Understanding commercial real estate rents is one of the most confusing topics for small businesses. Terms such as “base rent,” “net rent,” “triple net,” gross and CAM fees all add to the confusion. However, if you’re running a small business, you better understand these terms and how commercial real estate rents are structured, or you may have a nasty surprise after you sign a new lease. To fully understand the topic, you need to understand the basic business philosophy behind commercial real estate.
Unlike a typical residential real estate lease where the landlord assumes the maintenance, tax, and structural risk of a property, commercial tenants assume these risks to some degree or another. Commercial rents are customarily quoted as either “net” or “gross” and on an annual basis. For example, a $100-per-square-foot rental rate would mean the tenant pays $100 a year for every square foot of space leased. If the rental rate is quoted as a “gross” rent, the terms of the lease are similar to a residential lease where the tenant pays one amount each month that covers everything.
If the rental rate is quoted as a “net” rent, the tenant typically pays a “base rent” which gives the landlord a return on their capital investment in the property; and in addition, the tenant pays its proportional share (typically based on occupied square feet) of the building’s real estate taxes, maintenance costs, insurance, property management fees and, depending upon whether it’s a single-tenant or multi-tenant building, the structural costs of replacing the roof and walls in a true triple-net lease. These expenses are often referred to as “additional rent,” common area maintenance fees or “CAM” charges.
In a “gross” rent lease, the landlord is taking the risk that the real estate taxes, maintenance costs, insurance and other building expenses may increase annually above an annual escalation in the rent that’s negotiated between the landlord and tenant. In a “net” rent lease, the tenant takes the risk that the building expenses may increase at a faster than anticipated rate. If these same expenses increase at a slower rate than expected, a “gross” rent lease would benefit the landlord and a “net” rent lease would benefit the tenant. With a “gross” rent lease, whatever net rent remains after the building expenses are paid becomes the landlord’s return on their capital investment in the property.
One of the primary areas of negotiating in a commercial lease is what expenses can be included in the CAM fees. Landlords are often times trying to get capital expenses, such as repairing and replacing the building’s structure and mechanical systems included in the definition of CAM fees so they can get tenants to pay those costs. On the other hand, tenants typically are negotiating to eliminate from CAM fees any landlord expenses that are capital in nature. Capital expenditures are normally defined as any expense that has a useful life beyond a year and is related to the roof and structure of the building or its mechanical systems.
The process of comparing the total rent costs of different spaces can become very confusing for tenants when both the rent structure and CAM fees may vary significantly. The best method to use is called a present value analysis which is commonly used in the finance world to compare different investments and costs. A present value analysis is a process of discounting the total annual lease costs for each year of the lease using a discount rate (basically a reverse interest rate) to create present values of the different leases so their costs can be easily compared. The lease with the lower present value would generally be the least expensive option. Understanding these basic lease concepts can make it easier to understand the true costs of commercial leases.
William Small, JD, CCIM is the Managing Director of Frias Commercial Real Estate, a division of Frias Properties of Aspen. If you’re interested in receiving his monthly market reports, you can reach him at (970) 429-2419 or email him at email@example.com .