What is a Net Lease?
A net lease is a contractual arrangement where one party conveys land or property to another party in exchange for payment of rent and fees, including various operational costs. The property is provided by the lessor to the lessee, who will pay the lessor for the use of their property over a period of time.
How Net Lease Works
A lease is a contract in which one party grants the use of land or property to another party in exchange for regular payments over a specified period of time. Leases are a binding contract, usually for real estate and other personal property. Lease contracts state the duties of each party and are legally enforceable to each party. Consequences may be enforced in court and may be mild to severe depending on the clauses of the lease that are broken.
A net lease is structured so that the lessee essentially taking ownership of the property without actually getting the property legally entitled to them. It benefits property owners who do not wish to deal with the burden of managing the payment of taxes, insurance, and other fees, as well as the day-to-day operations of the property.
For the lessee, they usually will take on the extra fees for a reduction in the actual rent of the property and as compensation for the risk of bearing the associated costs.
Gross Lease vs. Net Lease
A net lease involves payment of all costs associated with the property, which is in contrast to a gross lease where only a flat fee is paid, and all other costs are covered by the lessor. The costs include several items, such as:
- Other operational costs
Types of Net Leases
A net lease can be classified under many different types of leases, but typically, they are structured in a way that will cover the cost categories of insurance, maintenance, and taxes. They can be structured in the following ways:
A single net lease entails paying for one of the cost categories, such as property taxes, in addition to rent.
A double net lease or “net-net lease” entails paying for two of the cost categories, such as property taxes and building insurance, in addition to rent.
A triple net lease or “net-net-net lease” entails paying for all three of the cost categories in addition to rent.
Use of Net Leases
Net leases are usually used in practice for commercial real estate agreements where the tenant (lessee) will pay rent in addition to the landlord’s (lessor) other operational costs. It makes the management process simpler for the landlord, which may be favorable if the landlord must manage multiple properties.
Accounting – Capital Lease vs. Operating Lease
Leases can be classified for a company as either a capital lease (finance lease) or an operating lease. A capital lease is treated as an asset on a company’s balance sheet where the risks and rewards are transferred.
An operating lease is a lease that is simply expensed by the company paying it. It can result in significant accounting implications, as classifying a lease as either capital or operating can overstate/understate assets and expenses.
For example, if management wants to manipulate the company’s net income to appear higher, they will prefer to classify the lease as a capital lease so that the payments are not expensed on the income statement. On the other hand, if management wants to manipulate the company’s assets to appear higher, they will also classify the lease as a capital lease so that the property appears on the balance sheet.
For the purpose of finance and valuation, leases should always be treated as debt. It is because, although it is not classified as debt, the characteristics of leases are similar to debt. The characteristics are as follows:
- Contractual agreement
- Periodic payments
- Tax-deductible payments
- Consequences for the failure of payment (bankruptcy or liquidation of assets)
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