Gross and Modified Gross Lease

How gross and modified gross leases work

A commercial lease answers one question before any other: when the building's bills arrive, who pays them? A gross lease (also called a full-service gross lease) answers "the landlord." The tenant pays a single rent, and the landlord pays real estate taxes, building insurance, common area maintenance and often utilities and janitorial out of it. The tenant's cost is the same number every month for the term, apart from any fixed rent increases written into the lease.

A modified gross lease answers "both of us." The landlord still quotes one rent, but the lease shifts some costs to the tenant, most often one of these ways:

• Base year. The landlord covers operating costs at their level in a named base year. The tenant pays its pro rata share of any increase above that level in later years.
• Expense stop. The same idea with a fixed number: the landlord covers costs up to, say, $12.00 per square foot and the tenant pays its share of anything above.
• Carve-outs. The tenant pays specific items itself, typically its own utilities and in-suite janitorial, while the landlord covers taxes, insurance and common areas.

Two cautions before going further. First, there is no statute that defines either term. "Gross," "modified gross" and "full service" are market labels, and brokers use them loosely: many leases sold as gross are in practice modified gross because they carry a base year. Second, the labels describe operating costs, not the whole building. Who pays for roof replacement, structural repairs and other capital items is a separate clause, and it matters just as much. The lease controls, not the heading on the listing.

Office buildings are where these structures are most common, along with some medical office and small multi-tenant properties. Industrial, freestanding retail and many shopping centers lean toward net leases; see triple net lease (NNN) for the other end of the spectrum.

Base year, expense stop and pro rata share

Three pieces of lease language do most of the work in a modified gross lease.

The base year

The base year fixes the baseline. If the building's operating expenses were $600,000 in the base year, the landlord's responsibility in later years is that $600,000, and the tenant pays its share of the excess. The lease defines which year counts, and the definition varies: it is often the calendar year in which the lease begins, but it can also be the first year of the tenant's term or another stated year. Also, the base-year total is not final until that year closes and the landlord reconciles it.

The expense stop

An expense stop is a base year expressed as a number: $12.00 per square foot, for example. It is simple to read and easy to compare across leases, but it can become stale if the stop is never reset while costs rise.

Pro rata share

The tenant's share of the increase is normally its rentable square footage divided by the building's, so a 10,000 square foot tenant in a 50,000 square foot building pays 20% of any increase. Which expenses count in the pool, and whether the building's rentable area is measured the same way for every tenant, are both worth checking.

The gross-up clause

Some operating costs rise and fall with occupancy: janitorial, utilities, trash removal. If the base year was a year when the building was half empty, those costs were artificially low, and as tenants move in the "increase" the tenant is billed for is partly just the building filling up. A gross-up provision restates those variable costs as if the building were fully or nearly fully occupied before the base year and each later year are compared. Costs usually classified as fixed, such as property taxes and insurance, are generally not grossed up. As an illustration, if a building at 60% occupancy spent $100,000 on janitorial and utilities, grossing up to 95% occupancy restates the cost as $100,000 ÷ 0.60 × 0.95 = about $158,333 for the purposes of the base year and each later year. The assumed occupancy percentage and the list of costs it applies to are negotiated, so they deserve a close read on both sides of the table.

Worked example: three lease types, same building

Take a 50,000 square foot office building, fully leased at $28.00 per square foot ($1,400,000 a year). Operating expenses in the base year are $12.00 per square foot ($600,000) and rise 3% a year. All figures here are illustrative assumptions, not market data. A 10,000 square foot tenant (20% of the building) pays as follows.

Lease type	Year 1	Year 4	Year 7
Building expenses	$600,000	$655,636	$716,431
Gross, $28.00 flat	$280,000	$280,000	$280,000
Modified gross, $28.00 + 20% of increase over the base year	$280,000	$291,127	$303,286
NNN, $16.00 + 20% of actual expenses	$280,000	$291,127	$303,286

Look at the bottom two rows. When the base year equals the whole expense pool, a modified gross lease and a triple net lease cost the tenant exactly the same amount in every year. The difference is who is exposed to the first $12.00 per square foot: under the base year structure the landlord has bundled it into rent, under NNN it is itemized and billed. To compare quotes on the same footing, convert each one to an all-in cost per square foot, which the rent per square foot calculator will do.

Now the landlord's side. Assumptions: every tenant shares the same base year, the building is fully leased, and the 5% vacancy and credit loss allowance applies to rent plus recoveries. The gross column keeps the same $28.00 rent and simply has no recoveries, to show the exposure; in practice a gross lease is priced at a higher rent to compensate for it. With a 5% vacancy and credit loss allowance, here is the building's year 4 income under two different leases, run through our NOI calculator with the expenses entered as one total.

	Year 1 (base year)	Year 4, modified gross	Year 4, gross
Base rent	$1,400,000	$1,400,000	$1,400,000
Expense recoveries	$0	$55,636	$0
Vacancy and credit loss (5%)	−$70,000	−$72,782	−$70,000
Effective gross income	$1,330,000	$1,382,854	$1,330,000
Operating expenses	$600,000	$655,636	$655,636
NOI	$730,000	$727,218	$674,364

The modified gross building holds its NOI nearly flat while expenses rise $55,636. The gross-leased building loses that amount directly (year 4 NOI of $674,364 against $727,218), about 7% less NOI than the modified gross building in year 4, and the gap widens every year: by year 7 the same pattern gives $724,178 against $613,569. That difference reaches the loan. At a 10% debt yield floor, $727,218 supports about $7,272,000 of debt and $674,364 supports about $6,744,000, so roughly $528,000 less loan from the same building and the same rents. On a $7,000,000 loan the debt yield is 10.39% against 9.63%, which is the difference between clearing a common institutional floor and missing it.

Gross vs. modified gross vs. net leases

Lease type	Who bears cost increases	Rent level	Typical property
Gross (full service)	Landlord, for the whole term	Highest quoted rent	Office, small multi-tenant, short-term space
Modified gross	Shared: landlord to the base year or stop, tenant above it	Between gross and net	Office, medical office, mixed-use
Single or double net	Tenant pays one or two of taxes, insurance and maintenance	Lower than gross	Varies
Triple net (NNN)	Tenant, subject to the roof and structure clauses	Lower base rent	Single-tenant retail, industrial

Descriptions of these types differ by broker and region. Treat the table as orientation and the lease as the answer.

Why lenders care about the lease structure

A lender does not size a loan on the rent in the listing. It rebuilds net operating income from the leases and operating history, and the lease structure changes how that rebuild works. For a gross or modified gross property the lender asks:

• What are the base years, tenant by tenant? In a multi-tenant building each lease can have a different base year, which means recoveries are different for each tenant. A tenant still on an old base year pays more in pass-throughs than a newly signed tenant, and when that lease renews the base year typically resets and the recovery falls. A lender who sees the reset coming may underwrite lower income than the current rent roll suggests.
• Are expenses growing faster than recoveries? On gross leases, and on any lease with a stop or cap, expense growth falls on the owner. The lender compares the trailing 12 months with prior years to see the trend.
• Is the gross-up clause symmetrical and correctly applied? Errors in how variable costs were grossed up are a common reconciliation problem, and they flow straight into recoveries.
• Is anything misclassified? Capital items passed through as operating expenses may be challenged by tenants, and repayments or credits reduce income. Lenders also add replacement reserves and, for office, often TI and leasing commission reserves regardless of lease type.
• What is the operating expense ratio? Gross-leased buildings run a much higher operating expense ratio than net-leased ones, since the owner pays the costs. Lenders compare the ratio against similar buildings and question numbers that look too low.

Lease expirations matter more here than on a net lease, because a new lease can reset the base year. A building with many leases rolling in the same two years can show a different NOI after renewals than before. Our office building loan and investment property loan pages list the terms we typically see for these properties, and what NOI is and how lenders use it explains the income math in more detail.

What to watch for

If you are the landlord or buyer

• Collect every lease, not the rent roll summary. Base years, stops, caps on increases, gross-up percentages and audit rights live in the leases. A rent roll shows rent; it rarely shows which tenants are on which base year.
• Test your NOI for expense growth. Run the building with expenses 3% higher and see what happens to NOI and to the loan. Gross leases are more sensitive to this than modified gross leases.
• Know the reset dates. When a base-year lease expires and is renewed, recoveries from that tenant can drop. Build the roll into your projections.
• Check the cost pool. Make sure items you pass through, such as capital repairs, are allowed by the lease. Disallowed charges mean refunds.
• Watch controllable-expense caps. Some leases cap annual increases, which leaves the landlord exposed above the cap even in a "modified" structure.

If you are the tenant

• Compare all-in cost, not the quoted rent. A gross rent of $28.00 and an NNN rent of $16.00 can be the same price in year one, as the example shows. Ask what each costs in year four.
• Negotiate the base year. A higher base year or a later one shrinks your future increases. Insist on a gross-up clause if the building is not close to full when your base year runs.
• Look for caps and audit rights. Ask for a cap on annual increases in controllable costs and the right to review the landlord's expense records.
• Understand the capital items. Confirm that roof, structure and building systems replacement is not passed through as an operating expense.

Gross lease vs. similar terms

• Gross vs. NNN: the first bundles the costs into rent; the second itemizes them. See triple net lease (NNN).
• Gross rent vs. gross income: a gross lease is about who pays costs. Effective gross income is the building's income after vacancy and credit loss, whatever the lease type.
• Base year vs. expense stop: the stop is a fixed figure; the base year is whatever the building actually spent that year.
• Gross lease vs. gross rent multiplier: unrelated despite the shared word. The gross rent multiplier divides price by gross rental income.

What it means for you

If you own or are buying a building with gross or modified gross leases, the lease abstracts are as important as the operating statement. Pull each lease's base year or stop, its gross-up clause, its expiration date and any caps, put them next to the rent roll and the trailing twelve months, and decide what NOI looks like after the next round of renewals. Underwrite that number yourself before a lender does. When you have the package together, send it with your application and we will show you which test sizes the loan.

Sources: lease-type, base year, expense stop and gross-up descriptions from industry references including PropertyMetrics, "What Is a Modified Gross Lease & How Does It Work?"; Marks Paneth, "Consider the Gross-Up in Lease Modifications and New Commercial Leases". There is no statutory definition of gross or modified gross lease; terms vary by broker, region and lease, and the signed lease controls. Lender underwriting factors are described in general terms and vary by lender. Example figures are illustrative; NOI results were computed with the BestLoanUSA NOI calculator and the debt yield with the debt yield calculator.