A modified gross lease falls between the two main types of commercial leases: gross leases and net leases. With a gross lease, the landlord is responsible for all of the building’s operating expenses. With a triple net lease, that burden falls on the tenant. When it comes to modified gross commercial leases, who pays for the operating expenses isn’t clear-cut. The landlord and tenant determine the details before signing the agreement.
What Is a Modified Gross Lease?
In a modified gross lease, the tenant is responsible for paying some — but not all — of the operating expenses. There also may be language related to the calculation of what the tenant owes. These expenses are usually common area maintenance, insurance, property taxes and utilities.
Modified gross leases are typically reserved for specific situations, such as shared office spaces or malls, where a tenant will pay their rent plus a portion of maintenance for the common area or a portion of the overall utilities. The agreement is also common for temporary tenants such as a pop-up store or restaurant.
Modified gross leases can refer to many types of arrangements in commercial real estate.
“There is no hard and fast definition of a modified gross lease,” Walt Batansky, Chief Financial Officer of Avocat Group, told Leverage.com. “Sometimes a modified gross just means that the tenant pays their own electric and janitorial expenses, and maybe is responsible for maintenance within their space.”
For example, if it’s a multi-tenant property with separate air conditioning units, the tenant might be responsible for the AC bill, and even for replacing the air conditioning units if they go out, he explained.
“It can be any version of that. A tenant or a landlord just has to decide what they’re going to include or not include,” Batansky said.
Essentially, modified gross leases are tailored to fit unique circumstances. These additional expenses tend to be itemized, according to Jo-Ann Marzullo, a commercial real estate attorney at Ligris + Associates.
When Are Modified Gross Leases Used?
It is common to see modified gross leases in buildings with a shared common space or one building with many tenants, such as an office building or a mall. They are often used when a building has one meter for utilities or electricity and the bill needs to be divided by tenants. The reimbursement methodologies may also differ for each tenant within the building.
Some other examples include cases where the tenant pays for liability insurance while they are occupying the space or is responsible for paying for electricity if they have exclusive access to the space.
Examples of a Modified Gross Lease
Modified gross leases work well for temporary tenants, like a Halloween store that’s only open for a few months per year, Marzullo said. In situations like these, where a tenant needs a lease on a seasonal basis, the lease agreement might include that the tenant will pay rent, utilities and insurance for the time they are occupying the space, in addition to being responsible for removing the trash while they are occupying the space.
Modified gross leases can provide tenants and landlords with mutually beneficial temporary solutions.
Shared office spaces are another example. Say a tenant is renting out their first office space, and a landlord has excess office space they don’t expect to use in the next two years. A modified gross lease can be a good solution for both parties.
“A subtenant is going in and has a budget number they know they can live with for that time period as they’re staffing up. The sublandlord, on the other hand, is getting some cash that they can count on to help pay the rent while they don’t need all the space,” Marzullo explained.
Modified gross leases are also common in specific markets, where specific structures have become typical. In New York City, retail tenants usually pay taxes over a base year (one form of a modified gross lease), while office tenants usually reimburse for taxes and operating expenses over a base year amount.
Pros and Cons of Modified Gross Leases
There are different ways a modified gross lease can benefit a landlord or a tenant. A landlord might want to use a modified gross lease if the tenant has particular needs for the property.
Imagine the tenant is using the property to run a 24/7 call center. “If the landlord would normally charge a full service lease in an office building based on a typical office user, they might do a modified gross lease that would shift that [cost] to the tenant if somebody wants to use it around the clock,” Batansky explained.
However, sometimes a modified gross lease benefits a tenant, depending on how well the landlord keeps track of expenses and billing changes each year. A modified gross lease will typically have a base year for expenses, which is the year the lease was written, Jeremy Mercer, Vice President of Mercer Company and CEO of Matador Capital, explained. If the taxes in 2020 were $10,000 and in 2021 they went to $12,000, the tenant would be responsible for the offset of $2,000. The increase in expenses may also be divided amongst multiple tenants according to their pro-rata shares.
“Most landlords are too lazy to bill this and let it go on for years, which leaves a bunch of money on the table,” Mercer said. “From that standpoint, it sometimes benefits the tenant, depending on how sophisticated the landlord is.”
A sophisticated landlord typically provides tenants with a budget for the year and estimates reimbursements to be paid monthly based on the budgeted figures. When actual expenses are reconciled, the payments are “trued-up” and adjusted. The landlord may also provide a reconciliation statement explaining the calculation of the payment.
4 Best Practices for Commercial Lease Agreements
Unlike gross leases and net leases, modified gross leases are tailored for specific situations, so it’s important to make sure both parties understand the lease language.
1. Hire A Real Estate Attorney
Making sure you can read and understand every word of the obligation is essential when signing a lease agreement. Of course, if the agreement is 40 or 50 pages, as it often is, that amount of reading can be intimidating, Batansky said.
“So number one is hiring a good real estate attorney, not just a general practitioner, because there are things that the general practitioner will look at in terms of liability, for example, but they won’t really understand the ins and outs of operating expense pass-throughs and what’s reasonable and how to limit the landlord and audit them if you think they charged you incorrectly.”
A real estate attorney will often specialize in preparing both sale contracts and lease agreements.
2. Make Sure All Terms Are Stated
Given that a lease is a contractual agreement, it’s important to ask clarifying questions as needed:
- “Is somebody being given exclusive use of the space or not?
- What spaces are they being given?
- When do [the tenants] get it and when do they need to get out?”
Marzullo said, as examples. These are some questions you’ll want to make sure are addressed in the agreement. While it might seem obvious, even a small misunderstanding could lead to problems down the line.
In the Halloween store example, a landlord might book a tenant to occupy their property immediately after the Halloween tenant leaves. Meanwhile, the tenant could assume they have extra time to pack their store up.
3. Clarify All Monetary Terms
In addition to the terms of the agreement, you’ll want to make sure you are fully clear on the cost of each additional responsibility. Marzullo gave an example of renegotiating an office sublease after the terms were clarified.
“In that office sublease, they said that they would take X amount of base rent and that they would pay their share of the additional rent. So I said, ‘You really need to find out how much that’s going to be.’ It turns out it was going to be half as much as the base rent they were going to pay,” she said. “Instead, they agreed to pay more of the fixed to base rent, and they don’t have to pay anything towards the additional rent.”
Batansky recommended the tenant consider implementing a stop loss that states any additional rents won’t exceed a certain amount per month. If a tenant is responsible for covering air conditioning repair maintenance, they could consider putting a stop loss of up to $1,000 per year.
“If it’s more than $1,000, or if the whole unit needs to be replaced for $10,000, then the landlord would pay the remaining cost,” Batansky said.
Maximum costs could also be expressed in terms of a percentage increase; for example, where the tenant is responsible for real estate tax increases but with a cap of 5% increases on an annual basis.
The agreement may also specify the subtypes of expenses that each party is responsible for. Structural repairs are often treated differently than ongoing repairs and maintenance, for example, and individual building components and systems may be listed individually with designations on who is responsible.
Modified Gross Leases Provide Tenants and Landlords Flexibility
There are plenty of reasons why a modified gross lease might work better to suit your lease agreement. Whether you are a landlord seeking a temporary tenant, or a tenant looking to rent out an office for the first time, modified gross lease terms are unique to each contract provide flexibility that can suit both parties’ goals. If your lease negotiations require an itemized list to identify the responsibilities of the tenant and the landlord, a modified gross lease might be the most appropriate option for your agreement.