The Pros and Cons of NNN Leases

NNN or Triple Net Leases – The Pros and Cons For Tenants

Written by Digsy Expert: Jamie Kim, CA Real Estate License #01869347

NNN or Triple Net Leases are one of many unique terms.  Understanding commercial real estate leases can be daunting, as the terminology used may have a common or general meaning, but exact definitions can vary widely and differ by property or may be specific to each landlord.  Assume that nothing is uniform, and everything should be verified. Trying to understand NNN or Triple Net, for example.

The main differences stem from what costs and responsibilities fall on the tenant versus the landlord.  The NNN lease structure is 0% Landlord vs. 100% Tenant.

  • A Triple Net lease was designed to be landlord favorable, protecting the landlord’s interests against any changes, unexpected costs, etc.
  • It creates 100% pass-through charges so that ALL the burden, responsibilities, risks and costs fall on the tenant(s)
  • It was designed to help the landlord minimize their costs, responsibilities and risks by shifting everything to tenants, maximizing the tenant’s financial burden
  • A NNN lease also makes the potential sale of a property more appealing to a potential buyer (new landlord) especially in the area of property taxes (further explained below)

 

So you might ask, “Why would anyone be crazy enough to ever sign a NNN lease?”

 Based on the above, the tenant assumes all the costs, responsibilities and risks associated with a property without the benefits of being the owner of the property.   

  • In most cases, it’s all about LOCATION, LOCATION, LOCATION and it’s unavoidable
  • Most NNN leases are found in prime “Class A” locations where the property owner has a significant real estate portfolio (is a larger owner of real estate), and the property has better features and functionality that may be essential to you
  • These properties are professionally managed and maintained by a property management company who is hired by the Landlord (but ultimately paid for through the NNN charges that the tenants are responsible for paying)

The basic components of a triple net lease (NNN Lease) are as follows:

  • The base rent
  • The NNN’s
    • Property taxes
    • Property insurance
    • Common Area Maintenance (CAM’s)
    • Other Expenses and Charges (TBD)

 

Consider the NNN lease as a kind of chameleon. It is loaded with unexpected bombs that can go off at any time during the lease.

 Whenever you are quoted the base rent and NNN’s, always remember the NNN’s quoted are only “a loose” ESTIMATE based on what is known at the time the lease is negotiated. There is always a reconciliation of ACTUAL vs. ESTIMATES on the NNN’s charged to you.  These reconciliations can happen quarterly, semi-annually and annually. It all depends on the property management company and or the Landlord.

  • When inquiring about a property, the listing agent (the broker who works for the Landlord) may quote you a base rent as $3.50 NNN psf (for a retail property); $.78 NNN psf (for an industrial property), etc.
  • You must ask, what are the NNN’s? AND are there any additional charges*?

* especially in retail leases that have anchor tenants – to be addressed in a separate blog post

 

From a Tenant’s perspective a NNN lease can be a nightmare as it contains the most risk and expense.

To the surprise and shock of some tenant’s, the unexpected changes in the NNN charges, make the property no longer affordable, and can put them out of business.

Always remember, there can be a huge gap between ACTUAL VS. ESTIMATE. The loose estimate originally quoted to you, and is written into your lease is actually a wildcard.  The time it takes for a landlord to reconcile can be long, and the final additional bill to you as the tenant can be significant and burdensome.  It may make a property that once seemed like a dream, suddenly turn the total overall occupancy cost into something that is cost-prohibitive.

  • Often times the reconciliations are NOT timely
  • They can hit you with a huge bill at any time during your lease term

 

So what exactly are the most dangerous components of the NNN charges?

 

(1) PROPERTY TAXES: A Change in Property Taxes (or the Property’s Tax BASIS)

Landlords who have owned bldgs for EONS, have a low tax basis, a low assessed value. So imagine signing a lease with a Landlord who has owned the property for over 60 years. Their tax basis may be very low, $65,000, meaning low NNN’s (especially in the property tax component).

Now they decide to sell the property for fair market value, the property is now worth over $2 million, so the tax basis has now increased DRAMATICALLY.

The Buyer of the property (the new owner) likes the NNN lease structure, because the increase in property taxes will be passed on to the tenant(s), as an increase in NNN charges.  When the new property owner does a reconciliation, they will call out an increase or adjustment in your NNN’s.

 

(2) THE BASE YEAR: All Leases have a BASE YEAR

The base year is the year in which you sign the lease (Let’s use 2010 for example).  This is the base line of all they expenses the Landlord incurred to maintain and operate the property, during 2010, the year when you signed the lease.

Going back to the property tax example above, now all of a sudden in 2016 the property has sold. Now the base year expenses, charges, etc. have gone up.  This will be factored into the ACTUAL vs. ESTIMATE calculation.

Also, outside of anyone’s control, there could also be changes to property tax legislation, huge changes to electricity to common areas, unexpected repairs, maintenance, etc.  So whatever it cost to maintain and operate the property has completely changed.

This is what is known as a difference between BASE YEAR EXPENSES and CURRENT YEAR EXPENSES.  So if expenses to maintain and operate the property used to be $200k in your base year, but things have suddenly changed and it now costs $250k; you will be charged for an increase, change over the base year.  That $50k will be part of the reconciliation of ACTUAL VS. ESTIMATE and charged to the tenant (based on your proportion share of these expenses based on your square footage vs. total square footage for the property).

 

(3) CAM’s (Common Area Maintenance): The areas common to all the tenant’s shared driveways, walkway’s, parking lots, lighting, electrical, landscaping, etc.  This is another area where they can have a change in ACTUAL VS. ESTIMATE.

 

(4) Repairs and Maintenance: NNN’s Leases make the tenant(s) 100% responsible for the building, maintenance and repair of a property. This includes everything about your space (the Premises) but also includes the structural stuff (inside the walls, the plumbing, the roof, etc.)

So for example, let’s say a pipe breaks, or the roof leaks (it has to be repaired), or some new legislation has come out that the building does not meet, so in order to meet the new bldg codes, upgrades have to be done.  These things may not affect your space directly, but you are responsible as a tenant of the property for your PROPORTIONATE SHARE.

The Landlord may pay for these repairs, upgrades, up front, so the work can get done expediently. But then they will add these expenses to the ACTUAL vs. ESTIMATE reconciliation they give to you.   You will have to pay your proportionate share of these costs.

 

(5) Reserve Accounts: If there are going to be significant repairs in the near future, or distant future, the Landlord can collect a little bit every month from tenants.  They will call it a reserve account, and hold onto the funds, for use when they actually complete the repairs.  So you are effectively paying into a Landlord managed and controlled fund to do FUTURE maintenance on the property.  All the Landlord has to do is notify you about the need to do these repairs, and then add it to your monthly billing, as a CHANGE in your NNN charges.

 

So what if any rights do I have as a tenant?

You have the tenant’s right to audit!

Before you pay out anything for changes in ACTUAL VS. ESTIMATES, you have the right to audit and question the Landlord about these changes in your charges. In a written communication, related to the DISPUTED PORTION of new charges, request to look at all their original invoices, the basis for their calculations, and the root causes for the increase(s).

– Many Landlords (whether intentionally or unintentionally) have committed highway robbery on these calculations. Sometimes an honest clerical error can cover many calculations and negatively impact you.

– Be sure to double check their allocation %’s, calculations, etc.

Please note, that auditing these bills takes someone with a strong eye for details and accounting knowledge. Often times these increased charges are so significant that auditing these bills are a must. But most often, it is a distraction from your business, and very time consuming.

 

When a property happens to be a NNN Lease, what does that imply?

NNN leases means the Landlord and or their property management company is real estate saavy.  They have the property management / accounting staff, the accounting infrastructure/software to manage and track all these costs and pass them on to the tenants.

When the NNN’s are a low amount, what does that imply?

It could mean the Landlord has owned the property for many years and has a low basis. It could also mean they run the property very lean and control expenses.  But it could also mean, that they may sell the property in the future, so although it may be enticing to sign the lease because of the low NNN’s but have your tenant rep broker investigate and find out more, to ensure there are no immediate plans to sell the property.

When the NNN’s are a higher amount, what does that imply?

It could mean the current Landlord recently purchased the property. In some instances this can give you peace of mind. Usually large holders of real estate have a strategy to hold onto the property for 5, 7 or 10 years before they will sell the property. In such a case, this means your NNN’s should be somewhat stable as it relates to property taxes.

 

In summary – TENANT BEWARE!

It would behoove you to find a qualified and experienced tenant rep broker, to be your advocate and negotiate lease terms that either CAP or limit these risky areas of a NNN lease.  Remember base rent is only one item in a lease negotiation. Although most people focus on that number, a seasoned tenant rep broker can negotiate a lease that protects your interests and limits your exposure for risk and expense.

 

Need Help?

Digsy’s On-Demand Commercial Real Estate Experts not only help you save time finding the perfect space for your business, they also remove the stress by helping you understand rents, operating expenses and even negotiate with landlords on your behalf. You can learn more about using Digsy to find commercial real estate here.

If you have further questions, please leave them in the comments below and we’ll get back with you right away!

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2 Comments

  1. Thank you for the post. Very helpful! Is it common for commercial leases to have NNN? I don’t want this type of lease. Can this be negotiated?

    • Hi Jeanne,

      This is a form of accounting that the landlord uses. It will be difficult to have them change that. Your main concern are your cost, and that is something that can be mitigated. This is done by asking for a limit on how much NNN fees may be increased.
      By the way all tenants pay expenses, I’ll try to explain how. In this example rent is either $1000 no NNN, which means the landlord uses part of the $1000 to pay expenses.
      Or $750 + $250 NNN, the tenant still writes one check for $1000 and the landlord still takes the $250 and pays for expenses.
      At the end the tenant pays. Also, the tenant decides where to move too.
      Hope that helped.