What Makes Up the NNNs of a Commercial Lease?￼
W. Scott Reichenberg – President / Principal with The Colorado Group, Inc.
Many different types of commercial leases are used in the commercial real estate industry. One of the most common is the triple net lease, also known as a “NNN” lease. Business owners may sign several of these leases throughout their lifespan; however, NNN leases are frequently misunderstood. Therefore, let’s examine these leases and what they consist of in more detail.
What is a NNN Lease?
A triple net lease (NNN) is a common type of lease structure in which the Tenant pays the expense to operate the property in addition to the base rent. The Tenant becomes liable for paying the various operating expenses based on the percentage of the building that the Tenant occupies. The “NNN” stands for “net, net, and net,” which includes:
These are the net of base rent:
● Property Insurance
● Real Estate Taxes
● Common Area Maintenance
Common area maintenance ends up being a catch-all for all the operating expenses beyond insurance and taxes. This may include landscaping, snow removal, repairs, maintenance, etc. You should note that utilities, janitorial, property management, and other services the Tenant uses may or may not be included within the costs mentioned above. Therefore, it is essential to understand how each Landlord includes or does not include these expenses as part of the NNN structure. It is typical to request the specific breakdown and two to three years of history prior to signing a lease. Requesting this information helps to pick up on trends to forecast the future and evaluate how well the property manager/landlord manages the operating costs.
You may be wondering how a NNN lease differs from a gross lease. Commercial property leases are typically classified as absolute base net lease, absolute gross lease, or a modified gross lease. A NNN lease is usually considered an absolute base net lease; however, NNN leases may be impacted by the age of a building.
For example, signing a NNN lease for a brand-new building can be favorable, as maintenance issues can be covered under its warranty. However, property taxes may not be fully assessed for the first year or two, and therefore, you could have reduced expenses during that timeframe. Tenants need to be aware and plan for these expenses to ramp up over time at greater inflation rates. We see this happen with property taxes on new projects where this specific expense can increase 50% to 100% in the second or third year, often catching a Tenant off guard. The advantage of an existing property is that they are predictable; however, as they age, you must be aware that maintenance expenses may escalate more than inflation. While the Tenant is not responsible for capital expenses (i.e., full replacement roof, HVAC, or parking lot), it usually does not limit the Landlord’s ability to continue to repair these assets while they are approaching or surpass their end of life. For this reason, tenants must always ask the age of these items and read the lease very carefully to understand how these items are managed/addressed before signing.
How NNN Leases Work
NNN leases are frequently used in multi-tenant buildings. There are some situations where the lease structure is noted as single Net (“N”) or a double Net (“NN”) lease. These are instances where the Tenant becomes directly responsible for paying one or more of these expenses directly with the vendor, and the Landlord isn’t involved with collecting and accounting for these expenses. These typically occur in single-tenant buildings. The budget/estimate for the calendar year is established by the previous year’s actual expenses and any known variations (increase or decrease) of those expenses. The Landlord sets these for the year as your operating expense budget. Then at the end of each calendar year (usually February/March), the Tenant is provided actual accounting of these expenses from the previous year. If the Landlord over collects, they will return those funds (typically as a rent credit). If the expenses were under collected from the estimate, the Tenant would owe more rent to make up for the shortfall. The good news is that the Landlord doesn’t profit from the expenses; you only pay what it costs to operate the building.
Understanding Property Insurance
- Landlords carry insurance to protect the property in case of a casualty and protect with general liability, which is part of the net expense that gets passed through. In addition to this expense that gets included in the operating expenses, the tenant is responsible for securing and paying their own policy coverage directly to cover, which may include: General liability insurance for the tenant’s employees and invitees.
- Business Interruption to cover the rent and related business operating expenses.
- Improvements & personal property coverage to address the insurance of the interior improvements and all the business assets (inventory, raw materials, and furniture)
The Tenants will be required to present a valid certificate of insurance to prove the coverage, which is all defined in the lease.
Understanding Real Estate Taxes
The property assessed value is set by the County Assessor and reviewed every two years. The mill levy is set annually by various taxing authorities (school districts, the County Commissioners, City Councils, and the boards of the different taxing entities). Most landlords will reserve the right to object and challenge the valuation if the assessor has incorrectly over-assessed the building. However, the Tenant may want to reserve the right if the Landlord elects not to object if there is clearly an assessment error. A 3rd party consultant/expert usually works on a contingency basis and would be paid a percentage of the successful reduction of the taxes.
Understanding Common Area Maintenance
The common area maintenance component of an NNN lease consists of many different things, including:
● Property repairs
● Cleaning of common areas
● HVAC preventative maintenance and repair
● Outdoor lighting
● Snow removal
● Common area utilities and janitorial (which sometimes include the premises)
● Roof and parking lot repair
What Does the Landlord Pay in a NNN Lease?
After learning about the different components of an NNN lease, one might assume that tenants must bear all the costs associated with the property. However, the Landlord will still be responsible for paying certain expenses such as their tax preparation or legal fees incurred by their attorneys, marketing the property, real estate broker commission, and, most importantly, capital items such as HVAC, roof, and parking lot replacement.
As you can see, the components of an NNN lease are usually defined clearly; however, prospective tenants signing a NNN lease should always take the time to understand what they include and how they are managed. Consult a real estate broker and/or attorney to fully understand which of these net expenses they will bear. If you would like assistance with understanding an NNN lease, please contact The Colorado Group, Inc.