There are many costs associated with running and holding a building. These include statutory costs such as rates and land tax, as well as operating expenses such as cleaning, repairs and body corporate charges required to keep the building functioning. Since most of these costs are billed to the landlord and service the end users, we see a variety of ways to split the costs between the landlords and tenants in their lease agreements.
One common arrangement is to have all of the building’s running costs included in the rent. In these arrangements, the total annual rental figure is higher to cover the landlord’s additional expenses. This is called a gross lease. Occasionally there are some arrangements where the tenant agrees to pay a single expense, such as a specific cleaning service directly on-charged to them, however in general it is very easy to predict the tenant’s contribution over a long period and little administration or auditing is required.
The other way to account for the costs under a commercial lease is to charge outgoings separately, often in a monthly additional amount on top of rent, reviewed and reconciled each financial year. Net leases allow for more accurate recovery of the actual costs, whilst still ensuring a manageable and consistent monthly payment.
Comparing Gross vs Net
Often the initial cost is the same. For example, a Net Lease might be $400/m2 plus $100 in outgoings contribution, whereas a Gross lease starts at $500/m2 (but includes all outgoings). One of the main differences is who takes the risk moving forward. In a Net Lease the tenant is at risk of the outgoings increasing beyond their expectation because they pay for the outgoings. In a Gross Lease, the landlord is at risk of the outgoings increasing more than his expectation, because he can’t recover the increased cost from tenants. Alternatively, the landlord might be confident he can reduce outgoings below $100/m2 and be more profitable offering a Gross Lease.
How do Net Leases work?
Tenants will pay an agreed portion of the building and common area outgoings. This could be a percentage based on the proportion of the premises size compared to the total lettable area of the building, or another agreed percentage of relevant costs that reflects the type of business in the space.
Each year, the property manager creates an estimate – sometimes called a budget – of outgoings relating to the property for the whole financial year. This will include costs such as rates, cleaning, repairs and maintenance, etc. The tenants will then pay their portion of each item budgeted for, according to their lease over the 12 months. Meaning at the end of the year, the tenants will have paid the total annual budgeted outgoings.
At the end of the financial year, the actual expenses the landlord has incurred will be totalled and reconciled against the budget that was charged. Some leases or regulations require an auditor at this stage, so it is important for landlords to double check what their obligations are with a professional if unsure. If the actual operating expenses of the building were higher than what was estimated, each tenant will be invoiced for their portion of the additional amount (shortfall). In the same way, if expenses were less than what was budgeted, then the total amount that the tenants paid was higher than the actual expenses, so the landlord must refund each tenant this difference, or give them a credit towards the next years outgoings or rent. This method results in the tenants paying exactly their agreed portion of costs; no more and no less.
At the same time, this format allows for consistent and predictable cashflow for the tenant and ease of on-charging in an exact way where a gross lease might not capture any savings or increases in the operating expenses of the building over time. This is an example of how agreements can differ according to each landlord and tenant.
One common variation of a gross lease is referred to as “increase over base year”. Under this arrangement, the tenant only pays an increase in operating costs over a set base year. This format addresses one of the pitfalls of a gross lease, where operating expenses increase in an amount disproportionate to the stipulated rent increases.
Let’s look at this scenario:
The outgoings for building have increased by a high 20% in one year, due to an unexpected increase in land tax for the site.
- In a gross lease, the increase in operating costs falls solely on the landlord, so it might not have been accounted for in the calculation of the rent. The landlord is at risk of not recovering the rise in costs.
- In a net lease, the increase would fall on the tenant so they will likely receive a shortfall invoice at the end of the year – alternatively they might be notified by the property manager if the costs are foreseen partway through the year and have opportunity to increase their payments . They can also expect a 20% + increase in next year’s estimate to reflect the new running costs more accurately.
- Where tenants are paying an increase in outgoings over a base year, the tenant only pays this estimated figure, less what the actual expenses were in their set base year.
For Tenants – What is best?
Tenants might automatically prefer gross leases due to the appeal of an ‘all-inclusive package’. If you are a business that values peace of mind and clear forecasts of costs over a long period, then gross is most appealing. On the other hand, if you are a business that values transparency and suspect outgoings to increase at a rate lower than your rental increases, a net lease might be the way to go.
For Landlords – What is best?
Again, this boils down to the values of the individual and the overall lease agreement. In a long-term lease it may be ideal to allow for operating expenses to accurately fluctuate over time to avoid falling short when operating expenses increase higher than the standard rent reviews.
Another consideration is that it may also be easier to raise costs where a tenant requests higher quality or increased services, knowing that the tenant who seeks a specific service ends up contributing to the cost premium of it.
Whilst more administration and auditing is required in a net lease, these costs are often on-charged to tenants in the total running cost as well. By engaging trustworthy professionals throughout the term, this can easily be a flexible and convenient arrangement.
Most landlords who have multiple tenants at a site have a preference to have either all tenants net or all tenants gross. This can make decisions clearer and means any additional costs of administrating a net lease is spread across multiple tenants.
At PURE – What do we do best?
We endeavour to provide the best value for both landlords and tenants no matter what agreement they have come to in their lease. Each lease will have different requirements in terms of auditing and what is or is not included. Through ensuring that outgoings are charged and recovered accurately, it eliminates any unfair cost to the landlord or tenant.
Another way that our agency assists all parties is by ensuring there aren’t any excessive or unnecessary expenses in the first place. Our team does this by establishing long term relationships with trustworthy providers who are familiar with the properties and by regularly reviewing large contracts such as cleaning or fire compliance. At the same time, we listen to tenants’ feedback and share their business concerns if there’s opportunity to effectively improve the building.
As we can see, outgoings are an opportunity to find a way that suits each business and the building they occupy. At the end of the day, each way to recover outgoings can be considered fair to both the landlord and tenant. If the way outgoings are charged is something valuable to you, you should advocate for this in your negotiation, however, it should not be a deciding factor in where you choose to rent, or who you choose to rent to. Ultimately, if all parties understand the costs and can clearly see the benefits of their expense, it can contribute to the health of the building as well as the relationship between landlord and tenant.