Transcription
This episode of the Commercial Real Estate Investor podcast is brought to you by my CRA Accelerator Mastermind, where you'll get access to my step-by-step investment blueprint, essentially a library of resources on how to invest in commercial real estate. You'll get connected to a supportive community of other commercial real estate investors that are doing projects just like you. You'll get personalized coaching and feedback from me every step of the way. Go to www.c central.com to learn more.
Welcome back to the commercial real estate investor podcast. We are live from the Cabbell Group studios here in Nashville, Tennessee. This is probably going to be our last office hours of the year uh until probably around mid January. You guys know I like to take a little break from everything, catch up on some other things that I've got going on. Uh today it is office hours. We are diving into your questions around commercial real estate. If you have a deal, if you have something you would like for me to take a look at, you are always welcome to submit those. We will dive into them. In fact, today we do have one if I can get into it. I guess I'll have to pull it up on my phone uh through that email. Uh, we have some questions u from a listener on a deal that they are looking at. We're also going to be diving into lease structures. So, modified gross, full service gross, triple net, which one is best? And in my opinion, it's actually none of those three. Most people think it's probably triple net. Uh, I will walk through the different lease structures today. We'll talk about the five main categories that I think most landlords should be paying attention to when they're trying to figure out which lease structure is right for their commercial property. Um, and we will whiteboard that out here as well. So, we'll be diving into that.
All right. First, let me see. Actually, you know, while we're doing that, let's go ahead and pull up this thread from Reddit and talk about lease structures. All right, so this is a uh this person's asking how to best structure leases from a landlord perspective. So, hi, I am doing some research around how leases are structured for commercial real estate and if there is any room for improvement. Generally per square footage price is based on market value with lease variables like term TI opex triple net gross or full service. There appears to be quite a few other variables at play when structuring leases. Rent escalations, free months, uh or we call that rent abatement, property financing, DSR, tenant credit, vacancy loss, etc. My question is from a landlord perspective, how do you think about all of these different variables when making a leasing decision? Do you think that you have the right information, economic data, or set these to set these variables and determine lease structure or can the process be improved and is there value to be unlocked? Really curious to hear your thoughts.
I thought that this was a pretty interesting thread for us to check out because first of all, when you're when you're transitioning into commercial real estate, you know, especially if you're coming from residential, the leases are entirely different, right? In in residential, you have essentially almost a standardized lease, right? You might get it from your local apartment association, maybe even from your local realtor's association. It's pretty rare that you're going to have your own lease like that. you have like personally an attorney draft on your behalf because a three-bedroom, two- bath house is a three-bedroom, two- bath house for the most part, right? Whereas an office building is going to be entirely different from the next office building. One could have amenities, one could have elevators, uh, one could be micro suites versus uh, you know, traditional office suites, one could have the utilities separately metered. There's all sorts of different ways uh that these commercial leases get structured because of how unique each individual deal really is. And so that's why we have all of these different types of leases.
So let's see here. Uh, I'm a commercial real estate professional. This is one of the responses there. 26 years experience. This really really goes on. We're not typically setting the lease structure based on underwriting the prospect like you ask. Different property types usually dictate the specific form of lease dock. Typically, retail leases will be triple net. Single tenant retail properties will be absolute net. Class A office will be modified gross. Class B and C will be full service gross. Industrial will be triple net and so on. That's actually a pretty great little overview of of most of the asset classes there. Now, one thing I will note is that they do say typically you're seeing this massive shift towards triple net in almost every single asset class now, even office space, you know, even office space, which I think is pretty interesting. They're starting to triple net uh those deals. And guys, by the way, if you are joining us live, feel free to drop your questions in the live chat and we will be getting to them here in a little bit.
When we're underwriting a prospect, there's a long list of information we require the broker to obtain from the prospect, but the list can be scaled based on the size of the deal. For example, I'm not going to get into tax returns and business plans for relocating a nail salon that's leasing a 12,200 foot retail suite as is for 36 months at $12 per square foot triple net. The dollars there don't warrant it. However, if we're talking about a national credit tenant leasing a freestanding 100,000t office building for 10 years at $35 per square foot modified gross with 2 and a.5% annual increases, six months free rent, and $50 a square foot in TI, then that's a much different scenario. Uh, let's see. I'm not really sure whether improving the process would unlock value. Ah, I think it could. I mean, I think a lot of leasing is is really u people just not getting creative and thinking that you have to operate within this one box. To me, it just doesn't make a lot of sense.
Let's see. This person is saying, "Manage less than a thousand square foot office warehouses." So, flex space. Uh, tenant covers common area maintenance, two to three year leases, but one-year deals are not uncommon. No buildout for units or leases this small. one month free at most during down periods or rest of the month free whenever a lease is signed. So the smaller you get, the less likely you're going to actually be doing any sort of tenant improvements at all. Now, retail can be an exception to that because there's plenty of, you know, national retailers that sign sub 2,000 square foot leases, right? And they will have very distinct brands that they would like for you to uh pay for the buildout of. However, when you're working in in flex space or industrial, it's pretty uncommon for those tenants to really need any sort of buildout because don't really have a whole lot. That's one of the reasons I really like playing in these smaller fields uh with smaller local, maybe even regional uh tenants, certainly not national. Not a fan of working with national tenants. They could be great. I mean, trust me, there like there's pros and cons to each. I mean, the the the pros of working with national tenants is that they have the balance sheet. They have the tenant credit to make banks very happy, right? an investor is very happy. However, uh they typically cost a lot of money uh and they've you know it's it's just a nightmare to deal with those tenants sometimes. So, you know, unless u you're actually like the preferred developer, you're not going to be making a whole lot of money on doing deals with those kinds of groups. Um, unless you're like buying an eight or nine% cap rate, you know, regional 150,000 square foot shopping center. um, then you can really start to add value by bringing in some of those uh national tenants.
Sorry if you notice me looking over to the side over here. I have my studio pup in the studio today. Uh, Paulie, my little boxer, and he is uh he's very curious. He hasn't hung out here too often, so it's fun to watch him explore.
All right, let's see what else we got. Someone mentioned risk. Bingo. I'm a tenant rep and can't tell you how many small business clients only focus on the dollars and dates and forget about the rest. Oh, that plumbing busted out in the parking lot. That's on you. One of your customers destroyed some property in the common area. That's on you. They don't realize they actually have to read and understand the 60-page landlord lease or it could mean their business. It is astounding how many people will go through life not reading these massive contractual documents, legally binding documents, and they just sign without asking a single question. I mean, of obviously that's going to come back and bite you in the tail.
Kevin is saying, "Good morning." Good morning, Kevin. Good to see you here, man. I thought triple net lease and absolute net lease was the same. Is it not? Uh, no, it's actually not. So, triple net leases and absolute net leases are very different. Um, in the sense that an absolute net lease means that the tenant is responsible for the structural components of the property. So, absolute net tenant is responsible for the roof, they're responsible for the foundation. If anything happens to that property, they have to pay for it. Whereas at a triple net, typically the landlord is responsible for uh those structural components. So if the roof leaks, landlord has to pay for it and fix it. So pretty big difference between the two.
Now I want to get into the differences between these leases here. All right. Well, looks like I just unplugged it. Give me one second. There we go. We're doing it live. All right. So, let me pull this up here. Um, if you were listening on the podcast, I've got my whiteboard here in front of me. I'll do my best to explain each of these as we are going through them, but I have a a chart here of full service gross, modified gross, and triple net leases. We're going to be talking about the differences between these.
All right. So, when it comes to NOI stability, full service gets an X. I mean, the full service leases have next to zero stability when it comes to their NOI predictability because if your property taxes go up, you as the landlord are fully responsible for that. Same with modified gross, right? Typically modified gross leases are basically saying it's a full service gross lease but the tenant pays their own utilities. Now you can modify a gross lease in any sort of way. You could also say hey tenant is responsible for paying for their you know prora share of the commonary maintenance right you pull that out great but generally you're still lumping a lot of expenses together and so as a landlord there's not a lot of of downside protection right. Uh, triple net is great for that, right? Triple net is pretty great because you have uh the three nets, right? The tenant pays you the base rent plus the additional rent. If the taxes go up, they pay you the difference. If the insurance goes up, they pay you the difference. If you have to pay for snow removal one year, that is not typical, right? Maybe you're not up in Buffalo, New York, where that happens every single year. Maybe you're in Nashville, Tennessee, where I'm having to deal with snow removal on rare occasions. It can be very expensive to do that, right? If that happens, I pass that expense off onto the tenant. You'll hear tenants argue though in triple net, well, why should I have to pay for all this? Well, you're the one using the property. Like, I'm not the one using the property. The difference between triple net and full service is that you're the tenants still paying for it in full service. there's just less downside risk for the landlord, which means the landlord's probably going to put more of a buffer into the rent to make sure that if any expenses do come up, they can keep their margin, right? So, that's one thing to keep in mind. Triple net leases actually keep landlords honest because in a full service gross lease, the landlord could save money and increase their NOI by just spending less on things like snow removal, right? So, it's actually in a tenants's best interest to have it um set up in a triple net manner because at least they can audit the landlord what they're doing. So, if anybody ever asks you, that's why.
All right. Risk exposure for full service gross, pretty high risk exposure, right? If something happens, again, that's coming on to you. Um, modified gross I would say is the same but maybe not quite as much as full service obviously because there are some aspects of the lease that you are able to mitigate that risk in triple net's pretty low right there's not a lot of risk that the landlord is actually having to take there.
All right. Operational workload. Um, you know, on the uh on the landlord's side, full service gross is pretty operationally heavy. All right. Now, that's because um the landlord is having to really oversee a lot of that. I mean, to be fair, if you hire a property manager, all of these are going to be relatively equal. Um, but on the operational workload, like you're really responsible for that as the landlord. It could be kind of the same. I'm circling these green for modified gross. Um, they're still getting red X's, but um it's it's still not quite as much on the triple net side. It's it's pretty low, right? Um, there's you still are doing the same level of work. Um, but the tenants are paying for it and it's just I don't know, not as much. in my opinion.
Here's where things start to really really shift towards full service and modified gross's favor though. Marketability to tenants 100% the full service gross lease is handsdown the most marketable lease for tenants because all you have to tell them is rent is $2,000 a month. That includes everything. Very easy, right? modified gross, you know, I mean, I'll give it a check mark with a red B red circle around it because it's still, you know, hey, it's still relatively easy. Hey, you're paying your base rent plus your utilities, right? You're paying your base rent plus your prora share of of maintaining the parking lot, right? Whatever. Triple net leases, and I know this from experience, are absolutely miserable to market to certain types of tenants. Now, it depends on the size and scale of the tenants that you are working with. I tend to work on properties that are sub $10 million, which means that we're generally and and they're they're bigger properties, right? So, class B and class C is probably a better way to put that. So, we're generally dealing with tenants that are not super sophisticated, right? And because of that, which is generally what most of y'all are dealing with too, right? I mean, we have I have a few people in the audience that, you know, exclusively buy single tenant Nelly's deals that we've worked with. And we've got people that buy, you know, super high-end commercial real estate. We represent people doing that all the time. But for the most part, a lot of you all that are that are, you know, transitioning into commercial properties, you're dealing with the class B and C tenants, typically the smaller businesses. And some of them have just, you know, like we said earlier, they don't even read the leases. So, they have no idea what they're getting into. And and telling somebody, hey, you're paying your base rent plus you're going to pay additional rent, which is your prora share of commonary maintenance, property taxes, and building insurance, and you're going to pay your utilities. starts to really confuse them, right? It's pretty straightforward to you and me probably because we deal with this every day, but you got to put yourself in the perspective of a business owner that is not used to working in commercial real estate. They're not typically signing these leases. So, it it gets very difficult for them to I it's just it's a barrier of entry there, right?
Long-term value creation definitely not full service, right? Unless actually, you know what? I will circle this green, right? Because it's going to create long-term value for the next guy, right? If I if I see a property that has a lot of full service or even modified gross leases, which I'm going to give the exact same rating, uh maybe a double circle on the green because it's it's more favorable than full service. If I see a property that has a bunch of full service and modified gross leases, to me, the immediate upside is let's change this. Let's change the lease structure, pass those expenses off onto the tenant. Even if we're going from $30 a foot full service to $23 per square foot triple net with $7 of of pass through expenses, like my triple nets, that's already a better deal for me as the landlord, right? Because as my property taxes go up, as insurance goes up, as commonary maintenance goes up, my NOI is not going to take a hit. All right, triple net obviously, hands down, the best for long-term value creation. Investors will pay lower cap rates for assets based on the predictability of cash flow. Right? If it's very hands-off and I know that I'm going to be getting a check every single month, I'm going to be willing to pay more money for that asset, right? Which is why you see Starbucks trade at a 5% cap rate. They're very likely going to pay their rent every month and you're not going to have to deal with that as a landlord, right? So cap rates will tend to increase as you start to look at assets that will need more active work.
All right, got a couple of questions here. Kevin's saying, "This is a bit outside the lease topic, but I was wondering how do you draw your development fees and how are they baked into your underwriting spreadsheet? How much of it is in the closing cost?" Um, so I don't draw any development fees um in my closing costs. The development fees are baked into the construction costs of the project and we draw those down as we draw down on our construction loan.
Katie Safy, Kimberly, what's going on? How did you handle the big utility increases that we in the last year or so um with full service tenants? So unfortunately um when you have full service tenants and utilities start to go up, there's not a lot that you can do, right? The as a landlord, there's no way for you to pass those expenses on. However, what we have done in the past, like this building that I'm sitting in now, when we bought it almost immediately came out, switched all of the lights over to LED. I put smart thermostats in all of the suites that cannot go below, I want to say 68 and cannot go above 75. There's no reason that anybody should ever be able to put their thermostat below 68 or above 75. Uh, it's it's not going to be more effective. It's not going to heat the room better. Uh, you know, this building actually when I first took it over, we had a tenant that had their AC down to like 58 and it didn't make the room any cooler than it would have at 68. It just froze the unit instead and and actually shut their entire HVAC unit in it down. So, uh, there's that. And then one other thing that we actually did with this building specifically is we tented all of the windows that face the sun all day. That made a I I swear 10 degree drop in temperatures in this building. pretty wild. So, that's a relatively affordable way to to drop that down. So, that's that's how I would handle that, Kimberly.
Okay. Now, for my favorite part, which is a lease structure that is is honestly not talked about enough. Um, and and it really should be because this in my experience really is all of the pros of triple nets and all of the pros of full service, which I mean, as you can see looking at this list, there's not a lot of pros for full service other than marketability tenants. It's just simple, right? Um, but really it's it's a it's a um I would call it probably a modified gross with base year expense stop. So if you're not familiar with what that means, let me show you. So So modified gross means you're paying base rent plus let's just say utilities. Okay. But if you are now doing a base year expense stop, you'll have your base rent plus utilities plus any overages above the year that they sign the lease, right? So, let's say that they signed the lease in 2024 and those expenses are $7 a foot. But in 2025, those expenses were $8 a flood. All right, so we signed a lease that was full service. All right, let's just say for simp for making it super simple, it was $30 a square foot plus utilities. All right, whatever that ends up being. So if you're looking at this, you're basically at a $23 per square foot triple net price, right? because they're $7 a foot in expenses. Well, as those expenses go up a dollar, if you're in a traditional modified gross or full service gross lease, you've now gone down to $22 a square foot triple net, right? I mean, of course, you're going to have probably a 3% annual increase in that, right? But instead in year two, right, they'll be paying their base rent plus utilities plus $1 per square foot in expenses. So they will pay for any expenses above and beyond what they were before they jumped into the building. Right? And that's a pretty reasonable thing to say because they're only paying their prata share. But if you jump into this building and it goes from being vacant to occupied, utility use is going to go up. We're probably going to have to clean more trash out of the bathrooms or whatever it ends up being. Our cost of operating the building will go up. And so this modified gross with a baseear expense stop is hands down my favorite lease structure right now. It is by far the best way to pitch these deals to tenants because it's relatively simple and straightforward and they get it.
All right. So, if we go back to our chart here and we're looking at NOI stability, it's a green check mark, right? Absolutely. The NOI pretty stable because as our expenses increase, it gets there. Risk exposure, it gets a green check mark. It's pretty low on the risk exposure side, right? Operational workload, I mean, it's the same as a triple net. We'll give it a a check mark. If you've got a a um property management company in place, it's not going to be any different in all of these to be honest with you. Uh, marketability to tenants gets two check marks in my opinion. Very easy. Um, I know that we gave full service one check mark and in all honesty, it's just as marketable as a full service lease, but I just like this better. And I know that my camera is kind of covering up this last one, but long-term value creation, one check mark, green. same as triple net leases. Right now, it's hard to argue that this isn't a better way of structuring your leases. I haven't seen it very commonly out there, which I'm really surprised by. So, um, you know, I first learned this when I was working for a a developer before I went off and started my own thing. It was actually how we structured our office leases, right? So, so everybody in our office building had this lease structure. They paid their base rent, let's say $30 per square foot. They paid their own utilities. Actually, in this in that building, they didn't pay utilities. It was full service with a base year expense stop. So, you can do this in different ways. So, let's just say they paid $30 a square foot. And as expenses went up each year, they paid the difference. And so what we would do in the lease is we would actually memorialize that the expenses when they signed the lease were $7 a square foot or whatever they are in your case. Right? This is I'm just looking at this oh uh example. All right. It uh I boxed it and it deleted from my whiteboard for whatever reason. Um, so we would memorialize that when they first started it was seven bucks a foot. So that in 2025 when we send them their cam reconciliation and say, "Hey, expenses are now eight bucks a foot. Your base year is $7 a foot. You owe us a difference moving forward of a dollar." Pretty great. Makes it super super easy um for everybody involved to deal with.
Let's see. Christian, uh, Kevin saying, "Does that base your year expense stop account for structural expenses as well?" Um, I mean, it can. It just depends on how you word the lease, right? Um, now I typically like, if you can get away with it, um, maybe. I've never seen that. Uh, most landlords will take care of the structural expenses on their own. Christian is saying, "That's what I do on my office buildings. It works out great. But tenants are a little confused sometimes. Yeah, they can be. I mean, when you're anytime I guarantee you this, anytime you go back to tenants, even retail ten, like we've worked with some big retail tenants before they were confused by camera reconciliations. It's pretty wild. It's very black and white in the lease. Sometimes you're just going to have to do, you know, deal with it. He's saying, I just kind of had to do a sample like you did and draw it out for them versus give them a lease. Then they get confused and think they have to pay for everything. That's exactly right. Best thing that you could do is to just draw it out for them. Just show them exactly what it is, like what I just did, right? To show them how that actually works. Question from Christian. Uh, what if you're doing a bunch of parking lot resurfacing and other repairs and you set with a super high base year? Um, so there's a big difference in operating expenses and cap capital expenses. Um, so I wouldn't actually include capital expenses. uh in that budget um at least not all in one year, right? You'll say, "Okay, how long is a parking lot going to last? Let's say seven years." I would I would just divide it by seven and we're going to, you know, do it over seven years at that point. Uh, let's see. Kevin's saying, "Does this require signing any additional documentation?" No, not at all. This is just all covered in the lease. Kimberly saying, "Plus you are doing rent bumps on these also in addition to the expense top." Absolutely. Yeah. So like that $30 per square foot that we were talking about would have 3% annual increases, right? So I mean technically, you know, if we want to if we want to get very granular here, this will actually be base plus 3% increase plus utilities plus $1 of foot in expenses. Yeah. Or whatever, you know, annual increase you have going on there. Um, but I I'm a big fan of structuring the leases this way. I mean, as you can see, um, maybe I'm biased, but you've got green checks in like every major category, you know, and of course, I I think I'm sure somebody could sit there and say, "Well, you didn't cover this category specifically of that I like to hear in leases." Well, I mean, if I didn't, then go through it. I guarantee you the modified gross or the base your expense is still going to be the best lease structure uh for for for you to do. So there you have it. I think that uh I think modified gross leases with a base your expense stop are really the way that a lot of um you know it's it if you're dealing with national credit tenants, you don't need to worry about this, right? Because they understand like a triple net lease is very marketable to them. They get it. They sign hundreds if not thousands of leases. I guarantee you they've done more of these leases than you ever have. Right? And so they don't need to be educated on what that is. However, uh the the business that is is opening their second location probably has no clue what that means or what it implies. And it's very beneficial for you as a landlord to be upfront with your tenants on the front end. Walk them through that lease. Show them everything. And the triple net stuff can just get confusing sometimes. So, if you are in a market where or you're dealing with the types of tenants that you feel like will get confused by a triple net lease, that is exactly what I would do. The modified gross lease with a base year expense stop.
Julian is asking, "How do I use AI? Anything that you found really uh helpful with AI?" Um, I mean, not really. I mean, we use chat GBT to to do some research for us on projects. Um, we'll use it for, you know, like drafting, you know, helping with LinkedIn posts and stuff like that. Um, I mean, outside of like creating transcripts from coaching calls and stuff like that for in the mastermind or pulling ideas out of, you know, hey, how could we like what's a common question that we get in our coaching calls? How could I handle that a little bit better? There's not a lot out there in AI that I think has actually made a massive difference in my day-to-day to be honest with you, like with with how we're going about um commercial real estate. We'll drop leases into uh chat GPT and have it create um, you know, our little uh lease tables, you know, lease abstracts. That way, uh we don't have to go through and dig through everything. So, it can be very helpful in that way. But, I wouldn't say that there's been anything kind of groundbreaking in AI yet for commercial real estate, which is kind of surprising. Now, there are some softwares out there that are starting to implement it and this that and the other, but I just don't I don't know. I mean, we're using it. It's a tool. Um, to me, it's like a it's like, you know, we're we're going from a hammer to a nail gun. Like, I still have to physically get out there and frame the entire house. Um, but it's a little bit faster now that uh that I've got a nail gun instead of a hammer and nails. So, that's it. Cool.
Guys, hope you enjoyed this conversation on lease structures. Uh, if you're enjoying this new format for office hours, if you guys like it that, you know, I'm doing some whiteboarding here. We're teaching some sort of small aspect of investing in commercial real estate, let me know in the comments. Uh, like, subscribe, of course, as always. Appreciate you guys. Tomorrow, we'll be diving into the data center boom on the Deal Desk, talking about news around uh, data centers, what's going on in that world? Because I get that question all the time. Should I be investing in data centers? We'll talk about all of that tomorrow. I will see you guys there. Cheers.
This episode of the Commercial Real Estate Investor podcast is brought to you by my CRA Accelerator Mastermind, where you'll get access to my step-by-step investment blueprint, essentially a library of resources on how to invest in commercial real estate. You'll get connected to a supportive community of other commercial real estate investors that are doing projects just like you. And you'll get personalized coaching and feedback from me every step of the way. Go to www.cre central.com to learn more.