What is a Modified Gross Lease?
Modified Gross Lease is a lease rental agreement wherein the lessee not only pays for the basic rent at the start of the lease, but also pays for the proportionate share of property taxes, insurance premiums, and maintenance expenses during the lease tenure. A modified lease is majorly used in the case of commercial properties where there is more than one tenant to share the property.
Example of Modified Gross Lease
Let’s discuss an example of a modified gross lease.
Let us say XYZ Mall is leasing out the commercial property spaces. ABC Inc. expressed its interest in taking one shop commercial in the mall under the modified gross lease agreement. Now, as per the modified gross lease agree ABC Inc. (the lessee) will pay US $ 100,000 p.a. as the basic rent to XYZ Mall every year. Apart from the basic leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.” rentals, ABC Inc. will also pay for the operating expenses (such as repair and maintenance, insurance, utilities, etc.) attributable to the common area proportionate to his occupancy level for subsequent years.
How Modified Gross Lease Works?
Let’s discuss how modified gross lease works.
In the case of a modified gross lease, to lease out the property, the owner of the property enters into an agreement with the lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. where lessee makes the payment of the basic lease rental for the initial year. During the subsequent years, the lessee continues to make the payment of the basic lease rentals. And, along with that, lessee also makes the payment of operating expenses attributable to common sharing areas in proportion to the level of occupancy. OpexOpexOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit. includes repairs, maintenance, utilities, and taxes attributable to the common sharing area of the leased property.
Benefits to Tenant (Lessee)
The following are the benefits of a modified lease to the tenant.
- The tenant may opt for a modified lease as in the case of the modified lease, he will only have to bear the proportionate operational expenses. Let us say ABC Inc. has taken a shop in a mall on lease with the 20% level of total occupancy of the entire property.
- Now, if in the subsequent year the operational expenses will rise by the US $ 50,000 as compared to the expenses incurred in the base year, even then the tenant will bear the proportionate increase, that is US $10,000 (the US $ 50,000 x 20%) and not the entire US $ 50,000.
- Also, the tenant will favor the modified lease as the structure of the modified lease ensures that the landlord or the lessor will share an obligation to keep the property in a good fit and will be involved in the repair and maintenance activities of the property.
Limitations to Tenant (Lessee)
The following are limitations of a modified lease to the tenant.
- If the landlord failed to maintain the common area as per basic standards, there might be a possibility that such bad maintenance can affect the business of the lessee.
- Moreover, the escalation of variable expenses can affect the budget of the lessee. For instance, if electricity consumption increases with the rise in the occupancy level of the property, in that case, the lessee may get overcharged and will pay the escalated price.
- One possible solution to avoid such a problem will be to add a gross-up clause in the agreement, which defines and sets the cap limit for the lessee in case of an escalation of the price of variable expenses.
Benefits to Landlord (Lessor)
From the point of view of the lessor, the modified lease offers a sense of control over the property as he can keep a check on the tenant to ensure he is managing and maintaining the property in a reasonable way.
Limitations to Landlord (Lessor)
The potential limitation of the modified lease to the lessor will be the underestimation of the lease rentals and amount due to operating expenses. The underestimation of expenses may cause operating losses for the lessorLessorA lessor is an individual or entity that leases out an asset such as land, house or machinery to another person or organization for a certain period.. That is why most of the landlords prefer a triple net leaseTriple Net LeaseTriple Net Lease is a type of lease agreement in which the lessee (tenant) agrees to also pay for other property-related expenses such as insurance of the building, maintenance of the building, property taxes in addition to the rent. agreement as it set the lessee liable to make the payment of lease rentals as well as all the operating expenses.
A modified gross lease is a commercial lease agreement wherein the lessee pays the basic lease rental and shares the operating expenses proportionately with the lessor. This type of lease agreement is a hybrid mix of triple net lease and gross lease.
This article has been a guide to what is modified gross lease and its definition. Here we discuss how the modified gross lease works along with practical examples, benefits, and limitations. You can learn more about finance from the following articles –