Royal LePage Regina Commercial Team - Produits, offres, nouvelles

In a commercial context, leases and lease terms can vary.  However, there are three common types of leases used in commercial tenancies: (i) net lease; (ii) gross lease; and (iii) semi-gross lease.  These three types of leases are mainly distinguished by the degree to which a tenant is responsible for the various expenses in relation to the property, as well as the risk allocation for any cost uncertainty with respect to the leased space.

 Net Lease

This type of lease is commonly referred to as a ‘triple net lease’. The three nets referred to are property taxes, building insurance, and common area maintenance. This means that the tenant is responsible for each of the foregoing costs; and the landlord is not responsible for any of these.  Additional expenses may also be included in the lease, offloaded by the landlord to the tenant.  As such, any risk of cost uncertainty is generally borne by the tenant. A triple net lease is most advantageous to landlord as the three major expenses that are required to maintain a building (with or without tenant) are passed on to the tenants proportionately. Generally, the landlord only maintains responsibility for expenses related to structural repairs/replacements.

As this lease will typically benefit the landlord more than the tenant, it is very important for the tenant to not only review the lease thoroughly, but also understand their rights, liabilities, and obligations in detail.

Net leases are very common in retail and industrial properties, but less common in office buildings.

Gross Lease

Under a gross lease, the tenant is only responsible for the rent per month, and generally, nothing more. The landlord and tenant agree on a price per month at the outset. As such, the risk of any cost change (e.g. change in property tax, utilities, or building insurance premiums) is borne by the landlord. Gross leases are typically used for older properties or by relatively small-scale landlords looking for simplicity. The leases generally have shorter lease terms, and are quite commonly used for office buildings.

For landlords entering into a long-term gross lease contract, it is important to take stock of and discuss any major expenses that property tax increase to protect themselves. Additionally, utilities are included in the rent; therefore, it is important for the landlord to take into consideration and plan ahead for any change in uses as utilities might rise over time.

Semi-gross Lease

This type of lease is sometimes referred to as a ‘modified gross lease’. In this type of lease, the landlord and tenant agree on the rent, utilities, and potentially additional expenses at the outset. This distinguishes the lease from a net lease, as the tenant is not responsible for any cost fluctuation, other than utilities.  However, this is also not a gross lease, as the landlord and tenant have determined and built in some certainty as to the costs of utilities and additional expenses. In other words, this type of lease is a gross lease, but the tenant agrees to pay the utilities. The rent portion includes the operating costs, reducing the risk to the tenant for the changes in these costs. When using this type of lease, it is important for a landlord to take consideration for potential increases in operating costs, especially if entering into an agreement for a long term. There is no one correct type of lease: each situation will require a particular determination of cost certainty and risk allocation. Parties are strongly encouraged to discuss their objectives and enlist the services of an experienced professional when entering into and negotiating a new lease.

The content of this article is meant for informational purposes only. It is not meant to provide any financial, business, commercial, or legal advice. Readers are encouraged to discuss all matters with a commercial realtor or lawyer for all particular situations involving the content of this article.

Commonly referred to as a ‘cap rate’, the capitalization rate is a benchmark in valuation methodology often used for commercial real estate investments. This method is generally used and accepted by lenders, appraisers, and real estate investors.

The cap rate is the relationship between the investment’s net operating income and its value. Net operating income is the remaining revenue from the property less all reasonably necessary operating expenses. Note – debt servicing is not part of the equation. Users of the cap rate method pay close attention to the profit-loss statement to ensure net operating income is accurate to, in turn, allow for an accurate calculation of cap rate. For example, a $5,000 difference in net operating income with an investor seeking a 6% cap rate can result in $83,333 dollars of difference in property valuation. It should also be noted that different asset classes (multifamily, retail, office) will have different cap rate that is acceptable for that market/trade area.

Equation

NOI/Value = Cap Rate

Example

An investor is considering purchasing a property with a forecasted first-year NOI of $50,000. The investor has established a cap rate requirement of 9.75% based on similar properties. What would this investor consider paying for the property?

NOI ($50,000)/R(0.0975) = V($512,821)

The investor will consider paying $512,821 for this property using the cap rate of 9.75% to determine investment value. The advantage of using this valuation method is its simplicity in calculation and the fact that it accounts for vacancy and credit losses and operating expenses; unlike alternative valuation methods, such as gross rent multiplier. On the other hand, because of its simplicity, it has certain limitations to its reliability: since the cap rate does not consider financing or tax impact. Additionally, the cap rate only takes into account a one-year forecast when determining value or measuring performance. A common misconception when using the term cap rate is that some investors assume that the overall cap rate is equal to the return on their invested capital. This is rarely the case.

While the cap rate can be a useful valuation tool for commercial real estate, investors should be aware of its drawbacks: it does not tell you everything about the investment going into the future. Therefore, investors should take into consideration a multitude of factors and valuation methods to determine their purchase decision.

The content of this article is meant for informational purposes only. It is not meant to provide any financial, business, commercial, or legal advice. Readers are encouraged to discuss all matters with a commercial realtor or lawyer for all particular situations involving the content of this article.