I have been in the process of underwriting many small apartment buildings lately. Also, Pine continues to grow as a commercial bridge lender, so I have been underwriting other commercial deals such as warehouses, self-storage units, mobile home parks, and many others. What I find very interesting is both the confusion on the different lease structures and how investors underwrite deals based on terms that can quit literally mean different things to different investors. This is never truer than Gross versus Net.
I was having a conversation with one of my clients, and honestly one of the smartest investors I know. Him and I were looking at a deal differently because we were not understanding these terms the same. The term he was using was Net rent. When I ran my numbers on his deal, I took his Net rent and subtracted his estimated expenses to calculate the net operating income or NOI. NOI is needed to calculate the value of the asset. Because I was subtracting expenses, I was coming up with a much lower value then he estimated. He was frustrated and called to give me an education on the difference between Gross and Net.
When I review a real estate deal or a business that has a financial pro forma, I start with a gross number and adjust to a net number. Your net is the final number. In the case of commercial real estate, I look at a base rent as gross rent and any adjustments to that are used to calculate the net rent. It is very common in the commercial world to charge the tenant for other required expenses such as taxes, insurance, and operating costs. After a vacancy factor, these charges or reimbursements are added to the base rent to come up with a final rent amount. Too me, this is a net number. My client disagreed. To him, all rent that comes in is his gross rent. To calculate his NOI he was taking what he considered his gross rent and subtracting operating expense. Confused yet?
In this specific case all operating costs were being charged to the tenants so his gross rent minus operating costs was equal to his net rent. We call this a triple net lease. Because I considered his net rent AFTER reimbursement for operating expense, I subtracted the operating expenses and came up with a number that was much lower than his. This small error on my part brought the value of the building down by over a million dollars making it almost impossible to finance.
He is much better at underwriting deals then I am so when he called, I listened. I was really getting hung up on his interpretation of Gross and Net and what I realized is we were both right. The problem is there are different types of lease structures in commercial real estate which adds to the confusion. What really happened in this case is a simple misunderstanding of these two basic terms and how they can literally mean different things to different investors. This was an important lesson to always review and understand the full current financials, including the lease structures and projected financials, when calculating your net operating income. It is also important to understand the three basic lease structures.
Gross Lease
This is the one that got me confused on my example deal. A gross lease means the tenant has a set lease amount and the landlord pays all expenses. Nothing is charged back to the tenant. This is common in residential real estate, self-storage, as well as multi-tenant buildings that share utility meters or have common areas that are difficult to calculate responsibility for. It is great for tenants because they have a fixed payment they can count on and have no risk of increases in operating costs. In these cases, the base rent is the gross rent and Net rent would be after a vacancy factor and any additional income such as laundry or vending machines.
Modified Gross
This is when the landlord can negotiate that the tenant cover portions of the operating costs. The tenant will always have a base rent which is then modified to cover some of the costs to operate. Maybe there are reimbursements for some common area maintenance CAMs, or a pass through of taxes, insurance, or utilities. You don’t typically see this lease structure in single family rentals but will in multifamily when the landlord charges back some utilities based on shared meters, or in situations with multi-tenant commercial space with common areas. In these cases, the landlord is still responsible for some expenses so you will see expenses being deducted from the adjusted gross number or what I would consider a Net rent number.
Triple Net or NNN
This is the lease structure that was being used in my example above. My client was buying a building where all the tenants were on a triple net lease. In these cases, the tenant pays a base rent and then adds to that their share of ALL operating expense. This includes taxes, insurance, and operating costs. Assuming no vacancies, the rent amount that landlord receives is equal to their NOI since all their costs are covered.
My client considered his net rent equal to his base rent because all the tenants were on NNN leases, and all expenses were covered by the tenant. That is why he used the term net rent as his base rent when I was using the term gross. Knowing the different lease structures, I should have realized he was on NNN leases and his net rent number he supplied to me was the number the property produced.
You may also hear of single net and double net leases which both fall into the modified gross lease category in my opinion. A single net lease typically means the tenant will pay a base rent and one of the other major expenses such as taxes. A double net lease typically means the tenant will pay a base rent along with taxes and insurance.