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Leveraged Breakdowns

A Beginner’s Guide To Commercial Leases, Part Two: Expenses

Commercial leases are the backbone of the REPE industry. Demonstrating a familiarity or a mastery of the terminology will help you nail a real estate private equity interview.

Part one of this series focused on understanding the terminology in commercial leases related to income. Part two will zero in on the expense side of the equation, which is just as important to your LBO model. To get practice using these terms and building models, take advantage of the real estate private equity online course offered through Leveraged Breakdowns!

To Net, or Not To Net

Expense terminology in leases centers around the terms “net” and “gross.” The idea behind this is that the tenant’s payment to the landlord is “net,” or excluding certain expenses that are paid by the tenant. You’ll hear terms like triple net, double net, or absolute net. If a lease is $30 psf gross, then the tenant will pay $30 psf to the landlord and there are no additional expense reimbursements. If a lease is $30 psf triple net, that means that the tenant is paying $30 psf in rent plus three categories of expense.

The three categories of net expenses in question are property taxes, property insurance, and common area expenses (utilities, janitorial, utilities, etc). Taxes and insurance usually stick together, which is why you will almost never hear the term “single net,” but you will hear “double net.” For many years, “triple net” was the landlord’s best case scenario, because it meant that the tenant was paying all of the operating expenses for the property.

In recent years, a new concept has emerged which requires the tenant to also pay for capital replacements (new roof, new parking lot, or structural repairs). The terminology isn’t settled yet, so you may hear the term “quadra net” or “absolute net” around the water cooler or during a real estate private equity interview. The intent of the phrase is that the landlord has no ongoing responsibility for costs associated with the property (other than the initial purchase, of course).

To Recap:

  • Gross: Tenant pays rent and landlord is responsible for paying all property expenses
  • Double net: Tenant pays rent, property taxes, and property insurance. Landlord pays everything else
  • Triple net: Tenant pays rent, property taxes, property insurance, and common area expenses. Landlord pays capital replacement and structural repairs.
  • Absolute net (or quadra net): Tenant pays all property expenses, both operating and capital. Landlord is responsible for no expenses during the lease term.

Odds and Ends

Some leases will include caps on expenses that the tenant pays, normally expressed as dollars per square foot. Other leases may require the tenant to pay expenses over a base amount, referred to as a “stop” or “expense stop,” also expressed in dollars per square foot.

Some leases will call for the tenant to make an estimated payment each month toward the annual budget for operating expenses. At the conclusion of the year, the landlord will provide a reconciliation of the actual expenses compared to what the tenant actually paid, and either bill for any shortfall, or credit back any over payment. The goal is to keep the over/under as small as possible to avoid any large charges to the tenant, or large credits back that negatively impact landlord cash flow. Whether you are building a real LBO model, or as part of a real estate private equity online course, making sure you treat the expense reimbursements exactly as described in the lease is critical.

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