Understanding Triple Net Lease in Commercial Real Estate
What is a Triple Net Lease?
A triple net lease, also known as ‘triple N’, ‘NNN lease’ or ‘net-net-net lease’, is a form of real estate lease agreement where the tenant is responsible for all the operating expenses associated with maintaining the property being leased, in addition to the rent.
Traditionally, building owners are the ones who are responsible for insuring parts of the building that tenants don’t occupy. But with triple net leases, the owners don’t need to insure the (entire) building and places (part of) the burden on the tenant.
This type of arrangement is most common in commercial real estate, where landlords want a predictable and steady income stream. One of the main reasons building owners prefers triple net leases is to shift certain costs.
What’s the difference between Gross and Net Leases?
- A gross lease is the exact opposite of triple net lease. With a gross lease, the landlord pays for most expenses associated with a property such as property taxes, property insurance and building maintenance – excluding tenant’s personal utilities and insurance. Sometimes, the tenant must pay all utilities, but some already include heat and hot water in the rent. This agreement is most common in residential leases and usually the rent is significantly higher to cover for the additional costs.
- A net lease can be divided into three categories:
- Single Net Lease – often referred to as ‘Net or N’ lease, is not that common in the rental world. Here, the landlord transfers a minimal amount of risk to the tenant (who pays the property taxes). Any other expense such as insurance and utilities are the landlord’s responsibility. The landlord is also responsible for any maintenance and repairs that must be done to the property during the lease.
- Double Net Lease – also known as ‘Net-net or NN’ lease, is popular in the commercial real estate where the tenant pays for property taxes and insurance premiums in addition to the rent. So, the base rent is generally lower with this type of lease because of the additional expenses the tenant must bear. On the other hand, all maintenance costs remain the landlord’s responsibility.
- Triple Net Lease – this type of lease absolves the landlord of the most risks as compared to any net lease. With this type of lease, all operating costs including maintenance and repairs must be paid by the tenant in addition to the rent, property taxes, and insurance premiums.
In short, the net lease expenses are divided typically into three categories: property taxes, insurance, and common area maintenance. In a single net lease, the tenant would pay for one of these costs, two of them for a double net lease and all three in a triple net lease.
Triple Net versus Absolute Net Lease – What’s the difference?
Among the different types of leases, triple net and absolute net are most often confused. In an absolute net lease, sometimes referred to as ‘bondable’ lease, the tenant pays for all imaginable expenses including major repairs or structural maintenance (even issues that might simply be the result of the building getting old). A tenant in an absolute net lease may still pay for the rent even after the building has been destroyed or rendered uninhabitable after a fire or a natural disaster. Accounting and legal expenses though benefit only the landlord are not typically a tenant’s responsibility.
The biggest distinction between an absolute net lease and triple net lease is that triple net leases often don’t include repair to the structure or roof as tenant responsibilities; but with absolute net leases, these expenses are still passed on to the tenant.
Rent and Triple Net Lease Expenses
In a triple net lease, the tenant is responsible for all three categories of expenses on top of the base rent, as well as personal insurance premiums, utilities, and maintenance expenses such as janitorial services.
There’s no golden rule that dictates what insurance premiums property owners and tenants are required to cover and pay every year. Usually, it depends on what has been negotiated between the landlord and the tenant. Even in joint policies, the landlord or property owner and/or the tenant may also need additional policies to cover personal interests in the building or business.
In cases where one company rents the entire building on a triple net lease, the tenant is required to carry an insurance policy for the building as well as potentially pay for any deductibles or uninsured damages during their tenancy.
The expenses for property taxes as well as insurance can usually be anticipated (unlike common area maintenance costs). Make sure to budget for annual property taxes and assume they will be raised yearly.
Common Area Maintenance
Often, the most vaguely defined stipulations of a triple net lease apply to maintenance fees. Common area maintenance includes utilities and operating expenses in these areas. With a retail space where there might be several triple net leased tenants, the costs for the common areas are typically prorated based on the percentage of the overall building they occupy. For example, if a tenant leases just 500 square feet of a 10,000 square foot building, then he would only be responsible for paying 5% of these costs.
The landlord usually gives an estimate or average and charge them going forward on a monthly basis, or they can be payable as they’re incurred, or it can be a combination of both. Since there’s really no way to anticipate maintenance expenses or cost of repairs, triple net leases can fluctuate from month to month.
The rent is typically lower with a triple net lease. In fact, for new buildings, tenants might find that this type of arrangement is preferable than the other ones. The tenant in a triple net lease who’s still establishing his business in a new building will be able to enjoy the lower rent and expenses during his first few years. Triple net leases often have contractual rent increases, so reviewing and setting aside a part of your budget in advance will be a smart thing to do.
Pros and Cons for both the Landlord and Tenants
For the Landlord:
- Fewer running costs. This is one key advantage for the landlord since they will not be responsible for paying bills and maintenance costs. Landlords with tenants who are wasteful of utilities or rough on their spaces would mostly benefit from this.
- Income security. Triple net lease can relatively make a more secure source of income – because the rent is typically lower with this type of lease structure compared to the gross or percentage leases. With lower rent, it’s easier for landlords to fill vacancies in the building and leases tend to be long-term (as long as 10 years or more), so the landlord doesn’t need to renegotiate the lease or find a new tenant as often.
- Risks for low-quality maintenance. The landlord is taking a risk in making the tenant responsible for repairs and maintenance. If the tenant does a bad job, the landlord may have to face additional costs or even go through the hassle and expense of enforcing the lease.
- Loss of insurance control. In a triple net lease, the tenant is the one responsible for the insurance. The landlord will not have a control on the insurance, and you won’t know how well your building is covered. And if your tenant doesn’t understand insurance or doesn’t pay the premium or maintain adequate coverage, then your building will be at risk.
- Lease violations can’t change property damage. If a tenant violated the lease and they didn’t have certain coverages required on their lease, then you’ll again be at risk. You will have to deal with the damaged building with no insurance money to fix it.
- Benefit of lower rent. The primary advantage of a triple net lease to a tenant is the lower rent since they’re taking a share of the property’s financial obligations. Typically, the rent is higher on a gross lease because the landlord is entirely responsible for the property expenses.
- Greater control over the property. Triple net tenants usually have more control over the property and its daily management. Unlike in gross lease where the landlord is responsible for management and control over the rental, in triple net lease, the tenant has more power in regards to daily rental management which means the tenants are more closer to an owning experience than that of a typical tenant.
- More running expenses. The tenants must be more careful and watch their expenses in this type of lease agreement since they will be responsible for maintenance and repair expenses.
- Risk of unfixed costs. One significant advantage for the tenant is the fact that your share of the building expenses may fluctuate. For example, if the property taxes or insurance on your property go up, your operating expense will rise too. Not to mention the unexpected cost that you’re responsible of such as emergency repairs which can strain your finances if you’re not prepared.
Landlord’s Property Insurance Dilemma with Triple Net Leases
Triple net leases may give landlords or building owners the advantage of not having to pay for insurance. But at what cost? Most insurance policies have special rights for the mortgagee of a property – which includes notification of changes and the ability to receive payments for a loss. This applies even if the loss is in direct violation of the terms of the insurance (for example. a tenant causing intentional damage such as arson).
These rights are vital while the mortgagee retains interest in the property. But most of the time, landlords are not mortgagees. The landlord might be on the tenant’s policy as an ‘additional insured’ which means that if there’s a claim, the landlord may still be entitled to receive or share the payment. But, being an ‘additional insured’ provides no additional rights to the policy.
To make matters more worrisome, we find that a tenant does not carry an insurance policy that protects both the business and the landlord adequately. While we often hear landlords referring to their rights that are described in their leases, which are usually written very favorably for the landlord, suing a tenant is often a costly endeavor.
For example, a customer slips on a patch of ice in the parking lot as she gets out of her vehicle. The lease spells out that the tenant is responsible for maintenance of the parking lot, and that “Tenant shall defend, indemnify, and hold Landlord harmless against all liabilities, damages, costs, and expenses, including attorneys’ fees, for personal injury…” So the ice was supposed to be treated by the tenant and the landlord should be held harmless. But what happens if the tenant let their insurance lapse and the customer broke her hip and will suffer physically for the rest of her life? It would be naïve for the landlord to assume that he is immune to any lawsuit resulting from ownership of the building and parking lot.
Another example is a situation where a customer throws a lit cigarette onto the ground in front of the building, causing the brush to catch on fire and causing significant damage to the building. If the landlord depends on the NNN lease to make sure the tenant’s insurance covers this damage, he might be facing an uphill battle.
If your tenant commits any violation of the terms of the insurance, the contract may be void for all insureds – including the landlord. Remember, being an additional insured or interest will not change the coverage provided by the policy either. So, if the tenant purchased the policy that does not cover flood loss and a flood damages your building, the insurance will not pay anyone, including the landlord.
How to Protect your Investment?
Triple net lease may have advantages for both the building owner and the tenant. And in most cases, building owners are encouraged by asset managers and/or legal advisors to opt for this type of arrangement. Unfortunately, many forget to seek advice from their insurance professional. A triple net lease may be able to save you a few premium dollars, but you must also consider what you’re giving up, so it is important that you consult an insurance professional before making a decision.
There are a variety of options and variations in a commercial real estate insurance. Consulting and working with an expert who knows the policies very well is your best bet every time you’re looking at moving forward on your investment property. You may benefit with independent insurance agencies who will help you make sure your investment is not only properly covered but that the premiums you are paying are maximized as well.
At DOK Insurance Agency, we can help walk you through the different options and help you decide on what insurance policies you’ll need to protect your investment from damage and lawsuits. We also strongly recommend working with an attorney that specializes in real estate laws.
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