Five things a commercial tenant should consider before signing a lease
A lease can be one of the most important factors in determining a business’s success or failure.
The “standard” lease document and landlord’s forms almost always favor the landlord, so it is important to review a lease carefully and understand the potential impact of its terms on your business over the course of the agreement. In most cases, you have more power to negotiate than you might think. Here are a few practical things to consider before signing – they are not intended to be all-inclusive. Carolyn Tawasha can provide more information and details about the issues summarized below and other issues that may arise.
1. Lease Term
Lease Period: To determine an optimal lease term, you will need to consider several personal and economic factors. Commercial lease terms typically run anywhere from five to twenty years with extension options. While it might seem ideal to commit to only a five year lease with multiple options to give your business the flexibility it needs to expand or contract, or should you want to relocate, it might be better to start with a ten year lease with one or two five-year options if you expect the rental market to increase substantially. On the other hand, longer term leases could become burdensome, especially if it will be challenging to assign the lease or sublet your space or if an owner is personally guaranteeing the lease obligations.
If you are investing a lot of money into renovating your space, you will typically want a ten-year initial term and at least one five-year extension option (and ideally two or more). This will provide certainty if your business is a success, even if rent increases to a market rate during the option periods; it could also make your business assets easier to sell if the business fails or your circumstances otherwise change. If a landlord is contributing a significant amount of money toward improvements, or making improvements themselves, they will often prefer a longer term.
Most option periods provide for fair market value rent, although occasionally a landlord is willing to fix the rent (with annual escalations) for the initial term and some extension periods.
Commencement: Once you have established your lease term, be sure to think about when it will begin. If you plan to spend time renovating or fixturing the space or waiting for permits or licenses, you should try to avoid having to pay these costs at the same time you begin paying rent. Instead, you will want to try to extend the term commencement and/or rent commencement date beyond the date you signed the lease, ideally to when you anticipate completing your work, receiving your licenses and opening for business.
Conditions: Will it be necessary to obtain a liquor license, zoning variance or other permit approval to effectively operate your business? If the answer is yes, you will want the option to terminate your lease if you are unable to obtain these essential approvals despite diligent efforts.
2. Rent (Base Rent, Additional Rent and Hidden Costs)
Your overall rent will vary based on the type of lease you are signing. Under a “gross” lease, you pay a single rent that covers base rent and landlord’s overhead costs. A “modified gross” lease, which is most common for office leases, will include base rent plus a percentage of the landlord’s overhead cost increases over a base year (usually the first year of your term). Overhead costs typically include utilities, property taxes, insurance, maintenance, repairs and common area expenses, such as janitorial services, landscaping, and property management. No matter the type of lease, most landlords will request that base rent increase on an annual basis, either based on the consumer price index or a fixed percentage.
Under a “net” lease (the most common of which is a “triple net” lease for retail or industrial spaces), you usually pay a base rent, plus property taxes, the landlord’s building and liability insurance, utilities and/or other operating, maintenance and repair costs. These additional rent charges are designed to allow the landlord to pass on its overhead costs and the costs of ownership to you.
Net Expenses:
Real property taxes: When doing your due diligence before signing a lease, be sure to understand the landlord’s current real property tax costs and the potential for increases. If a landlord has owned the property for a long time, taxes will be relatively low but could increase substantially if it is sold or reassessed. It is important to try to negotiate exceptions or caps for certain tax increases.
Landlord’s Insurance: If your landlord owns multiple buildings make sure that insurance costs are only those attributable to the building in which your space is located. You might also want to try to negotiate exceptions for the higher costs associated with earthquake or flood insurance.
Common Area Maintenance: Common area maintenance costs, also known as “CAM,” are intended to cover a landlord’s costs to own, maintain and repair the property, including common areas; examples include roof repairs, maintenance and repairs to building utility systems, fire and life safety systems, landscaping, and security. CAM is usually charged in proportion to the square footage of your space. When negotiating a lease, it is important to look at what these costs have been historically and ask to review any budgets for anticipated expenses and repairs. It is also important to negotiate certain exclusions and caps if possible. For example, if you are paying for your own utilities, and while you will be responsible for your share of common area utility costs, you want to make sure that CAM does not include other tenants’ utility costs.
Percentage Rent: If your lease provides for percentage rent, it is important to make sure it is not triggered until your gross revenues exceed the equivalent of what you are paying in base rent, what is referred to as a “breakpoint.” You should also try to negotiate a cap on percentage rent if possible.
Hidden Costs: If you are responsible for paying utility costs, make sure you factor in the costs of water, gas, electricity, and trash removal for your space. Also be sure to pay attention to provisions in which the landlord is entitled to reimbursement for consultant’s and attorney’s fees, for reviewing documents or plans or providing consents, or is entitled to construction management fees for any alterations you make in the space. You will want to limit the fees or reimbursement obligations, which are often tucked into inconspicuous areas within the lease, as much as possible.
3. Maintenance & Repair Responsibilities
A tenant’s responsibility for maintenance and repair costs will vary depending on the type of lease and the nature of the space you are leasing. If you are leasing an entire industrial building, you are more likely to bear the responsibility for most of the maintenance and repairs. If you are leasing an office space, the landlord tends to be responsible for most maintenance and repair and is able to pass these costs through to its tenants as operating expense charges.
For retail spaces, you will likely be responsible for maintenance and repairs within your space and will want to make sure the landlord is responsible for the structure, roof and exterior of the building as well as utility connections to your space. You are typically responsible for maintaining equipment serving your space, including electrical and plumbing. The responsibility for any plumbing or sewer systems or a heating, ventilation and air conditioning system is a small detail that could end up costing you thousands – if you cannot get the landlord to take responsibility for these systems, you may try to get caps on annual costs for these expenses.
4. Tenant Improvement Allowance
It is unlikely you will find a space that is perfectly suited for your particular needs and you will probably need to make some changes. If the process for obtaining a tenant improvement allowance or a landlord remodel is negotiated properly, it can provide an essential contribution towards the capital you need to start your business. In some leases, a landlord will make certain pre-approved improvements and use the tenant improvement allowance towards the cost of completing its work. In those cases, especially if you are responsible for anything in excess of the allowance, you will want to make sure you have complete detailed plans and bids in place before signing a lease to avoid unexpected costs.
If you will be making improvements to your space, be sure that any tenant improvement allowance is used towards progress payments. Otherwise, if the landlord plans to reimburse you once your project is complete, you will have the raise or borrow the money up front then wait for reimbursement. As with a landlord-controlled project, you should identify all costs and expenses and the timeline for planning, permitting and construction before signing your lease and commencing your project. The most prudent tenants will identify their architect and contractor up front to do basic due diligence on the space and sometimes even schedule a pre-planning meeting with their local planning department so there are no surprises during the permitting process. Because you will probably be responsible for compliance with laws related to your use and alterations, including upgrades to the building triggered by your work, you need to understand any existing code requirements and the breath of the consequences of your work.
5. Pay Attention to the Often-Ignored Provisions
Sublease & Assignment Clauses: Although a landlord will always want the right to approve transferees, make sure it cannot unreasonably withhold its consent and try to include an exception for inter-company transfers and transfers of interests among owners.
Some leases give a landlord the right to terminate as to the space being assigned or subleased. Although some tenants may not care if they intend to assign their lease or sublet their space as a means of reducing costs and this is often less of an issue for office tenants, a lease termination could be a disaster for a retail tenant who has spent a large part of its startup capital improving its space or who wants to sell its business. If you can, you should always try to eliminate a landlord’s right to terminate or, at a minimum, give the tenant a right to retract its request rather than lose the lease entirely.
Damage & Destruction: If there is a casualty such as a fire in your space or the building in which your space is located, the lease should not make it too easy for the landlord to terminate rather than restore the damage. Tenants who have spent money improving their space will be most motivated to define the Landlord’s rights to terminate the lease as narrowly as possible but still give the tenant the right to terminate after an outside date so they are not in limbo if the restoration takes longer than expected. If a landlord has the right to terminate when the damage cannot be restored within a specific period of time (90-120 days in many unnegotiated leases), you will want to extend the period for as long as reasonably possible (180 days to one year). If the landlord has the right to terminate if the damage occurs during the last 12 months of the lease term, you will want to have the right to exercise any extension options to avoid the termination. If the landlord has the right to terminate because the cost of restoration is in excess of its insurance coverage, you will want to exclude deductibles (which you may have to pay) and have the right to avoid termination by paying the shortfall – this option might not be viable if it is more than you can afford but it is better to make a decision at the time so you do not lose one of your primary assets if you can avoid it.
Relocation Rights: A relocation right is an option given to the landlord to move the tenant’s business to another space in the building or complex. A retail tenant will want to delete this provision in most cases and an office tenant will want to negotiate the terms to ensure its new space is comparable or better and the move, improvements and any associated costs are all the landlord’s responsibility.
Connect with Carolyn about negotiating a COMMERCIAL lease that best suits your business needs.
The content of this blog post is for informational purposes only and does not constitute legal advice.