Rant: Full Service Gross/Gross leases are the dumbest lease type imaginable
There is virtually no upside in offering a FSG/Gross/Modified Gross lease to a property owner. There, I said it.
For starters, you charge inflated rents on a “guess” of what the anticipated operating expenses for that space is going to be. Then you “cap” gross ups to 90, 95, or 100% over a “base year”. This has got to be one of the most stupid and flat out ignorant practices I see in the CRE world, for various reasons.
First, some tenants don’t move in right away or reach their maximum capacity during their base year. This is easily foreseeable and logically explained. Some tenants take months to fully move over their employees to a new location since they already have another location with an expiring lease in the area. Some tenants that are “growing into their space” take months to hire and onboard new hires. As a result? You get lower utility usage and occupancy, and therefore an artificially lower base year expense load. While the tenant may cover some of this overage, it defeats the purpose of the structure. It also works inversely that if during the first year a tenant racks up expenses, then it throws off reimbursements for all years that follow.
Second, the concept of “base year stop” potentially screws the owner out of expense reimbursements for the first year. Also, since owners allow tenants to bully them into this sort of structure, smarter tenants and tenant brokers will negotiate that certain expenses are strictly capped or unqualified altogether for reimbursements on expenses like property management fees, janitorial, and G&A.
Thirdly, the cost of labor incurred for doing gross lease types reimbursements from an accounting and asset management perspective is incredibly wasteful. It takes hours and a significant amount of money for property accountants and analysts to work together to reconcile tenant-specific expense reconciliations. Imagine how much money is wasted in a high-rise office tower every month/quarter in this process?
Fourth, gross leases don’t account for unexpected increases to expenses. I think it’s a relatively safe bet to assume that virtually every office owner in the country experienced an enormous increase to property insurance expenses over the past 2 years. I’ve heard of (and personally experienced) increases over 50-75% in some cases YoY. The property owner ultimately gets screwed by this and eats that cost. How’s your 5% annual cap treating you?
Conclusion: While we are generally in a tenant-driven market, it makes sense why owners bend over for tenants who demand gross lease types. However, if we all, as a collective, flip this narrative and demand NNN leases, we can solve this atrocious theft against owners. If you owned one rental property personally, and knew how tight margins are, would you “cap” expense reimbursements on expenses for your tenant and give them renewal options that may be below market? No, you wouldn’t. Sure your tenant average only $40/month in electrical usage their first year, but from then on you’re going to limit your pass-throughs to $40/month plus whatever your annual cap is? This is downright asinine. Even if you’re splitting some overage with the tenant.
If I was in charge, I would ONLY offer NNN pro-rata expense reimbursement leases to tenants, even if that means a possibly lower effective rent at my properties. There’s something innately valuable about having predictable, easily underwritable NOI that it seems most boomer owners can’t quite understand.
In recent years, inflation has been out of control and much higher than your underwritten 2.5-3.0% growth. Gross leases provide less protection against this. Compound this with floating rate increases and you have a higher expense load on operators. End rant.
Based on the most helpful WSO content, it's clear that the debate over lease types, including Full Service Gross (FSG), Gross, Modified Gross, and Triple Net (NNN) leases, is a hot topic within the commercial real estate (CRE) community. Each lease type has its own set of pros and cons, and the preference for one over the other can vary significantly depending on the perspective of the property owner or tenant, as well as the specific circumstances of the property and market conditions.
Full Service Gross/Gross Leases: These leases are often favored by tenants because they offer simplicity and predictability in budgeting for rent expenses. The landlord covers all or most of the property operating expenses, which can include utilities, taxes, insurance, and maintenance. This lease type can be particularly attractive in tenant-driven markets where landlords are willing to offer more inclusive terms to attract or retain tenants.
Modified Gross Leases: Serving as a middle ground, modified gross leases allow for a more balanced sharing of expenses between the landlord and tenant. Typically, the tenant pays a lump sum rent from which the landlord pays property operating expenses, but certain expenses like utilities, taxes, and insurance may be excluded and paid by the tenant. This can offer a compromise that benefits both parties, depending on the negotiation of the lease terms.
Triple Net (NNN) Leases: NNN leases are generally preferred by landlords because they pass most, if not all, operating expenses onto the tenant, including property taxes, insurance, and maintenance. This lease type provides landlords with more predictable net operating income (NOI) as the tenant covers the variable costs associated with property operations. However, it requires tenants to take on more responsibility and risk for the fluctuating costs of property expenses.
Your concerns about the challenges and inefficiencies associated with FSG/Gross leases, such as the difficulty in accurately predicting operating expenses, the potential for disputes over base year calculations, and the lack of protection against unexpected expense increases, are valid and shared by many in the industry. These issues highlight the importance of carefully considering the lease structure that best aligns with the financial goals and risk tolerance of both landlords and tenants.
Inflation and rising operating costs, as you mentioned, have indeed put additional pressure on property owners, making the predictability and stability offered by NNN leases even more appealing to some. However, market dynamics and tenant preferences can still make FSG/Gross leases a viable option in certain situations.
Ultimately, the choice between lease types should be informed by a thorough analysis of the property, market conditions, and the financial objectives of the parties involved. As the CRE landscape evolves, so too will the strategies for structuring leases that meet the needs of both landlords and tenants.
Sources: Types of RE Leases - A Primer, Let's Talk About the Pros and Cons of our Gigs in RE Finance, https://www.wallstreetoasis.com/forum/real-estate/lets-talk-about-the-pros-and-cons-of-our-gigs-in-re-finance?customgpt=1, Assisted Living - Pros and Cons, Loss/Gain to Lease
I'm in resi but I love the passion you're bringing to the table. From my (very) limited experience with commercial leases (namely my Argus training collecting dust and a few retail leases), I agree with you entirely.
The passion comes from first-hand experiencing how stupid this structure is. Why would anyone with half a brain agree to a Gross lease instead of a NNN structure? I mean come on. Here, come operate your business or residence in my building, and also let me cap myself on potential reimbursements from YOUR use of variable expenses each year. I’m not saying NNN is the way to go across the board, but if you go to a gas station and pump 15 gallons of gas at $5/gallon, why should the gas station charge you only $1.50/gallon in pass-throughs because when you signed a lease there back in 2016 gas prices were cheaper? Did the gas station drive your car or have any say in your fuel consumption? No. Also, why should another customer who signed their lease in 2020 pay $1.00/gallon in reimbursements because their base year was different than the other customer? It literally makes no sense. Tenants should pay for their actual usage of variable and pro-rata fixed expenses.
damn bro gross leases have a family. But 100% agree its an administrative nightmare that makes residential headaches seem small.
Gross leases are dumb. Tenants should pay for their allocation of actually-incurred expenses and pro-rata share of expenses in multi-tenanted properties.
I think you need a new lawyer..
if you’re operating a large building, opex won’t change that much with a new tenant. And if they are on a base year stop and they have light usage in their base year - they will pay a larger expense the following year due to an increased building expense and them paying their proportionate share. Also - of course we all want NNN leases. But from the tenant side - why should they take ownership risk (taxes & insurance) it cuts both ways. And if you look at markets where there are net and MG leases - for example, Miami - net leases in Wynwood are $60 with opex of $20. MG leases are $80..the rent and therefore margins is the same. And don’t fool yourself thinking tenants don’t negotiate caps to expenses and specific items are taken out of net expense reimbursements..
Love the passion. I'll entertain!
1. If the tenant has an "artifically low" base year, well then they'll eat the overage in higher subsequent years. If the base year is "artifically high", well I've priced in my rate given the currently OpEx projection and if expenses go down, great, I pay less for the same rent.
2. The inability to recover expenses in the base year should be priced in. You're assuming a base line of expenses and $X rent will cover my costs. If my costs go up, tenant eats it. And as pudding said, caps and expense exclusions are negotiated in NNN leases too.
4. Tenant eats overages, that's the whole point. I don't need to foresee cost increases when I'm doing the deal.
The only point I kind of agree with you on is #3, the admin nightmare aspect, but that's mainly because I had to go through it first hand. It truly does add several multitudes more work to your staff. That said, assume this scenario:
NNN leases and Gross leases have the same net effective rate, and both price in the "industry-wide" admin cost of managing the respective lease type. OK - well if my company is more efficient at sorting through Gross leases, I can decrease my cost to the property if admin fees are non-reimbursable, or I can make my building several cents/SF cheaper than yours if they are reimbursable. (You can only be so efficient at sorting through a NNN lease - the competitive advantage is miniscule compared to that potential in Gross leases.) So if I'm such a company where I've fully automated and streamlined my Gross reimbursement process, and it takes you 10x the time, and so you have to either increase your rents to get the same property-level return, or you have to quote a higher OpEx per SF for comparable product, I'll sign Gross leases all day and edge out ahead of you. This is pretty extreme, but it could explain why some owners at some time in history would choose a Gross lease, and from there it's maybe just become convention.
As a landlord, NNN leases typically means tenant pays rent on the entire building or floor plate. So, I get rent on that space you don’t think of like elevator lobby space, janitor room, electrical room. And the tenant pays for their own repairs - justified so because the tenant will be there longer (longer lease).
FSG though has its advantages and I see why it’s also used.
Nice rant.
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