Lease Structures: Gross, Net, NNN, Percentage, Ground

Introduction

Lease structure decides who pays property taxes, insurance, maintenance, and capex on a commercial property, which in turn decides how much of the property's cash flow is landlord-economic versus tenant-economic. The same building leased under a full-service gross lease and under a triple-net lease produces meaningfully different cash flow profiles for the landlord, and the cap rates the two trade at can differ by 100 to 200 basis points because of the structural risk transfer the lease accomplishes. Understanding the structure landscape is a prerequisite for any property-level valuation, REIT comp analysis, or sale-leaseback advisory work.

Five structures dominate the institutional market: full-service gross (landlord pays everything), modified gross (landlord pays some operating expenses, tenant pays others), triple-net (NNN) (tenant pays taxes, insurance, and CAM), absolute net or bondable (tenant pays everything including roof and structure), and ground lease (long-duration land-only lease). Plus percentage rent as a retail-specific overlay. Each has its dominant property types, its standard tenant types, and its valuation implications.

In a full-service gross (FSG) lease, the tenant pays a single all-in monthly rent, and the landlord is responsible for all property operating expenses: property taxes, insurance, common area maintenance, utilities (in some structures), janitorial, and management. The tenant's occupancy cost is the rent number on the lease; the landlord absorbs all operating-expense risk and growth.

Full-Service Gross (FSG) Lease

A lease structure in which the tenant pays a single all-in rent and the landlord pays all property operating expenses (taxes, insurance, CAM, utilities, janitorial, management). Common in older Class A office buildings, traditional CBD office markets, and many medical office buildings. The landlord absorbs operating-expense growth risk, which compresses the property's effective net rent over time as expenses grow.

FSG is the dominant structure in older Class A office markets (particularly traditional CBD office buildings in New York, San Francisco, Chicago, and similar gateway markets), in many medical office buildings, and in some flex office and creative office sub-markets. The structure is gradually losing share to modified gross and net structures as landlords push expense risk back onto tenants in new leases and renewals.

The valuation implication is direct: an FSG-leased property's NOI is more operating-expense-sensitive than a triple-net-leased property's NOI. If property taxes rise by 5% or insurance premiums double, an FSG landlord absorbs the entire hit; a triple-net landlord passes the same expense increase to the tenant. The cap rate that applies to FSG NOI is structurally wider than the cap rate that applies to a comparable property's net-of-pass-through NOI, because the FSG cash flow is more volatile.

A modified gross (MG) lease sits between full-service gross and triple-net. The tenant pays base rent that includes certain operating expenses (typically property taxes and insurance, sometimes also a "base year" CAM amount), and is responsible for expense increases above a baseline. The most common modification is the base year structure: the landlord pays operating expenses up to the base-year (usually year 1) amount, and the tenant pays the increase over base year in subsequent years.

Modified gross is the dominant structure in many multi-tenant office buildings outside the CBD, in flex office, in many smaller and mid-tier office markets, and in some industrial sub-categories. The structure splits operating-expense risk: the tenant bears the inflation risk on expenses above the base year, while the landlord bears the structural risk that the base-year amount is set too low.

The net lease family transfers progressively more expense responsibility to the tenant. Four levels exist, with conventions on what each covers:

Triple Net (NNN)

The triple-net structure is the dominant net lease in most institutional markets. The tenant pays base rent plus property taxes, building insurance, and common area maintenance (CAM). The landlord typically remains responsible for roof and structural repairs, capital improvements with a useful life beyond the lease term, and (in many leases) certain mechanical systems. NNN is the standard structure for single-tenant net lease retail (the Realty Income, NNN, W. P. Carey, and Agree Realty portfolios), most new industrial leases, drug stores, dollar stores, fast-food restaurants, gas stations, and bank branches.

The mechanic of CAM pass-through is straightforward: the landlord estimates annual CAM expenses, divides by 12, and collects a monthly CAM contribution alongside base rent. At year-end, the actual expenses are reconciled against the collected amount, with the tenant receiving a refund (if over-collected) or being billed for the difference (if under-collected). The CAM reconciliation is the year-end accounting event that turns up periodically in lease audits and tenant disputes when CAM definitions are unclear or when landlords push aggressive pass-through items.

Triple Net (NNN) Lease

A commercial lease structure in which the tenant pays base rent plus the three operating expense pass-throughs: property taxes, building insurance, and common area maintenance (CAM). The landlord retains responsibility for roof and structural repairs and for major capital expenditures with useful lives beyond the lease term. The dominant structure in single-tenant net lease retail, most institutional industrial, and many newer multi-tenant office buildings. Net lease REITs (O, NNN, WPC, ADC) build their entire franchise around NNN portfolios.

Absolute Net (Bondable) Leases

The absolute net or bondable lease is the most tenant-intensive structure. The tenant pays for everything: taxes, insurance, CAM, capex, roof, structure, parking lot resurfacing, mechanical system replacement, and any other property-level cost. The landlord's only economic role is collecting rent; the lease is often non-cancelable and remains in force even if the building is destroyed (in some structures the tenant has obligations to rebuild). Bondable leases are common for single-tenant industrial build-to-suit transactions, mission-critical corporate headquarters sale-leasebacks, and certain single-tenant retail structures.

The cash flow from a bondable lease is bond-like: predictable, contractual, with the tenant's credit quality as the dominant risk factor. The valuation methodology often follows the credit-spread approach rather than a pure real-estate cap rate: an investment-grade tenant on a 15-year bondable lease produces cash flow that prices at a small spread to comparable-duration IG corporate bonds, sometimes 100-200 basis points wider depending on lease-end residual considerations.

Lease Term and Lease-Roll Dynamics

Beyond the expense-pass-through structure, lease term length and lease-roll schedule drive valuation almost as much as the gross-vs-net distinction. A multi-tenant office building with leases averaging 7 years of remaining term carries less near-term rent-renewal risk than the same building with leases averaging 2 years remaining; the cap rate reflects the duration difference. Weighted average lease term (WALT) is the standard metric: the sum of each lease's remaining term weighted by its share of total NOI, expressed in years. A property with a WALT of 10+ years on investment-grade tenants prices at a meaningfully tighter cap rate than a property with a 3-year WALT on non-IG tenants, even when the current NOI is identical.

The lease-roll schedule (when each lease expires across the next 10 years) drives the cash flow pattern that any property-level DCF projects. A property with a major rent-roll event in year 4 (a 40% lease expiration) faces concentrated re-leasing risk that the DCF must model explicitly: expected market rent at the rollover date, lease-up vacancy duration, tenant improvement and leasing commission costs, free-rent concessions, and the probability the existing tenant renews. The same property without a concentrated rollover wave has materially different DCF outputs.

Rent Escalators

For long-duration leases, rent escalators matter. The standard structures:

The escalator type and magnitude meaningfully affect lease NPV: a 3% fixed annual escalator over 15 years compounds to roughly 56% rent growth; flat rent over the same period generates zero. The cap rate that applies to the year-1 NOI implicitly prices in expected escalators across the lease term. A property leased on flat rent for 15 years trades at a meaningfully wider cap rate than the same property leased on 3% bumps, even when current rent is identical, because the forward cash flow trajectory differs.

The interaction between escalators and inflation is also worth knowing. Fixed-bump leases outperform when realized inflation is below the contractual escalator (the landlord captures the spread); they underperform when inflation runs above the escalator (the landlord receives rent that grows slower than market and risks below-market rent at expiration). CPI escalators track realized inflation directly but may have caps that limit upside in high-inflation periods. FMR resets capture market shifts but introduce reset-date negotiation risk and short-term volatility. The 2021-2024 inflation cycle pushed many net lease investors to re-evaluate flat-bump exposure as inflation outpaced contractual escalators in many portfolios.

Tenant Credit and Lease Covenants

Beyond the structural lease type, tenant credit is the dominant single driver of net-lease cash flow risk. An investment-grade tenant (S&P BBB- or better; Moody's Baa3 or better) on a long-duration NNN or absolute net lease produces cash flow that approximates an unsecured corporate bond of the tenant; a non-IG tenant on the same structural lease introduces materially more risk and prices at a wider cap rate. The standard institutional underwriting framework looks at the tenant's rated credit (where rated), public-company financials (where public), and lease-specific credit enhancements (corporate guarantees, letters of credit, security deposits, parent-company guarantees).

Lease covenants also matter. Standard covenants include:

Each covenant has valuation implications. A strong renewal option at a below-market rent compresses the landlord's expected rent growth; a co-tenancy clause introduces correlated rent risk if the anchor tenant fails; a termination option creates optionality value for the tenant that the landlord effectively pays for. Sophisticated underwriting reviews every material covenant and prices in the contingent cash flow impact.

Free Rent, TI Packages, and Effective Rent

Reported base rent rarely tells the full story of a commercial lease. The tenant's actual effective economic rent (and the landlord's actual effective received rent) reflects three meaningful adjustments. Free rent is rent abatement during early lease months, typically 3 to 18 months in office and longer in lease-up periods or in soft markets. Tenant improvement (TI) allowances and leasing commissions are landlord-funded build-out costs and brokerage fees, typically $50 to $150 per square foot of TI for new office leases (less for industrial; more for life sciences and trophy office) plus 4-6% leasing commission on new leases and 2-3% on renewals. All three reduce the landlord's effective received rent.

Effective Rent

The lease's true economic rent to the landlord after netting out free rent, amortizing tenant improvement allowances over the lease term, and subtracting leasing commission costs. Effective rent is materially lower than the reported base rent in most modern office leases (often 70-85% of base) and is the metric institutional underwriting uses for valuation purposes. Two leases at the same headline base rent can have very different effective rents depending on the concession package.

The effective-rent adjustment matters because a landlord competing for a tenant in a soft market often holds the base rent constant (to protect the building's reported rent comps for valuation purposes) while increasing the concession package. The headline rent looks unchanged; the actual landlord economics decline. Office markets in the 2020-2024 work-from-home transition saw exactly this pattern: reported base rents in many CBD markets declined only modestly, but free-rent and TI packages expanded significantly, pulling effective rents down materially more than the headline data suggested.

Lease Accounting (ASC 842) Implications

The ASC 842 lease accounting standard, effective for public companies starting 2019 and for private companies in 2022, brought operating leases onto the balance sheet as right-of-use assets and corresponding lease liabilities. The accounting change does not affect the underlying economics of a commercial lease but does change how the lease appears on the tenant's balance sheet, which in turn affects the tenant's reported leverage ratios, debt covenants, and credit metrics. For real estate underwriters, the ASC 842 implication primarily matters when assessing the tenant's credit: companies with material operating-lease portfolios now show grossed-up balance sheets, and credit analysis must now treat those operating leases as debt-like obligations rather than ignoring them as it did under the old accounting. The change has not materially shifted lease decision-making at the tenant level, but it has made cross-tenant comparisons cleaner because the lease obligations are now consistently reported across companies.

Percentage rent is a retail-specific overlay typically layered on top of a base lease structure. The tenant pays a fixed base rent plus a percentage of gross sales above a defined breakpoint. The percentage rate varies by retail format: 5-8% for in-line specialty retail, 1-3% for grocery and big-box anchors, higher for cinemas and restaurants. The breakpoint is calibrated so that the percentage rent kicks in only when sales exceed a threshold that supports the property's expected NOI.

A ground lease is a long-duration (typically 50 to 99 years) lease of land only, with the tenant retaining the right to develop and operate improvements on the land. The land owner collects rent; the tenant builds, owns, and operates the building on the land, with ownership of the improvements reverting to the land owner at lease end (or being subject to a buyout at fair market value at lease end, depending on structure).

Ground leases are common in trophy urban locations where the land owner (often a long-tenured family holding, a religious institution, a university, a sovereign-owned entity) prefers to retain the asset rather than sell it. Examples include some Park Avenue trophy office buildings, certain Manhattan retail flagships, and many high-end hotel sites. The ground lease creates two separate economic interests:

The two interests trade at very different cap rates. Fee interest in a ground lease often trades at a tight cap rate (4-5%) because the cash flow is contractual and the asset is durable. Leasehold interest trades at a wider cap rate (sometimes 200-400 basis points wider than the fee equivalent of the underlying building) because the lease end creates a residual-value cliff and the operator's economics are sensitive to ground-rent escalators.

The structural risk transfer accomplished by the lease has direct implications for cap rates and valuation:

The variance across structures is meaningful enough that lease structure is itself a primary input in any property valuation. A sponsor underwriting a portfolio of single-tenant industrial properties on long-duration NNN leases to investment-grade tenants applies a structurally tighter cap rate than the same sponsor would apply to a portfolio of multi-tenant office properties on FSG leases, even if the headline NOI is identical.

The five structures form a coherent progression. Full-service gross keeps every expense with the landlord, which is why it persists in trophy CBD office (BXP, SLG, Vornado portfolios) where the landlord wants direct control of the tenant experience. Modified gross splits the risk through the base-year mechanic, dominant in suburban and mid-tier multi-tenant office. Triple-net transfers taxes, insurance, and CAM, which is why it underpins the net lease REIT model (Realty Income, NNN REIT, W. P. Carey, Agree Realty). Absolute net transfers everything including capex, making the cash flow nearly bond-like and the dominant structure in corporate sale-leasebacks and mission-critical single-tenant industrial. Ground leases transfer only the land, with the fee position (Safehold's entire business) prized for its long-duration contractual cash flow and the leasehold position discounted for the residual-value cliff at lease end. Each step further along that progression compresses the landlord's cap rate because the cash flow becomes more contractual, and each step has produced its own dedicated listed-REIT franchise.