Leveraged Breakdowns

REPE Interview Prep: Leasing Fundamentals

Leases are fundamental to real estate. They drive revenue and greatly determine private equity real estate returns. Yet how much do you understand the basics of each type of contract? After reading this article, you will be able to: (i) quickly differentiate between triple-net, double-net, single-net, and full-service leases, (ii) explain the risks and benefits of co-tenancy clauses, and (iii) master a frequent lease-based mental math interview question. Whether building a real estate private equity model or negotiating with a future tenant, a successful investor must understand the intricacies of leases and be prepared to perform quick mental math.

How do Triple Net (NNN), Double Net (NN), Single Net (N), and Full-Service or “Gross” Leases differ?

First, all leases are similar in that they charge base rent. Yet where they differ is whether and how they collect expense reimbursements over and above the base rent for a leased space. In a Triple Net Lease, the Tenant is responsible for paying all operating expenses associated with the leased space. In Double Net lease, the Tenant pays their share of property taxes and insurance. And in a Single Net lease, the tenant only pays their share of Property Taxes. Finally, a Full-Service, or Gross Lease, means that the Tenant has no responsibility for paying any operating expenses at all.

Diving Deeper: A fourth type of lease is emerging, sometimes called a Quadra-Net Lease, or Absolute Net Lease. This type of lease makes the tenant responsible for any capital replacements, such as roof, structural replacements, parking lot, mechanicals, and so on. In some investment circles the term Modified Gross is used in lieu of single net or double net.

Ready to learn more? Check out our article, A Beginners Guide to Commercial Leases, Part Two: Expenses.

What are co-tenancy clauses and what are the benefits and risks?

Co-tenancy clauses are common in retail leases, where smaller tenants often benefit from the spillover business of a major anchor tenant. An example would be a hair salon that benefits from the traffic of a nearby grocery store. Co-tenancy clauses typically permit such a small tenant to terminate their lease or significantly reduce rent if the anchor tenant goes dark. Co-tenancy clauses are especially common in enclosed malls and power centers.

This type of clause is a significant risk mitigation strategy for tenants, allowing them to close stores or reduce operating costs if foot traffic drops significantly. For landlords, the benefit is leasing more space, but the risk is that losing the anchor tenant can create a domino effect of store closings and rent reductions that quickly erodes net operating income, sometimes to the point of insolvency.

Answer this math question with a pen, a sheet of paper, and no calculator within sixty seconds.

The question: A tenant offers to lease 10,000 SF of space of an industrial building (20% of total space), and pays rent of $8 PSF per year, which is the market rate. This tenant receives 3 months of free rent upon move-in, it’s NNN, and Total OpEx and taxes are $3 per year. Calculate the Y1 Effective Gross Income (EGI) from the tenant, assuming a January 1 move-in.

The solution: $8 rent + $3 NNN = $11 PSF all-in. $11 PSF x 10,000 SF = $110,000 per year.  3 months free rent = 25% discount in year 1, so 75% of $110,000 = $82,500 Y1 EGI.

LB Comments: This is a great question to rehearse with different numbers. Challenge yourself to do the math mentally. Also, be aware of sneaky interviewers changing the time frame to a half year (assuming a 7/1 move-in).

Ready to dive deeper? Check out our article: A Beginners Guide to Commercial Leases, Part One: Income.

Conclusion

You don’t know real estate if you don’t understand leases. This article should give you a grasp of the basics, but there is much to learn — starting with the articles linked above. If you’re eager to move forward, I suggest you dive in and build a full real estate private equity model with our flagship course, Breaking Down Real Estate Private Equity (we offer a seven day free trial if you’re curious what it’s like). If you want a quick sampler of essential knowledge, you could also try our REPE Starter Kit (also covered by the free trial). And make sure to keep your eye out for our Real Estate Private Equity Interview Guide, which we are hard at work preparing and will release in the coming months.

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