What Is a Modified Gross Lease, and How Does It Work?

A modified gross lease shares the risks and rewards of property ownership between the landlord and the tenant. In this lease agreement, the tenant pays the basic rent and shares the operating expenses related to the property with the landlord. While it offers flexibility and control, modified gross leases require careful scrutiny. 

This article takes a deep dive into the world of commercial real estate arrangements. We examine how various lease structures work and how they can impact the price you'll pay per square foot. We also weigh the pros and cons of signing a modified gross lease agreement, offering key insights for anyone considering this lease structure.

What is a modified gross lease?

A modified gross lease is a unique real estate rental agreement that splits the property's operating expenses between both the landlord and the tenant. In a modified gross lease agreement, a property owner can make the tenant responsible for paying a portion of property taxes, insurance, and maintenance expenses.

Modified gross lease agreements are common in commercial spaces where there are multiple tenants like:

• Office parks
• Condo towers
• Multi-tenant office buildings

However, no two modified gross leases are ever the same, with negotiable liabilities. As the tenant's responsibilities can vary across properties, it's essential to understand and document the terms in a legally binding contract.

How does a modified gross lease work? 

A modified gross lease can be structured in multiple ways, and the lease agreement will have specific terms on who is in charge of what. For example, a tenant can pay the base rent and be responsible for a predetermined portion of utilities, minor repairs, and small-budget interior maintenance. The landlord pays for major repairs, exterior maintenance, property tax, and remaining insurance costs.

How to calculate base rent

In modified gross leases, the base rent, which is the starting point for rent negotiations, is typically expressed per square foot, either monthly or annually. Commercial real estate investors can use the rates of other spaces in the area as a benchmark. The quality of the property and its amenities are also factors in the calculation of base rent. A real estate attorney can be a valuable resource in determining a fair base rent.

How to calculate expenses in a modified gross lease

Operating expenses can be calculated using fixed-rate, prorated, base-year, or expense-stop strategies.

• Fixed rate. Both parties agree to a fixed share of property expenses, like a flat fee of $500 per month over the base rent.
• Prorated expenses. Under this method, the property owner will ask each tenant to pay a pro-rata portion of all property expenses. Here's how it would work: Say you occupy 1,500 square feet within a 10,000-square-foot building. You'd be responsible for paying 15 percent of the total expenses.
• Expense-stop. This strategy involves the property owner paying individual or group expenses up to a certain limit. After that threshold is crossed, the tenant takes over the costs. For example, the property owner will cover common area maintenance expenses up to $5 per square foot. Any common area housekeeping cost above that amount will be covered by the tenant's business.
• Base-year stops. This works similarly to an expense stop, but the cost per square is tied to the base year's expenses. In real estate, the base year is the year you signed the lease. If you signed the agreement in May 2024, the base year is January 2024 to December 2024. If the base year expenses for a 10,000-square-foot facility are $500,000, the base year stop is $50/per square foot. The tenant will cover the costs above that base year rate. Suppose, in 2025, the total building expenses come to $550,000, which is $55/per square foot; the tenant will pay the additional $5 per square foot.

An additional consideration in a modified lease is how expenses are grouped, as this also impacts the fee one will pay. If expenses such as property taxes and common area maintenance are clubbed together, the tenant is more likely to hit the base year or expense year stop threshold earlier than expected, and they might end up having to pay more.

The lease terms are influenced by each party's needs, negotiation skills, and budget. Look at these 10 lease agreement points or consult a real estate lawyer before you sign the dotted line to ensure you completely understand what you're getting into.

Modified gross leases vs. other gross and net leases

As a small business owner or commercial real estate developer, a modified gross lease is not the only lease structure available. There are other commercial real estate arrangements that you can explore.

Gross leases

A gross lease, also known as a full-service lease, is a typical lease between a landlord and a tenant. The landlord covers all of the property's operating expenses, from real estate taxes, property insurance premiums, maintenance expenses, utilities, repairs, and janitorial services. These factors are calculated into the base rent amount. The tenant pays a flat fee to the landlord to get exclusive use of the premises.

Gross leases are favorable leasing arrangements for tenants with limited resources who need to budget judiciously. They are also popular for top "Class A" office spaces with state-of-the-art amenities.

Net leases

In a net lease, it's the tenant's responsibility to cover some of the operating expenses. Many commercial real estate investors and property owners want to avoid the headache of managing the property and, therefore, pass on the expense burden to the tenants. Owners, in turn, charge a lower rent amount as they no longer have to worry about the day-to-day upkeep and administration.

There are three types of net leases:

1. Single net lease. Also known as N lease; the tenant pays net rent and property taxes.
2. Double net lease. Other names are NN lease or net-net lease. In addition to rent, the tenant pays property taxes and insurance; the landlord foots the bill for maintenance costs.
3. Triple net lease. Commonly known as an NNN lease, triple net leases require the tenant to pay property taxes, insurance, and minor structural maintenance costs. They are signed for big-box stores, national restaurant chains, gas stations, free-standing banks, or pharmacies with the funds to pay these additional costs.
4. Absolute net lease. The tenant covers ALL expenses, including major structural repairs and costs, such as replacing the HVAC system or repairing the roof, as part of their business expenses.

Advantages and disadvantages of the modified gross lease

There are certain pros and cons to using a modified gross lease.

Advantages

A modified gross lease offers the following:

• Balance and flexibility. Modified gross leases serve as a midway point between two commercial real estate extremes for tenants and landlords. You can pick and choose which operating costs you want control over.
• Predictability. Unlike triple net leases, where costs can change drastically from year to year, a modified gross lease has some predictability. Tenants pay a base rent and then a fixed rate for a portion of the expenses. The rental agreement also locks in how the lease payment will increase yearly. This predictability leads to better budgeting and cash flow estimation.
• Control. A modified gross lease allows property owners and tenants to have more control over the property’s maintenance and operating costs. For instance, a business can implement energy-saving measures to lower its utility expenses if it knows it is only responsible for its unit's consumption.
• Fewer maintenance hassles. In most modified gross leases, the tenant only has to worry about minimal maintenance costs. They aren't hassled with major repairs as they would be in a triple-net lease.

For commercial real estate investors, this method removes some financial pressure from their shoulders and gives them a more stable source of income, as some operating expenses are part of the base rent.

Disadvantages

Modified gross leases aren't always a win-win. Some common pain points are:

• Complex terms. Modified gross leases can be extremely confusing and difficult to understand. Expense stops, expense groups, and base year stops are just a few of the legal matters that would need additional explanation.
• Undervalued expenses. Both landlords and tenants can under-estimate the costs they expect to pay. For instance, a landlord can miscalculate maintenance upkeep and charge a base rent that is too low.
• Money disputes. If contract terms are confusing, a modified gross lease could spur dispute over area measurement and associated payment and administration fees.

Is a modified gross lease right for you?

Are you confused about which commercial lease agreement to use? Make your decision after reading our tips.

Consult a real estate attorney

What makes modified gross leases complex is that, unlike gross and net leases, a modified gross lease has no set industry standards for cost distribution. Multiple variables can impact what you might end up paying. For instance, the landlord might demand that the anchor tenant pay a higher percentage of expenses. If you're the anchor tenant (one who occupies most space in the building), you could face a higher financial burden. Hiring an attorney to draft or review your commercial lease agreement will protect you from financial and legal risks.

Understand your lease's terms

In a modified gross lease, the tenant's responsibility can vary from property to property. For instance, in one commercial building with a single electrical meter, you might be responsible for paying an equal percentage of the building's electricity bill, regardless of your usage. In another, you might be on the hook for an amount tied based on your space. Each modified gross lease is different and there could be unexpected financial surprises if you don't dot all the I’s and cross all the T’s.

Financial predictability

While a gross modified lease doesn't put the majority of expense onus on the tenant like an absolute or triple net lease, it still brings in some variable operating costs. Your business should have enough buffer to handle the fluctuating operating expenses.

Consider business nature and location

Does your business use significant utilities? Does it have standard operating hours? Irregular operating hours and fluctuating utility usage can make budgeting a challenge. Also, consider the utility rate trends in your area; frequent price hikes add to the uncertainty. 

Evaluate business growth plans

Envision growth and want to maintain a consistent brand image? It might be better to go for an absolute net leasing arrangement where you absorb all the financial and physical responsibility. It may provide more control over your business' branding and operations.

FAQs

Can modified leases be converted to another lease structure?

Yes, it's possible to modify lease agreements as long as they don't break any laws or infringe upon the rights of either party. Remember that you're altering a legal document, and thus, it's advisable to have a lawyer on your team to ensure the new agreement is legally sound and enforceable. 

How are expenses calculated in a modified gross lease? 

Expenses can be calculated using the fixed-rate, pro-rated, base-year stop, or expense-stop methods. The landlord and tenant can negotiate which expenses each party is responsible for. The final terms and payment conditions should be mentioned in the modified gross lease agreement.