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Leases for rental properties come in three basic forms. In some leases, the tenant may be responsible for paying certain costs (like janitorial); therefore, the cost of such services shouldn't be included as an expense of the property.
- Gross lease: In a gross lease, the landlord pays for almost all of the operating expenses of the property.
- Modified gross lease: Some of the expenses of owning and operating the building are passed through directly to the tenants. Examples of modified gross leases include leases where the landlord pays all operating expenses except for certain items such as utilities, parking, or janitorial expenses.
- Net lease: These provide for the tenant to pay for the majority of the costs of operating the building, including property taxes, insurance, and maintenance costs. Those leases in which the tenant pays virtually all costs associated with operating the building are called triple net leases.
The leases for a commercial property can be gross leases, modified gross leases, or net leases, but residential properties are almost always leased on a gross basis, except utilities.
Counting on CAM
Costs in multi-tenant commercial buildings that are passed on to the tenant are called common area maintenance charges or CAM charges. CAM charges are paid proportionately by each tenant for the upkeep of areas designated for the use and benefit of all tenants, and include items such as parking lot maintenance, security, snow removal, and common area utilities. Some tenants negotiate that they won't have CAM charges. But, for those tenants whose rent includes CAM, they're handled pursuant to the lease in a variety of ways and can be due in advance or paid in arrears. For accounting purposes, CAM charges are typically reflected in the cash flow as "CAM reimbursement." Although they're indicated as an income item, they're essentially offsetting the corresponding expense items included in the operating expenses for the property.
The most common method is to use an estimated annual budget for the property as a basis for the collection of a monthly CAM charge. At the end of a previously agreed upon time period (usually annually), the actual expenses incurred for the items are calculated and reconciled against the sum total of the estimates paid during that time period. Then either a billing is generated to collect the shortfall that the tenant hasn't paid or a refund of any excess funds collected is provided to the tenant.
 | Handle the CAM reconciliation as soon as possible after the accounting is complete for the relevant time period in order to quickly collect any funds that are due as well as to provide feedback in case the future estimates need to be increased or decreased. |
As the potential purchaser of a commercial property, carefully evaluate the leases and determine what operating expenses, if any, are paid by the tenants. You need to understand whether the property is using gross or net leases. Otherwise, you may be deceived regarding the actual NOI and cash flow that you will receive for the property.
Clearly, the rent charged for commercial properties with net leases, where the tenants are directly responsible for making the property tax and insurance payments and where they handle their own maintenance, will be lower than a similar property with a gross lease. But the end result may be similar because the higher rents received on the gross lease property will go toward those same expenses and costs that the tenant is paying at the net leased property.
Balancing things out
Different people have different thoughts about which works best: gross leases, modified gross leases, or net leases. Many investors believe that the management of the property is reduced if the tenant is on a net lease, but this isn't necessarily true. The owner must still ensure that the property is properly maintained. One argument against net leases is that the tenant may skimp on the maintenance of the property. That is why you typically don't see net leases in residential properties. Can you imagine a residential tenant being responsible for all of the maintenance of his rental home?
| Modified gross leases in which the tenant pays for expenses that she can control provide a good balance for all types of properties. This is essentially how the relationship is structured in most apartment buildings: |
- The landlord retains control of the property maintenance and makes the necessary repairs and upgrades inside and out to ensure the long-term integrity of the building rather than allowing the building integrity to be compromised by a thrifty tenant. The landlord is also be able to ensure that the assessed value is kept low and the property taxes are paid on time, plus make sure that proper insurance coverage is in place.
- However, the landlord doesn't control certain expenses that are better suited to be paid directly by the tenant. For example, tenants have a direct impact on the utility usage and will be more careful to conserve if they pay that expense. This is why we recommend you limit your investments in residential property to those buildings with separate meters for water, sewer, and electricity. Likewise, some commercial tenants will be able to live with weekly janitorial service rather than daily if they're paying the cost directly.
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