Owners of commercial real estate can either occupy their property or lease it to third parties. Lease structures range from absolute gross—where the owner covers all operating expenses—to absolute triple net (NNN), where tenants cover all expenses, with many hybrid models in between.
Absolute Gross:
Tenant pays no operating expenses.
Absolute Net:
Tenant pays all operating expenses.
Lease structures and corresponding rental rates are influenced by market expectations and risk tolerance, with sophisticated end users increasingly evaluating lease structures based on the total cost of occupancy and expense exposure, rather than base rent alone. In basic terms, the derivation of net operating income (NOI) depends on how operating expenses are allocated.
Owners mitigate operating expense risk by shifting costs to tenants, but how much can be passed through depends on market dynamics and asset quality. Owners of premium, well-located properties typically have greater leverage in lease negotiations. Ultimately, property values are fundamentally tied to NOI, which grows only when rental income growth outpaces operating expense inflation.
This raises a key question: If operating expense inflation outpaces rental income growth, how will property values be affected?
Rapid increases in taxes, utilities, insurance, and maintenance are now outpacing rent growth across many property types. Tenant resistance to higher pass-throughs may force owners to lower base rents to maintain occupancy. When rents flatten or decline, NOI erosion worsens—often compounded by incentives like free rent months, which further reduce effective income and value. Managing these pressures is critical, as sustained expense inflation directly impacts property performance and long-term value across asset classes.
The Shift Toward Expense Pass-Throughs
To preserve NOI amid rising expenses, owners are increasingly shifting costs to tenants through NNN or similar lease structures. Multifamily owners now often attempt to pass through water, sewer and trash costs. Retail and industrial owners are attempting to do the same by shifting market standards for Class B and C assets from modified gross to NNN leases; and some office owners are transitioning from absolute gross to modified gross structures.
From an owner’s perspective, the ability to exercise this movement depends on supply, demand and asset positioning. By transferring these costs, owners can better navigate inflationary pressures and preserve NOI, safeguarding long-term value.
While tenants may initially balk at these added costs, there is a psychological advantage for owners: Tenants may experience less “sticker shock” with lower base rents, even if their total cost of occupancy rises when accounting for pass-through reimbursements.
Tenant Retention, Market Trends
While expense pass-throughs help stabilize NOI, they risk driving tenants away if total occupancy costs exceed market tolerance—especially in urban office markets where space demand is shifting.
Replacing tenants often requires rent concessions, tenant improvement allowances or costly space reconfigurations, all of which compress NOI and reduce property value. Balancing expense recovery with tenant retention remains a key challenge.
Expense Categories Under Pressure
Owners are feeling the pressure of higher costs in a number of areas:
- Real Estate Taxes. These remain one of the largest and most unpredictable expense categories for building owners and can increase even as market values decline, especially in heavily tax-reliant jurisdictions. Volatility and unpredictability in how certain jurisdictions handle property taxes and assessments have actually caused many property owners to pause on expanding their portfolios in certain states.
- Insurance. Premiums have surged due to climate risks and pooled exposure, affecting even low-risk areas. This pressure on operating margins is expected to continue.
- Utilities. Energy costs, particularly electricity and natural gas, have been highly volatile. Rising utility costs are often passed through to tenants, but owners must navigate tenant resistance, especially as energy efficiency expectations rise. With data centers receiving increased development demand throughout the country, the anticipated result is a further strain on the energy grid and an increased financial burden to retail consumers. Much like pooled risk in insurance, it is entirely possible that electric becomes increasingly expensive even in areas where data centers are not developed. Progress in clean energy initiatives (specifically nuclear) could mitigate the trend for energy costs.
- Maintenance and Repairs. Labor shortages and material cost increases are driving up maintenance expenses. Non-routine capital expenditures can be difficult to predict, especially for owners with fixed rental income streams.
Balancing Competing Risks
When the threat of operating expenses outpacing rent growth arises, combating NOI erosion is critical to preserving property value. Triple net-style leases help shift costs but introduce risks around tenant retention, competitive positioning, and lease negotiations.
Owners must proactively manage these challenges through lease restructuring, cost-saving initiatives, and monitoring total occupancy costs for tenants. Without action, persistent expense inflation will continue to erode values, making forward-looking, adaptable strategies essential for long-term asset performance.
