Modified Net Leases for Apartments? By Joseph DeCarlo

Modified Net Leases for Apartments?

BY JOSEPH DECARLO, CPM, CCIM

Commercial properties have used Net Leases for many years. These Net Leases require the tenants, in addition to the base rent, to pay some of the operating costs related to the property such as property taxes, property insurance and maintenance costs. If all three of these items are included in the Net Lease, it is usually called a Triple Net Lease or NNN Lease. What if we considered implementing the same type of lease terms for apartments and other residential rentals?

Since apartment owners have an implied warranty of habitability, which is non-waivable by the tenants per Civil Code 1941.1 and State of California Health and Safety Code, we can only include the incorporation of the property taxes and property insurance as an additional item to be included as part of the terms of residential tenancy.

Apartment rents have been traditionally gross leases. Gross leases are when a tenant pays the base rent only. The base rent is supposed to include all the owner’s costs such as the following: • Property Taxes • Maintenance

• Capital Improvements • Unit Repairs • Cost of Materials

Net Leases — continued on page 32

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• Property Insurance • Common Area Utilities

• Pool Maintenance

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All these costs are supposed to be rounded and covered by one word and charge — rent.

Over the past few years, operating costs for the owner (housing provider) have been increasing dramatically. The charges for the items that were mentioned above and some others that were not mentioned increase year after year, sometimes with little-to-no restrictions. These increases were happening even before the pandemic.

Housing providers are between a rock and a hard place, as even though these costs of doing business go up, they cannot raise their rent because of the restrictions imposed by the state and local governments. Housing providers may soon need to be put on the endangered species list to be kept from going out of business.

Under the proposed Modified Net Lease, we will take the cost of property taxes, property insurance, common area landscaping and a few other charges, and pass them through to the tenant as a separate line-item charge, in addition to the rent.

A few charts will outline some examples of the proposed Modified Net Lease.

Example 1: Estimated Percentages of Owner Costs incorporated into Base Rent

Operating Expense % of Base Rent Property Tax Bill & Assessments 12% Property Insurance 3% Common Area Maintenance 1% Total % of Base Rent 16% The percentage amounts would be based on each individual apartment complex’s bills, unit mix, and other variables related to that specific property. As you can see, these pass-through charges alone already account for 16% of the base rent tenants are charged. If this was a new purchase of an older apartment building, the tax rate is 1% plus school, sewer, and other bonds, and other costs that would amount to almost 1.2% of the purchase price. A $5,000,000 purchase would then have on the property tax bill, those items and that bill would be $60,000 per year. This means on new acquisitions, this percentage of base rent would be over 20%.

Based on the numbers, the housing provider’s NOI increases using the modified lease terms, as does their property’s value. On paper, the numbers look good. We want to test these modified lease terms on incoming tenants. The rental market is tight, but the on-site manager will have a challenging task selling the modified lease to incoming tenants. We intend to test this new method on a few of my rental properties and would be happy to work with other owners to further test out the Modified Lease concept. We will have our attorney prepare a modified net lease and we would bill each tenant monthly, like our existing RUBS system. In summary, the state of California and other local laws are becoming more stringent and more tenant friendly with legislation such as rent control, eviction moratoriums, inspections, and others. The goal of the Modified Net Lease is

to pass the costs to incoming tenants. The RUBS charges and, hopefully, the Modified Net Lease charges will not be counted as Base Rent. Separating these

Example 2: Example of Modified Net Lease Billing

Cost Per Unit Present Modified Net

Base Rent (Monthly) 2,000 1,800 **3

Operating Expenses (47%) RUBs (Utilities) 6% –120 Taxes, Insurance, Landscaping (16%) –320 Maintenance Repairs (20%) –400 –400

Misc. Expenses (10%) Total Expenses

–200 –1040 –200 600

Net Operating Income Loan Payment (45%) Cash Flow (Monthly) Assuming a 10 Unit Building Monthly Operating Expenses Rent 960 1,200 900 900

60 300

20,000 18,000

Operating Expenses Net Operating Income Loan Payment Cash Flow –10,400 –6,000 9,600 **1 12,000 **2 –9,000 –9,000 600 3,000

**1 Annual NOI is $115,200 with 4% CAP = $2,880,000 Value **2 Annual NOI is $144,000 with 4% CAP = $3,600,000 Value **3 Move-In Rents are $1,800.00 instead of $2,000.00 ($200.00 less), but billing back $320.00 per month, in addition to rent, via modified lease terms.

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