Industrial Gross Lease
The industrial real estate sector is perhaps one of the least well understood among all commercial real estate asset classes. Most people are familiar with the basics of multifamily, office and retail. Industrial real estate, however, has historically been disaggregated and overwhelmingly owned by mom-and-pop firms.
As demand for industrial real estate has skyrocketed, more – and more sophisticated – investors have entered the playing field. Industrial is now considered one of CRE’s “darlings” that people can’t add to their portfolios fast enough.
In this article, we look at the key features of industrial gross leases and specifically, how these compare to industrial net leases.
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What is an industrial lease?
An industrial lease is a formal, legally-binding rental agreement in which a commercial business agrees to rent industrial space from the property owner. Industrial leases can take many forms, ranging from gross leases to net leases, which will be described in more detail below.
How an industrial lease is structured will often depend on the size of the property, the nature of the business, and whether that business will be the only tenant occupying the space (vs. the property being leased to multiple tenants).
Most industrial leases range from five- to seven years in length. In some cases, leases will be much shorter (as little as 1-3 years) or significantly longer (20+ years) which is more common with large, anchor tenants like Amazon or Wal-Mart who often need extremely large spaces that they intend to occupy for the long-term.
What is an industrial gross lease?
An industrial gross lease is when an industrial landlord is responsible for paying all property taxes, property insurance and common area maintenance (CAM). Therefore, any time there is an adjustment in the cost of those expenses, the landlord will be responsible for covering those costs. For example, if the municipality in which an industrial property is located increases their tax rate, any additional costs will fall to the landlord in an industrial gross lease situation.
What does an industrial gross lease include?
As noted above, an industrial gross lease payment will include the base rent as well as any costs associated with the property taxes, property insurance and CAM charges. For example, if a landlord quotes a tenant $12/SF industrial gross, the only additional costs a tenant will be expected to pay are for their utilities and any business taxes (i.e., not any real estate taxes).
What is a gross lease vs. a net lease?
One of the most common questions industrial investors ask pertains to the difference between a gross lease and a net lease. These are the two most common structures for industrial leases.
With a gross lease, the tenant pays a price per square foot for their space and included in that fee is the base rent plus any payment toward the landlord’s taxes, insurance and common area maintenance.
An industrial net lease functions much differently.
There are three types of net leases, referred to as “single net,” “double net” and “triple net” leases.
With a single net lease, the tenant is responsible for paying the property taxes associated with the property. The landlord continues to pay for all other operating expenses associated with the industrial real estate.
With a double net lease, the tenant pays for both their pro rata share of the building’s property taxes and insurance. The landlord only pays for property maintenance.
Neither single net nor double net leases are used often when leasing industrial property.
Instead, industrial landlords who want to use a net lease structure will generally utilize a triple net lease. A triple net lease, or NNN lease, is especially common when an industrial property is leased to a single tenant. NNN industrial leases require the tenant to pay base rent in addition to property taxes, insurance, and all property maintenance. In other words, the tenant is required to cover all operating expenses associated with the property, no matter how large or small.
With NNN industrial leases, the quoted base rent is generally lower than it would be on a price per square foot basis than a gross lease given that the tenant will be responsible for all other operating costs.
A NNN industrial lease may be quoted as $10/SF for base rent plus an additional $2-4/SF for all other costs. Most industrial NNN leases will stipulate what is included in that amount, and will require the tenant to cover the cost of any additional expenses that exceed that amount (including but not limited to any increases in the tax rate or property insurance).
When leasing an industrial property, owners will commonly cite a rental rate using a gross square footage number, which allows tenants to make apples-to-apples comparisons when comparing their likely costs for different spaces. However, when it comes to signing the lease, that lease may be restructured and written as a NNN lease that effectively results in the same amount that was originally quoted when advertising the space on a gross SF basis.
What is an industrial gross lease vs. a modified gross lease?
Not all industrial gross leases are the same. There is an important distinction to be made between those that are full-service gross leases vs. those that are modified gross leases.
With a full-service gross lease, the tenant pays a predetermined base rent and the landlord covers all operating costs. It’s like going to an all-inclusive resort where all activities, amenities, food and beverages are included with your stay.
A modified gross lease uses a similar base rent that will cover the majority of costs. However, a modified gross lease may stipulate that some portion of the operating costs fall to the tenant. These costs may include certain utilities (water, electric and/or gas), janitorial services, internet and security measures like an alarm system.
Common Terms Used in Industrial Real Estate Leasing
For those who are unfamiliar with commercial real estate leasing generally, navigating an industrial lease can seem complicated. Understanding a few key terms will make it easier for owners, investors and tenants to understand the industrial leasing process.
Common terms found in industrial leases include:
- Base Rent: This is the rent, usually expressed on a per square foot basis, that is paid directly to the landlord. Base rent is often quoted in modified gross leases as well and triple net leases. Many industrial leases will have an annual base rent escalation equivalent to 1-4% of the existing base rent.
- Common Area Maintenance: Common area maintenance, also referred to as “CAM,” refers to the costs associated with maintaining the building. Some owners (and by extension, their lenders) will use different definitions to describe what is included in CAM. This may or may not include things like painting, landscaping, elements exterior to the building (e.g., the roof, windows, etc.), parking lots, as well as any common area spaces interior to the building (e.g., hallways, bathrooms, lobbies, etc.).
In NNN lease situations where the tenant is responsible for paying CAM charges, the tenant may negotiate a CAM cap per year to prevent the owner from potentially overspending on common area improvements that then fall to the tenants to pay.
- Gross Lease vs. NNN Lease: The difference between an industrial gross lease and NNN lease is primarily based on who is responsible for paying for the property’s operating expenses. With a gross lease, the owner incurs these costs. With a NNN lease, the tenant is responsible for these costs. Most sophisticated industrial landlords will utilize NNN leases. Owners of smaller industrial properties, especially in the case of long-time legacy owners, may be more apt to utilize gross leases given their simplicity.
- Build-Out/Leasehold Improvements: These are terms that are commonly found in leases for industrial properties that are either newly constructed (and hence, not yet finished) or in situations where the industrial building is older and in need of improvements. This section of a lease will stipulate what sort of build-out (or improvements) the landlord is willing to make prior to the industrial tenant occupying the space. This could include bringing upgraded power to the property, improved lighting, new loading docks/doors, finished office space and much more.
Alternatively, the landlord may give the tenant a budget to make those improvements on their own, which is referred to as a “tenant improvement” or “TI” allowance.
One of the benefits to the owner making these leasehold improvements is that the owner can then depreciate the costs associated with those improvements. Doing so provides a valuable write-off for industrial owners come tax time.
- Lease Concessions: Lease concessions refer to any financial or non-financial benefit that the landlord provides to the tenant as an incentive to sign a lease for the space. Lease concessions can take many forms, ranging from some number of free months’ rent to the purchase of equipment that would help the business get up and running. Lease concessions are often used in combination with build-out or other leasehold improvements incurred by the landlord.
Common Industrial Leasing Mistakes
Any landlord or tenant navigating an industrial lease for the first time should be careful to avoid the top three most common industrial leasing mistakes. These mistakes include:
- Not knowing what sort of power is needed for a business to operate effectively. Some industrial buildings, particularly older Class B and Class C industrial assets, have limited power. The cost of running new or upgraded utility lines can be costly – both in terms of actual expenses and the amount of time it can take to coordinate with the local utility provider. Knowing a property’s utility capacity is essential for industrial tenants who anticipate having large equipment with significant power needs.
Industrial landlords should be prepared to discuss their property’s capacity for both single-phase and three-phase power. Three-phase power runs at a lower voltage so it is more economical (something that is important depending on whom is responsible for utility costs under the industrial lease agreement). Three-phase power can also carry loads of various equipment at the same time. However, depending on an industrial tenant’s line of business, single-phase power may be sufficient for their needs.
Industrial owners should also know their property’s voltage capacity. 110V, 208V, and 480V are all common at industrial properties. 110V will run low energy equipment whereas 480V is needed to run high energy equipment. In an industrial gross lease situation, the owner will want to know what the tenant’s need for voltage is prior to signing the lease agreement.
- Poor loading and/or trucking service. Industrial tenants need to ensure that a building’s loading area supports its needs, both now and as projected into the future. If the loading or trucking area does not meet the business’s needs, these will need to be overhauled and potentially re-engineered – costs that can add up and will fall to either the owner or tenant depending on the lease language. Failure to invest in upgraded loading and trucking service could force a tenant to relocate against their wishes.
There are different loading and trucking configurations for owners and tenants to understand. These include “grade-level” loading where a warehouse door is at street level; and “dock-high” where loading can support semi tractor-trailers backing directly up to the loading doors. Knowing which is needed for each industrial tenant is very important for their long-term success in the space.
- Not knowing a property’s “clear height”. The final leasing mistake that industrial owners and tenants make is failing to properly assess ceiling clear height requirements. Clear height constitutes the usable space available to tenants for stacking inventory. Gaining even a couple of extra feet of height can mean adding an additional rack for storing items, which allows businesses to shrink their leasable floor area.
Many industrial tenants are hesitant to sign a long-term lease simply because they are unsure of what will be required of them under their lease agreement. There are many terms for industrial tenants to learn, some of which may require the assistance of a real estate attorney or broker.
That said, those who spend the time learning the ins and outs of an industrial gross lease or industrial net lease will find that the process isn’t as “scary” as it might be perceived to be.
Industrial leases are a linchpin to successful industrial real estate investing. Owners and prospective operators of space should also familiarize themselves with standard industrial lease terms in order to prevent any surprises down the road. Having a solid, well-crafted lease is a great way to ensure an owner and its investors’ profits are protected throughout a business’s tenancy.
Interested in learning more about industrial real estate? Contact us today.
Chris Rising manages the day-to-day business activities of Rising, while also serving on its Investment Committee.
He received his J.D. Law, Real Estate from Loyola Law School and his B.A. in History and Political Science from Duke University.