Operating Expenses in Leases:?FSG vs. NNN vs. MG vs. WTV (“Whatever” for those over 40!)

One of the biggest mistakes our clients (and young brokers) make is deciphering what the tenant actually pays every month in their office or industrial lease. This is because landlords have repeatedly changed the structure of the rent/operating expense (“OpEx” or “Nets” in real estate parlance).

To add to the confusion, different geographies and product types (industrial, office, retail) structure rental payments differently. Here is the vocabulary, acronyms and how it should work…should!

There are three basic types of structures:

1. Triple Net (NNN): Add all of a building’s expenses or nets to the Base Rent.   
2. Full Service Gross (FSG): Tenant pays the additional amount over a Base Year. The Base Year is typically year 1 of the lease. So, if your lease started in 2019, the Base Year would be, you guessed it, 2019. It is usually a nominal extra cost. 
3. Modified Gross (MG): Variations on 1 and 2. MG differs slightly from submarket to submarket. In general, tenant pays its own utilities plus amounts over Base Year. 

If the Landlord is abiding by the lease and using generally accepted accounting principles (GAAP), one rent structure should not be more tenant-friendly than the other. To clarify this, your tenant rep broker should provide you with a financial model showing the increases over time, which also should include - most importantly - your All In Year One cost. Lastly, the devil is in the details and, in this case, your broker should also include a list of operating expenses that can and can’t be included in the cost pool. 

Let’s break down each rent type and discuss its nuances.

Net or NNN

The three Ns stand for net of Operating Expenses, Taxes (property), and Insurance. Net or “Triple Net” as it is commonly referred to, is the landlord’s favorite form of operating expense pass-throughs (as in the expenses get “passed through” to the tenant). It separates the Base Rent, say $20.00/sf per year, and the Building’s or Project’s Operating Expense, say $15.00/sf per year for an office building. In this case, the landlord knows the take home - $20.00 - as his net operating income (NOI), and the tenant knows that they pay $35.00 “all in.” The Base Rent typically increases per the lease’s rent schedule. The OpEx (the $15.00 in this example) increases per actual inflationary increases.

In retail, landlords almost always use NNN and in class A industrial it is quite prevalent as well. The key question when evaluating NNN offerings is to ask your would be landlord, “What are your current ‘nets’ or NNN charges?” If they do not readily know, it smells trouble. If you are a large tenant and the landlord is sophisticated, you can and should ask for a line item breakdown of the entire number.

Gross or Full Service Gross

This format is most pleasing to tenants because during the Base Year (reminder: typically year 1 of the lease), the tenant pays only the Base Rent. However, as the operating expenses escalate over the term, the landlord passes through to the tenant the pro rata increase. While this sounds horrifically open-ended and potentially exposing you to big costs, it typically is a very small number because it is just the “increase.” 

Since the math is somewhat complex, a simple Excel model that increases the Base Year OpEx number at 2% or 3% per year and subtracts the actual OpEx number from the Base Year should provide relief. Instead of trying to cap OpEx increases, take a detailed approach in the Operating Expense language in the lease. Caps are a blunt instrument because the increases are outside of their control and most landlords will not agree to this.

Modified Gross and Variations

Modified Gross (MG) is the typical third variety. We just used this in a scenario where the client will occupy an entire office building in Torrance, CA. A modified gross lease splits off a portion of the OpEx pool and sends those costs directly to the tenant.  

In Los Angeles, when we say “MG,” it typically means that the tenant pays its own, separately metered, utilities (electric, janitorial, and maybe water) and receives Base Year treatment for taxes, insurance and other project costs such as parking or maintenance.  

This format is often seen in older industrial buildings and single-tenant office. In the case mentioned above, the tenant was going to be a heavy electrical user and by government mandate had to use certain janitors, thus those costs had to be carved out of the landlord’s project wide pool.

More Confusion

I’m thirty years into this world and I’m still amazed at what’s revealed when one digs a little deeper into what truly comprises a tenant’s rent. With that said, some key points that I will save for another article include what items should be listed as operating expense exclusions (think: the landlord’s yacht payments!), how the Base Year is defined and constructed (gross-up provision), tenant’s right to audit said expenses, lessons learned from when the never imagined really happens (think post Northridge earthquake and 9/11 expenses), and California specific clauses around Prop 13 and 8.