When investing in commercial real estate (CRE), understanding the different types of leases is critical. Each lease structure offers varying degrees of responsibility and risk, which can affect your returns—especially if you're utilizing a 1031 Exchange to defer capital gains taxes. Below, I’ll walk you through the most common lease types: Absolute NNN, NNN, Modified Gross, and Full-Service Gross—and how each one fits (or doesn’t) into a smart 1031 Exchange strategy.
When investing in commercial real estate (CRE), understanding the different types of leases is critical. Each lease structure offers varying degrees of responsibility and risk, which can affect your returns—especially if you're utilizing a 1031 Exchange to defer capital gains taxes. Below, I’ll walk you through the most common lease types: Absolute NNN, NNN, Modified Gross, and Full-Service Gross—and how each one fits (or doesn’t) into a smart 1031 Exchange strategy.
1. Absolute NNN Lease:
- Tenant Responsibilities: Pay for ALL operating expenses—including property taxes, property insurance, common area maintenance (CAM), and even capital improvements like HVAC & roof replacement!
- Investor Perspective: Absolute NNN leases are the ultimate “hands-off” investment. With the tenant taking on literally EVERY financial responsibility, you can enjoy a truly passive income stream.
Advantages: This lease type pairs beautifully with 1031 Exchanges. Because investors often look for long-term (10 to 15 year leases are common), low-maintenance income post-exchange, an Absolute NNN lease is ideal. Retail giants like Dollar General, Firestone, Taco Bell often structure their leases this way, providing investors with creditworthy tenants leading to a very durable income stream for many, many years. This is epitome of a ‘coupon clipper’ that provides low-risk mailbox money.
Disadvantages: These lower-risk deals often come with lower yields so engage a broker that will perform a national property search to find the highest yield/best deal. Don’t just settle for a lower-yielding property in your home town…the Wright Brothers made it easy to effectively own & oversee property in another state.
2. Triple Net (NNN) Lease:
- Tenant Responsibilities: property taxes, property insurance, and CAM.
- Investor Perspective: NNN leases shift the vast majority of the operational burden to the tenant, making them attractive to CRE investors who want predictable cash flow with minimal management effort. These leases can be found in retail, QSR, industrial and medical office building (MOB) asset classes.
Advantages: Like Absolute NNN, NNN leases align well with 1031 Exchange strategies by offering a durable, passive income stream with minimal landlord involvement. Acquiring a property with a stable, creditworthy tenant simplifies your life. You’re still somewhat insulated from property expenses, which helps with budgeting your post-exchange finances.
Disadvantages: There’s still some risk if unexpected capital expenses arise. Be sure to perform a thorough property inspection of all major systems & components including roof, HVAC, foundation, electrical, plumbing, parking lot, etc.
3. Modified Gross Lease:
- Tenant Responsibilities: Shared operating costs (e.g., utilities and CAM), but the landlord covers major expenses like property taxes and property insurance.
- Investor Perspective: Modified gross leases are a middle ground between NNN and full-service leases. Investors may need to stay somewhat involved in property management, which isn’t always appealing for post-1031 investors.
Advantages: With the right tenant, a modified gross lease can still generate reliable cash flow without being too hands-on. This structure is typically utilized in office and light industrial/flex properties, making it an option for investors looking to diversify their portfolios by investing in various asset classes.
Disadvantages: Landlords assume more responsibility for operating expenses and capital expenses. This structure may require occasional management and oversight—not ideal for investors seeking a truly passive income stream after a 1031 Exchange.
4. Full-Service Gross (FSG) Lease:
- Tenant Responsibilities: None except to pay Base Rent plus Base Year pass through expenses —landlord covers all expenses.
- Investor Perspective: Full-service leases demand the most active management from the landlord, who must absorb and manage all operating costs, including property taxes, property insurance, CAM and capital expenses.
Advantages: This lease type might work for investors with a team in place to handle operations, or those pursuing higher cash flows. Office and medical office properties often have FSG leases.
Disadvantages: FSG leases are not typically favored for 1031 Exchange investors looking to retire from active management. These properties can be time-intensive and increase exposure to fluctuating operating costs.
Which Lease Fits a 1031 Investor Best?
Investors using a 1031 Exchange aim to defer capital gains taxes by reinvesting in properties that generate stable, passive income. Given the tight IRS timelines (45 days to identify replacement properties, 180 days to close), your best bet is often Absolute NNN or NNN leases with creditworthy tenant(s). These leases offer the kind of predictable cash flow and low management overhead that allows investors to enjoy the benefits of their hard-earned wealth without getting bogged down in property issues.
Pro Tip 1: 1031 Exchange investors should diversify not only across asset types (like retail or MOB) but also by geography, lease structures, tenant types and even lease expirations (when feasible). A mix of properties as noted above can help mitigate risks while providing income streams that mature at different intervals.
Pro Tip 2: A tenant default could leave you scrambling for re-tenanting solutions. Have a relationship with a strong broker, that specializes in that asset class/product type (e.g. industrial, retail, office or MOB), who can quickly back-fill the space to protect your cash flow.
Final Thoughts: Aligning Leases with Your Investment Goals
Whether you're eyeing a national retail tenant under an Absolute NNN lease or considering the complexities of a modified gross lease in a suburban office building, understanding these structures is essential. The key is to choose leases that align with your post-1031 Exchange investment goals: cash flow, stable tenants, long-term wealth preservation plus capital gains tax deferral.
With the IRS clock ticking on a 1031 Exchange, acquiring the right property under the right lease structure is crucial. That's where having an experienced CRE broker who has your best interest in mind makes all the difference. With proper planning, market knowledge and skillful negotiation, you'll be able to avoid costly mistakes, defer egregiously high taxes, and set yourself up for the financial freedom you’ve earned.
Call Fountainhead Commercial to get started on creating a durable income stream so you can spend more time doing what matters most to you—whether it’s seeing your grandkids, traveling, fly fishing in the Rockies or relaxing at that Belize vacation home you’ve been dreaming about.
