A.CRE

Full Service Gross Lease

A commercial lease where the tenant pays a base rent and the landlord pays for all operating expenses related to the tenant’s occupancy of the space such as common area maintenance, utilities, property insurance, and property taxes. Full Service Gross (FSG) leases generally include an Expense Stop, or expense ceiling, above which any additional expenses are passed through to the tenant. FSG leases contrast with net leases, wherein the tenant pays for some or all operating expenses.

Putting “Full Service Gross Lease” in Context

Scenario Overview

Apex Commercial Partners, a value-add real estate investment firm, has recently acquired Peachtree Park Corporate Plaza, a 125,000-square-foot suburban office property located just outside Atlanta, Georgia. Built in the early 1990s, this three-story office building has historically operated under Full Service Gross (FSG) lease agreements. Under these leases, tenants pay a single base rent of $25.00 per square foot, and the landlord covers all operating expenses, which total approximately $12.00 per square foot annually.

Apex’s value-add strategy involves transitioning new and renewing tenants from FSG leases to Triple Net (NNN) leases over time. The goal is to stabilize the property’s net operating income (NOI) and align its lease structure with prevailing market practices. Under the proposed NNN lease structure, tenants would pay a lower base rent of $15.00 per square foot but would also reimburse the landlord for operating expenses proportionate to their leased space. The landlord would continue to manage and pay for all operating expenses, recovering a significant portion through tenant reimbursements.

Why Transition from Full Service Gross to NNN?

Under FSG leases, landlords bear the full risk of rising operating expenses, which can erode NOI and reduce investment returns. These leases also lack transparency, as tenants are not directly exposed to the actual costs of operating the property. By transitioning to NNN leases, Apex aims to:

  • Shift Operating Expense Risk: Tenants become responsible for their share of operating expenses, protecting the landlord from cost increases.
  • Enhance Financial Predictability: Separating base rent from operating expenses allows for more accurate forecasting of revenue streams.
  • Align with Market Norms: Many suburban office markets favor NNN leases, making the property more competitive and attractive to future investors.

Hypothetical Details of the Property

  • Building Size: 125,000 square feet
  • Occupancy at Acquisition: 85% (106,250 square feet leased)
  • Annual Base Rent Under FSG Leases: $25.00 per square foot (gross)
  • Annual Operating Expenses: $12.00 per square foot (totaling $1,500,000 for the entire building)

Net Operating Income (NOI) Under FSG Leases

The NOI under the current FSG lease structure is calculated as follows:

  • Gross Revenue (Base Rent):
    $25.00 psf × 106,250 SF (occupied space) = $2,656,250
  • Operating Expenses Paid by Landlord:
    $12.00 psf × 125,000 SF (entire building) = $1,500,000
  • Net Operating Income (NOI):
    Gross Revenue – Operating Expenses = $2,656,250 – $1,500,000 = $1,156,250

Hypothetical Impact of Converting to NNN Leases

Under the NNN lease structure, tenants pay a base rent of $15.00 per square foot and reimburse the landlord for operating expenses based on their proportionate share of the occupied space. The landlord continues to pay the total operating expenses but recovers a portion through tenant reimbursements.

  • Gross Revenue (Base Rent):
    $15.00 psf × 106,250 SF = $1,593,750
  • Expense Reimbursements from Tenants:
    $12.00 psf × 106,250 SF = $1,275,000
  • Total Operating Expenses Paid by Landlord:
    $12.00 psf × 125,000 SF = $1,500,000
  • Net Operating Income (NOI):
    (Base Rent + Expense Reimbursements) – Operating Expenses
    ($1,593,750 + $1,275,000) – $1,500,000 = $1,368,750

Comparison of NOI Before and After Transition

  • NOI under FSG Leases: $1,156,250
  • NOI under NNN Leases: $1,368,750
  • Increase in NOI: $1,368,750 – $1,156,250 = $212,500 annually

By converting to NNN leases, Apex stands to increase the property’s NOI by $212,500 annually. This increase is due to the recovery of operating expenses from tenants, reducing the landlord’s net expense burden.

Implementation Challenges

Transitioning from FSG to NNN leases presents several challenges:

  • Lease Agreements: Existing leases are binding contracts that cannot be altered unilaterally. Apex must wait for lease expirations or negotiate amendments with tenants.
  • Tenant Resistance: Tenants accustomed to FSG leases may resist the shift due to increased responsibility for operating expenses.
  • Market Competitiveness: If competing properties offer FSG leases, tenants may prefer them for their simplicity and predictability.
  • Education and Communication: Apex’s leasing team must clearly communicate the benefits and implications of NNN leases to tenants.
  • Administrative Complexity: Managing and reconciling operating expense reimbursements requires accurate accounting and can lead to disputes if not handled transparently.

Strategies for a Successful Transition

To mitigate these challenges, Apex can:

  • Offer Incentives: Provide tenant improvement allowances or rent concessions to encourage tenants to accept NNN leases.
  • Phased Implementation: Gradually introduce NNN leases as new tenants are secured and existing leases come up for renewal.
  • Market Alignment: Ensure that the combined cost of base rent and operating expenses under NNN leases is competitive with the gross rents of similar properties.
  • Transparent Reporting: Implement clear and regular reporting of operating expenses to build trust with tenants.

Conclusion

This hypothetical example illustrates the functioning of Full Service Gross Leases.

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