base rent.
Maintenance, taxes, and other supporting costs must be incurred by the landlord. Insurance, electricity, water bill, repairs, janitorial, cleaning, real estate, and taxes are some of the supporting costs covered by the landlord.
Many lessees prefer the full-service lease because of the certainty it provides. Tenants are not required to pay any additional bills after they have paid the base rent and the rent remains constant throughout the lease.
The lessee also saves time by not being involved in active property management.
However, landlords tend to overcharge rent in this type of lease. This is because landlords do not want to be caught off guard by fluctuating and rising operating and maintenance costs.
The landlord is free to maintain the house as he sees fit, preserving the building’s value.
Full-service leases are common in high-end buildings such as multi-story buildings, multi-tenant buildings, and office spaces in buildings.
For example, if your landlord hires a handyman to replace lightbulbs or repair a leak, you’re on a full-service lease.
2. Percentage Lease
A percentage lease is an agreement in which the tenant pays base rent plus a percentage of sales to the landlord.
You’re probably wondering if paying base rent plus a percentage of your revenue is too expensive. The truth is that the cost is rarely prohibitively expensive.
A percentage lease’s base rent is typically not very high. The percentage of the tenant’s gross revenue payable to the landlord is the main draw for the landlord.
Only business owners are eligible for this type of lease. It is common in shopping malls with many retail outlets.
If the property gives the tenant good visibility and sales, the landlord will receive a good return. However, if the business isn’t doing so well, the company won’t be under pressure to keep up with an exorbitant base rent.
Most landlords facilitate tenant sales under this type of lease by strategically positioning outlets. For example, a landlord may place a laundry service near a fabric seller and a dressmaker.
A ‘natural breakpoint’ is used to calculate percentage leases. It’s the point at which the landlord begins to receive a percentage of profits.
You owe the landlord a percentage of your earnings if you earn more than the natural breakpoint. The sweet spot is typically 7% of revenue; be wary of landlords who charge as much as 12%.
How Percentage Lease Works
The base rent for a retail outlet is $20,000; regardless of profit, the tenant owes the landlord that amount. The revenue-sharing percentage is 5%, with a breakpoint of $100,000.
This means that if a tenant’s sales exceed $100,000, the tenant must now pay the landlord 5% of the excess.
So, if the tenant generates $150,000 in revenue in a month, the tenant will pay $20,000 in base rent plus 5% of that amount. The total rent accrued to the landlord is now $22,500.
Businesses that use percentage leases must be cautious not to overstate profit. Sales tax, refundable deposits, catalog or mail order sales, vending machine sales, and delivery or installation charges should be deducted from gross revenue.
The most strenuous aspect of the percentage lease is the tenant’s obligation to accurately report financial information to the landlord down to the smallest detail, and the landlord’s obligation to verify the accuracy of the information.
3. Absolute NNN lease
The absolute lease is also known as a bondable lease. The landlord leaves all maintenance obligations to the tenant in an absolute NNN lease.
The tenant is responsible for all major and minor expenses on the property. Insurance premiums, rent, property taxes, property repairs, and maintenance (including structure and roof) are some of the costs to be covered by the tenant.
This is a common arrangement between commercial property owners and their tenants. Absolute NNN leases are distinguished from triple net leases by the addition of structure and roof maintenance to the tenants’ obligations.
4. Net lease
A net lease is an arrangement where the landlord lets a property to the tenant on the condition that the tenant will bear a part of the property expenses.
Aside from rent, the tenant is usually responsible for other property expenses such as utilities, insurance, property taxes, and operational costs. Rent is usually lower than in other arrangements due to the tenant’s expenses.
There are various types of net leases available, depending on what parties find suitable. Net leases are classified as single net leases (N Leases), double net leases (NNN Leases), and triple net leases (NNN Lease).
A. Triple Net Lease/ NNN Lease
The most common kind of net lease. In addition to paying rent, the tenant is responsible for all property-related expenses.
Because of the additional costs that the tenant will bear, the base rent is usually not very high. Rent, utilities, repairs, taxes, and maintenance are typically borne by tenants.
The only exceptions are the roof and structure, which are incurred by the landlord.
The benefit for landlords who use this type of lease is that they don’t have to worry about rising insurance, tax, and repair costs—all of that falls on the tenant. Typically, the tenant pays the taxes to the landlord, who ensures that they are promptly paid to the appropriate collectors.
The major drawback for the landlord, however, is the consequences of the tenant’s failure to pay those expenses. If a tenant falls behind on property taxes, there may be a claim against the building.
Also, if a tenant fails to make necessary building repairs, the value of the building may depreciate, causing the landlord to incur a loss on the building’s market value.
A significant benefit of the NNN lease for tenants is the ability to choose which repairs are necessary. Also, because the tenant will be responsible for their maintenance, the tenant can seek out the best insurance deals and negotiate for the landlord to make some investments in utilities or renovations.
B. Double Net Lease (NN Lease)
The tenant pays the rent, insurance, and property taxes under this type of lease. Insurance and tax payments are made to the landlord, who remits them to the collecting authority.
If the property is occupied by more than one tenant, the landlord calculates taxes and insurance by the space occupied by each tenant.
The landlord bears the cost of repairs and maintenance, giving the landlord control over building repairs and structural changes. However, the landlord must bear the financial and logistical implications of building maintenance, which is not cheap.
C. Single Net Lease (N Lease)
The tenant only has to pay rent and taxes in this case. The tenant pays the taxes to the landlord, who forwards them to the appropriate collecting authorities.
The N Lease is the rarest type of net lease, owing to the landlord’s exposure to the consequences of failing to pay property taxes.
The government may file a claim against the property if the tenant fails to pay the property taxes on time. This is a major concern for the landlord because it jeopardizes the landlord’s reversionary interest in the property.
As a result, landlords prefer to collect taxes from tenants monthly.
5. Modified Gross Lease
The modified gross lease is typically a customized hybrid of the gross lease and the net lease. It is a modification because, in an absolute net lease, the tenant bears all property expenses, whereas, in an absolute gross lease, the landlord incurs all property expenses.
As a result, any lease that has both net and gross lease characteristics is a modified gross lease.
Both the landlord and the tenant are responsible for the payment of the property’s operating expenses with this lease. The lease agreement specifies the specific expenses that must be borne by either the landlord or the tenant.
This is a common arrangement in multi-tenant buildings. The landlord is responsible for the property’s general expenses, while each tenant is responsible for expenses within their unit.
Conclusion
As a landlord or a tenant, make sure to read and negotiate every aspect of your lease agreement. This is to get you acquainted with your rights and obligations for the duration of your occupancy of the property.
When deciding on the type of lease to sign as a landlord, consider the purpose of the building to determine the revenue you’ll generate from it to choose the best lease.
You should also consider how much control you’ll have over the maintenance, which will affect the long-term value of your property.
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