Of the many things, you’ll have to pay extra attention to as a Toronto real estate owner, agent, or investor, the terms of your arrangement with a tenant sit at the top.
A lease, as it’s commonly known in real estate, is a legal contract in which the renter agrees to part with a specific amount of rent over a certain period of time in exchange for the right to be the tenant of the space.
The importance of understanding gross and net rent
Rent can take several forms, based on the type of lease in place. Unless you understand what each type presents, it will be difficult to have a clear understanding of things like your property’s financials, potential operating risks, management fees, gross rent, net effective rent and so on.
Something else worth mentioning is that the structure and terms of a lease have the capacity to affect the property’s operating cash flow and valuation.
Now, looking at the weight leases carry in influencing financial outcomes, among other aspects, you have a lot to gain by learning about them in detail, which we shall do later on in the article.
First, we’ll discuss two of the most common forms of rental income take; i.e., gross rent and net rent, plus additional information that may be of help to you as the one renting out a unit to a tenant.
Gross rental income is the total of all rent paid by tenants minus the cost of all utilities paid by the partnership. At the highest level, gross rental income is how much rent and other related payments you received. The gross amount is how much you received before subtracting expenses like insurance, maintenance, taxes, homeowner association fees, and advertising costs.
We’ll begin with the definitions.
Simply put, this is the total amount paid for a rental before subtracting other expenses such as utility and repairs. The amount can further be broken down into two parts, namely gross scheduled income and gross operating income.
These terms are important to you as a landlord as they help in planning, forecasting, and the general analysis of the property’s performance.
Metrics for owners
Gross scheduled income, for instance, helps the landlord see the actual rent potential that units of various buildings can bring irrespective of whether they are occupied or not. It’s defined as the rent being collected from all occupied units in addition to potential revenue from properties or commercial real estate not currently occupied.
This figure will help landlords see areas in which they can improve in order to retain currently renting clients and perhaps ramp up your marketing efforts in order to fill the vacant units for higher occupancy and actual returns.
Gross operating income, sometimes also referred to as effective gross income, is the actual rent amount you are collecting from occupied units.
Net Effective Rent/Net Operating Rent
Net rent and net effective rent are not the same things. Net rent is the amount that you as a landlord arrive at after subtracting every expense from the gross operating income. Net effective rent is the average monthly rent paid for an entire year, including free months, which reduces the average monthly rent, making it as if the renter had paid during those months. Operating costs are basically the day-to-day expenses, which include:
- Area maintenance
- Property taxes
Although there may be other operating costs that may be wholly or partially tax-deductible such as loan payments, depreciation, interest, and capital expenditures, these are not treated as operating expenses as they are not part of operating the building.
With this in mind, calculating the net operating income (NOI) becomes very simple because you will only need your gross operating income less the operating expense as defined above.
Gross Rent and Net Rent/ Net Effective Rent
On the surface, it does look like only tenants should be concerned about these two terms because the tenant pays rent. But that’s not really the case, as we saw earlier. As the one renting out a home or office in the building, it’s important to know how either of these options can affect you and which is more suitable for your renter.
There are two gross leases: modified leases and fully-service leases. Gross leases are commonly used for commercial properties, such as office buildings and retail spaces. They differ from net leases, which require the tenant to pay one or more of the costs associated with the property.
We will break this down for you.
Either option might be suitable, depending on what the renting needs of your tenants are. Where gross leases are concerned, the tenant pays a flat rate for the exclusive use of the real estate. You, as the landlord, may have used previous real estate data to arrive at a rental figure that covers the rent, standard utilities, and day-to-day expenses.
Gross leases are fairly flexible and can be customized to suit both you and the tenant. For instance, you could come to an understanding with the renter that the flat fee should also include landscaping or waste pick-up. Or the gross lease could be modified to not only include the principal provisions of an agreement but also state that the tenant will take care of electricity utilities while landlords will provide janitorial services and waste pick up.
When to use a gross or net lease
A gross lease is beneficial for tenants who want to only pay a flat fee. This is very sound for Toronto commercial renting, especially when you are looking to get rid of variable operating expenses related to real estate.
Net leases, on the other hand, are the exact opposite of gross. Landlords seek to shift part or all the costs that come from properties to the tenant.
Conventionally, a tenant pays rent, and landlords take care of taxes, insurance, and utilities of the building as in a gross lease. A net lease, however, will shift all or some of these responsibilities to the tenant. This includes upkeep, real estate tax, or insurance.
Types of net lease
So, if you are opting for a net lease, it would be either of the three options below:
- Single Net Lease – In this case, the tenant will pay rent and real estate tax
- Double Net Lease – This option will have the tenant paying rent, tax, and insurance
- Triple Net Lease (net net net) – What is the net net-net? Just as the word suggests, the tenant pays for the net rent, which will comprise net property tax, net insurance, and net maintenance for the building. This explanation also doubles up as the triple net rent definition.
When to use each type of contract
If your tenants are the kind who want more control over costs related to the unit in the building, then the above net lease options afford them control to various degrees. It also means added responsibility.
Even though this may be the type of lease a tenant opts for, many landlords will still prefer that renters remit payments to them directly, and they, in turn, make the necessary payments in time like taxes. This usually is to ensure that such fees as real estate taxes are paid on time and in the proper amounts.
Making a determination over gross lease vs net lease is solely dependent on an individual’s rental needs. For some, a gross lease allows them to pay a flat fee, helping eliminate variable expenses. A net lease, on the other hand, allows one more control over issues like maintaining the unit. The overall operational cost might end up being lower. It does, however, open a person to fluctuation in taxes and insurance costs, which they would be obligated to absorb.
As a landlord, keeping both leases is beneficial as you are likely to have clients who want to rent your building but have different needs. Giving them options allows them to make an informed decision that is in line with their renting requirements.
Given that gross leases are flexible, they can always be modified to reach a consensus that is tenable to both a tenant and you as a landlord.
Net Rental Income
Net rental income is the amount of money you earn from your rental property after subtracting its costs. This includes things like repairs, mortgage costs, and taxes. If you’re a landlord, you will need to report this income on your tax return, even if it’s not a lot of money.
In general, having a clue about the difference between net rent and gross rent and the different lease types we’ve looked at is beneficial not just for you as a landlord but also the renter. If they seem clueless about this kind of information, it would be great to share it with them. In the end, like the one renting out space, you will get insight on how to maximize profits while your tenants can have some flexibility in choosing options that are suitable to their business or residential requirements.