Introduction to Commercial Leases – Part 1

Introduction to Commercial Leases - Part 1This is a multi part article which will focus on Commercial leases.

Negotiating commercial leases often times is not for the faint of heart. It is with this in mind, that we will attempt to shed light on the various aspects of commercial leasing. In this article we will examine topics including: terms, clauses, negotiating and requirements for these types of leases.

There are many aspects of a commercial lease that to the layman or inexperienced, often are confusing, and when read aloud sounds like “garble-garble-warble-goo-be-goo?”

Understanding the terms used in commercial leases and the position of those holding the lease will help when negotiating the lease. If you are not an experienced commercial real estate negotiator, it is suggested that you contact a professional commercial real estate agent and/or legal advisor prior to entering into any commercial real estate lease.

Let’s start with a few basic concepts…

There are always two sides involved in a lease: The tenant and the owner. While the owner may be represented by a Management Company or law firm who draw up the lease, often tenants are self represented.

Each side in a lease has objectives for obtaining leased space:

A tenant’s objectives may include:

Obtaining a lease with a reasonable rent payment Maximizing their exposure to the consumers Calculable and expected operating costs Ability to Expand for future needs and growth

An owner on the other hand has significantly different objectives which may include:

Obtaining and keeping high quality tenants Maximizing the return on their investment Protecting their investment property through risk shifting And the ability to regain possession of the property should the tenant default

While both sides of a lease have differing objectives, there are some commonalities as well. Items such as:

Establishing a clearly worded, binding contract Protection of the financial investment both sides will/have incurred And the ability for both sides to be profitable

Types of leases

There are many types of leases that are employed in leasing commercial property. Let’s examine a few common lease types such as:

· Gross lease – This type of lease is where the owner will pay all the expenses associated with the operation and maintenance of the property. The tenant pays the owner a gross or fixed amount for rent. From this rent, the owner will pay the operating expenses (property taxes, insurance, maintenance, utilities, janitorial and security costs) for the property.

· Net Lease – In this lease type, the tenant pays all or some of the operating expenses as expressed in the Gross lease. This type of lease provides the owner with the ability to pass on as much responsibility for operating expenses to tenants as possible. This type of lease varies based on location and the local market as well as the bargaining or negotiation ability of the two parties (owner and tenant).

Absolute net lease – This lease type requires the tenant pay all operating expenses related to the operation and maintenance of the property. Percentage lease – A lease of property in which the rental amount is based on a percentage of the volume of sales made by the lessee (the tenant). Usually this type of lease will stipulate a minimum or base rental plus a commission on the volume of sales and is regularly used for retailers

Considering the complexity of the various types of leases, you might conclude that entering into a commercial lease unprepared is comparable to stepping off a cliff. And you’d be correct!

Prior to entering into a contractual agreement to lease a commercial property, it is of paramount importance to your business success that you understand the terms, type and financial implications of the lease.

What makes a lease valid and enforceable?

Valid leases are similar to valid contracts. Aside from variations in length, complexity and financial considerations, enforceable leases typically contain the following:

· Identification of the owners and tenant: Each party to the lease should sign the document. It is also recommended that each page of the document contain the initials and date of each party.

· A Description of the property to be leased: Descriptions of the property will include the street address (including the unit or store number if applicable), any recorded plats as applicable, the government rectangular survey system as well as the metes and bounds in a rural area. Any property improvements should also be included in the description of the property for lease.

· Financial consideration: This requirement is often met by the tenant’s promise to pay rent and the owner’s inability to occupy the property during the lease term. Often times, the first step in leasing a commercial property is by submitting a Letter of Intent (LOI) and is some times accompanied by financial statements outlying the intended tenants ability to pay or liquidity (access to cash or funds).

· The legality of the objective: When leasing a commercial property, the objective or proposed use of the property or lease must not violate any federal, state, or local laws.

· Offer and acceptance: Basically, these statements identify that the owners agree to lease the property for a specific period of time and that the tenant agrees to pay am agreed upon amount of rent periodically to occupy the property as identified in the lease.

· The written lease: In most states, leases for longer than one year must be in writing. It is highly advised that all leases be in a clearly worded, easily identifiable document.

The lease and your Cash Flow

Some lease clauses have the ability to affect the lessees’ cash flow. These clauses contain alternatives for the owner to pass some operating expenses on to the tenant. Some clauses may limit the payment of operating costs (called Expense stops), while others provide the ability for the owner to continually pass on some of the current or increasing operating costs of the property (Expense pass through) to the tenant.

Before we examine these items, let’s understand the simple calculation of the rent. Typically, commercial rents are expressed in price per square foot (ppsf) and are calculated annually. Those new to commercial leasing are often surprised by the initial price of this type of property. What they fail to realize is that the total price is then divided by 12 (the number of months in a year). Example: a 1000 sf space is being leased at $18.00 per square foot or $18,000 per year ($18×1000). The actual amount of rent per month then is $1500.00 ($18,000/12).

As mentioned previously, operating expenses such as real estate taxes, maintenance, repairs, trash removal, salaries of the landlord’s employees, and costs of building improvements frequently are paid by the owner and often passed-through to the tenants. This is typically true in multi-tenant office buildings and shopping centers. In retail properties, a tenant’s share of these pass-through expenses is based on the gross leasable area (GLA) of the tenant’s store.

Expense Stops

Expense stops allow the owner to pay a portion of the operating expenses up to a specified amount, usually based on a price per square foot (psf). Excesses of the expense stop are then passed through to the tenant based on the amount of rentable building space the tenant is occupying.

Here’s an example: A lease for an office may contain a clause that states the tenant will pay $18 per square foot per year in rent and that the owner will pay all operating expenses associated with the property – as long as the expenses do not exceed $4 per square foot of the rentable area.

If the building has 50,000 square feet of rentable area, with this clause the owner is required to pay the first $200,000 in annual operating expenses ($4 per square foot X 50,000 square feet). If there are any additional expenses required to operate the building that exceed $200,000, the tenant will be charged the overage based on the percentage of the building’s rentable area or the square footage that the tenant occupies.

This then limits – or stops – the owner’s operating expenses at $200,000. To further illustrate this: if the operating costs of this property are $220,000 annually, using the example above you could expect the rent to be an extra $.40 per sq ft ($20,000/50,000). The adjusted monthly rent then becomes $1533.33 ($.40×1000 sf / 12) since the owner is paying the initial $200,000.

Expense stops typically benefit owners by limiting their risk exposure to operating expenses being greater then expected. These stops also allow owners to forecast operating costs based on predictable expenses. Often, owners will in turn offer tenants something of value in exchange for the expense stop clause such as a lower contracted rental rate if other leases in the local market do not contain expense stops.

Common Area Maintenance

The common area maintenance (CAM) charge is a common expense pass-through in shopping center leases and other multi-tenant situations. These are the costs associated with maintaining all common areas of a property, such as: hallways, lobbies, grounds and parking lots. These costs usually are calculated and based on the percentage of rentable space that the tenant is occupying. CAM clauses benefit owners by passing through increases in costs of these expenses to the tenants.

Tenants also benefit, from CAM costs in that monies collected for CAM expenses are not driven by other property expenses, a standard of upkeep and general maintenance will ensure the property remains in satisfactory condition and alleviates the tenants from paying for the maintenance of the common areas.

Tenant Improvements or build out costs

Owners will often incur expenses when leases expire and vacant office and retail space must be made ready for new occupancy. These additional expenses are known as build out costs. As an example, the re-leasing of commercial space may require substantial changes be made to the interior, such as removing or adding walls, raising ceilings, and altering electrical capacity. Many commercial property leases provide a tenant with an improvement allowance. Some leases may require plans for the alterations been submitted by a general contractor with any and all work to be performed by a contractor employed by the owner. This lease term/clause obligates the owner to incur a pre-specified dollar amount in expenses to improve the space to the new tenant’s specifications.

Tenant Improvements may provide tax benefits

The responsibility for payment of these improvements may provide tax benefits to the owner or the tenant. If the owner pays for improvements, these costs may be expensed over a number years. When the tenant vacates and the improvements are removed, the owner may write off the remaining amount at that time.

Likewise, if a tenant pays for improvements, and the alterations maintain the value of the property, the tenant may write off the costs in the year the improvements are done. If the improvements increase the value of the property, the tenant may write off the cost over a given number of years or when the tenant vacates the property. Always confirm any tax incentives and benefits with a qualified tax professional before incurring extra costs.

Summary

As you can see, leasing commercial space can be very complicated. To potential new commercial lessees’ understanding these complexities is imperative for a successful business to prosper.

Obtaining professional guidance in both negotiations and the legalities of a lease may save a commercial tenant not only short and long term monies that may be re-invested into the business, but also provide them with protection by obtaining an enforceable lease.