Modified Gross

Definition of Modified Gross

In the context of commercial real estate and mortgage underwriting, a Modified Gross Lease is a rental agreement where the tenant pays a fixed base rent in addition to a specific portion of the property's operating expenses. It represents a middle ground between a Full Service Gross Lease (where the landlord pays all expenses) and a Triple Net (NNN) Lease (where the tenant pays all expenses, including taxes, insurance, and maintenance).

Detailed Description of Modified Gross Structures

The specific "modifications" in a modified gross lease vary from one contract to another. Typically, the landlord remains responsible for the "big three" expenses—property taxes, property insurance, and common area maintenance (CAM)—while the tenant assumes responsibility for costs directly associated with their specific unit, such as:

• Utilities: Electricity, gas, water, and sewer.
• Interior Maintenance: Janitorial services and minor repairs within the leased space.
• Trash Removal: Specific waste management for the tenant's operations.

In many cases, these leases include an "expense stop" or a "base year" provision. This means the landlord covers the operating expenses up to the amount incurred during the first year of the lease. If expenses increase in subsequent years due to inflation or rising tax assessments, the tenant pays their pro-rata share of the increase above that initial base year amount.

Impact on Commercial Mortgages and Underwriting

When a lender evaluates a property for a commercial mortgage, the lease structure significantly impacts the Net Operating Income (NOI) and the Debt Service Coverage Ratio (DSCR). Lenders view Modified Gross leases differently than Triple Net leases for several reasons:

• Expense Risk: Because the landlord is responsible for major structural repairs and the base level of taxes and insurance, the landlord (and by extension, the lender) bears more risk regarding rising costs compared to an NNN lease.
• Income Stability: Modified Gross leases offer a predictable "top-line" income, but the "bottom-line" NOI can fluctuate if the landlord’s share of expenses increases faster than the scheduled rent bumps.
• Underwriting Adjustments: Lenders will often apply a higher vacancy and credit loss factor or a larger replacement reserve when underwriting a property with Modified Gross leases to account for the landlord's ongoing maintenance obligations.
• Valuation: Properties with Modified Gross leases may be valued differently than NNN properties because the landlord must actively manage more of the property's operational aspects, which can lead to higher management fees.

For a borrower, the Modified Gross structure requires a careful balancing act. While it may be easier to attract tenants by offering a lease where the landlord handles taxes and insurance, the borrower must ensure that the base rent is high enough to cover these costs while still leaving enough cash flow to comfortably service the commercial mortgage debt.