A triple net lease is a type of commercial lease agreement requiring tenants to pay the property’s operating expenses such as utilities, taxes, insurance, and maintenance fees in addition to base rent. Essentially, each tenant is responsible for their own repair and maintenance and each tenant further pays a pro rata share of all of the landlord’s expenses associated with the operation of the commercial property including a management fee to the landlord. Triple net leases are commonly used for multi-tenant industrial and retail properties where operating expenses can be very high.
Commercial property landlords prefer triple net leases because they pass on the risk of unexpected costs to tenants. While landlords most often oversee the maintenance of the common areas including maintaining insurance, paying property taxes, making improvements and marketing the center to the public, they don’t have to worry about the costs related to these efforts. If there are unexpected increases in utility rates or insurance rates, the cost is generally absorbed by the tenants. If the commercial property’s value is reassessed resulting in an increased property tax, the cost is generally absorbed by the tenants. With each tenant responsible for the expenses associated with their specific space and each tenant paying their pro rata share of the rest of the property’s expenses, landlords eliminate or at least limit their risk of unexpected costs. Moreover, hiring management to oversee the property’s maintenance of the common areas and passing this expense onto the tenants allows landlords to collect the base rent free of expenses. This provides landlords with a consistent income stream from rental income. Otherwise, landlords seek a higher base rent when they are paying for all of the property’s expenses.
Although tenants generally dislike triple net leases because of the uncertainty associated with the payment of operating expenses, triple net leases often feature a lower base rent than tenants may otherwise get with more traditional leases. This aspect of triple net leasing can prove particularly beneficial to tenants in newer properties which require less maintenance and often make more efficient use of utilities.
To see how a triple net lease works in the real world, consider the following example:
The owner of a small computer business enters into a triple net lease to rent a 2,000 square foot retail space at $20 per square foot annually for a term of five years with an annual 3% increase in base rent. The 2,000 square feet represents 20% of the retail center’s square footage. The base rent for the property for year one would be $40,000 per year. Because this is a triple net lease, the tenant is responsible for paying 20% of the landlord’s operating expenses for the retail space (its pro rata share). Operating expenses include real estate taxes, insurance, repairs and maintenance, utilities and an annual management fee equal to 10% of the annual operating expenses.
Assume that, in year one, the landlord incurs the following expenses:
- $20,000 for real estate taxes.
- $5,000 for insurance
- $10,000 for repairs and maintenance.
- $15,000 for utilities.
- $5,000 for management fees.
During the first year of the lease, the tenant pays the landlord a total of $51,000.00 ($40,000 in base rent and $11,000.00 for its pro rate share of the total operating expenses). Assume in year two that all of the operating expenses stay the same but the building’s roof caves in and the landlord spends an additional $100,000.00 on repairs. The tenants total burden increases from $51,000.00 in year one to $72,200.00 in year two ($41,200.00 in base rent including the 3% annual increase and $31,000 in operating expenses including the cost for the roof repairs).
The above example reflects an uncommonly high percentage increase in total rent due to significant damage to the property. In addition, every commercial lease addresses operating expenses differently. In some leases, structural damage to the roof may remain the landlord’s responsibility. The roof’s collapse may also be covered by insurance. However, the above example illustrates how tenants are affected by unexpected increases in operating expenses.
Clearly, triple net leases are beneficial to landlords because they minimize the risk of unforeseen increases in expenses. In most cases, especially in the retail context, tenants aren’t given an option. They are, however, able to negotiate better terms regarding which expenses are included as operating expenses (most often referred to as Common Area Maintenance expenses or CAMs). For instance, it may be possible to limit capital expenditures for improvements to the property. See “Understanding Your Lease – Common CAM Exclusions“. Negotiating a commercial lease in California can be particularly complex. Whether a tenant or a landlord, it is best to consult an experienced San Diego commercial lease attorney.