What You Need to Know About Commercial Leases
Commercial leasing contracts are legal documents that lay out the terms and conditions under which a business rents or leases a property. They are vital because they set the standard for all the obligations and rights between the lessor and lessee. This contract is even more important between independent companies when a company rents part of a structure while another company occupies the rest of the structure or when a business starts out renting a single room from someone with an established business. These agreements determine everything from how much the rent is to how long the lease is. They can prove to be legally binding in most cases in court.
Many people think of leasing or renting as too similar to contracts used in residential leasing situations. Residential leases do share many similarities with commercial leases in such areas as the length of the rental, price of the rent, etc. To further the comparison, many commercial leasing contracts follow the basic structures of residential leases with the following:
Despite the similarities , there are considerable differences. In general, a residential leasing is very simple covering all the basic landlord-tenant issues. People looking for a good commercial lease need to keep in mind that these contracts can be very complex. Also, most commercial leasing contracts are presented as leases "forms." This means they are presented as something that a lawyer would have prepared. It may be simple to get out of residential leases if you need to do so. However, it is not so easy to get out of a commercial rental.
Beyond finding the contract’s form, the below items push commercial leasing contracts away from the simple. Also, although these items may prove to be critical to establishing the terms and stipulations of a commercial lease, these items may not even be present in a residential lease document.
Together these items can significantly change the bottom line, so a careful evaluation of a commercial lease should be made before a business signs for the rental.
What Makes up a Commercial Lease?
A commercial leasing contract is really nothing more than an agreement between a lessor and lessee. But this simple transaction is anything but simple. A commercial lease must include many terms and conditions, but these vary greatly on the type and nature of the business, the property, the area, even the amount of development in the area. Usually the lease will include a term of tenancy (its duration), the payment of rent (its amount), the obligations of each party (typically referred to as covenants), and a default clause which explains what happens if an agreement is broken. Let’s take them one at a time.
Duration
The first item has obvious components, such as how long the lease will be in effect. Some leases are for a set period of time, such as one, two or five years, or as a one- or two-year renewable lease. This is sometimes referred to as a "lease option" agreement, meaning that although the lease will end after a two-year tenure, the tenant will have the option to renew the lease for another two years if they choose to do so. A new rental rate could be agreed upon at that time. The option renewal period is often at the discretion of the landlord. When the tenant has a full, unqualified right to renew, the renewal is generally done based on the current market rate.
Rental Amount
The rental amount and method of payment will be spelled out in a commercial leasing contract. Rent is generally paid in advance of the month it is required, often by the fifth day of the month. As mentioned above, a commercial lease may require the tenant to pay a fixed rent for the lease term, or pay a set rent plus a percentage of revenue over a predetermined base sales amount. Other commercial leases might require rent based on the tenant’s gross sales. In some cases, rents may be based on other measures, such as a square-foot rate. Any agreements reached about rent increases or rent concessions are generally included as part of the leasing contract. Rent increases can stem from the passage of time, the nature of the business and the type of property being leased, and can reflect changes in the cost of labor or raw materials in the area.
Obligations of the Lessor and Lessee
The landlord’s and tenant’s obligations are generally outlined in the covenants of a commercial lease. For instance, a commercial leasing contract usually spells out whether the owner or the tenant will pay for things such as:
Default
A default clause will indicate actions that constitute default and the remedies available to the injured party, which can include termination of the lease agreement. For example, failure to pay rent on time could trigger default and penalties, including eviction for tenants, while landlords who don’t provide heat as required by law or make "diligent efforts" to repair leaks or faulty equipment could be at risk of counter-suing their tenants.
Different Types of Commercial Lease
The second element in the contract is the lease itself. The type of lease affects both tenants and landlords. A gross lease is where the owner pays all of the expenses of the property such as taxes, insurance and maintenance and in return receives a set rent each month. The tenant checks in the mailbox and all the owner has to do is deposit the check. In a net lease, the tenant pays some or all of the property expenses such as taxes, insurance and maintenance, and in return pays a lot less rent than is paid for a gross lease. A net lease may be for three types of taxes. Sometimes these are called "triple net leases" because there are three kinds of taxes. All net leases work to some degree like this. Not for all sorts of reasons, sometimes the lease says that the landlord will pay the tax, or insurance or maintenance. In other words, it may be a mixed lease. A tenant may prefer a net lease because the tenant does not want his rent to rise due to the size of the tax bill. A landlord may prefer the opposite. However, all things being equal—and they rarely are—a tenant should pick a gross lease and a landlord should pick a net lease. Until about 30 years ago, most commercial leases were gross leases. Nowadays, most commercial leases are net leases. However, the owners of small shopping centers still hang on to gross leases as they may have overbuilt and depend heavily on signing "mom and pop" retail businesses with new, uninsured owners.
Negotiating an Office Lease
The commercial lease negotiation process can vary greatly, depending on the type of lease and the level of sophistication of the landlord. For example, some landlords may have standard lease forms and terms which they would use with all tenants much like a home builder uses standard forms for home building and may be unwilling to negotiate variations from those forms. In contrast, many landlords will be more flexible providing much negotiating room with regard to the proposed terms of a lease based upon the type of tenant, length of lease term, the strength of the tenant financially or otherwise and other factors. For this reason, it is imperative that a tenant, with the assistance of legal counsel, gives thought to how it may be able to benefit from negotiations with a landlord and a good sense of when to push for better terms and when to let matters lie.
The first step in negotiating a commercial lease is selecting a "lead" negotiator. This person is typically the owner or operator of the business looking for suitable space and will serve as the primary point person for the landlord and his/her representatives. This person’s role is to spearhead the negotiation process, represent the interests of the business in negotiations, and bridge the gap between the signers of the lease and the underlying operations of the business.
The lead negotiator should be clear in conveying the goals of the negotiation to a potential landlord. These goals can vary greatly with the tenant at hand , but typical goals include: Often a negotiation process begins with one party submitting a proposed written lease to the other party for review. A savvy lead negotiator will address issues such as rent, lease term, length of option periods, rent concessions, late fees, assignments, renewals, improvements, and restrictions (i.e. restrictions on the use of the premises) prior to submitting the lease to a potential landlord for review.
The lead negotiator may want to keep some items in reserve in order to trade them to the landlord in exchange for something else. However, it is critical that any trade-offs must occur in a way that is structured and maintain the integrity of the transaction.
Each lease is unique, and some may be more negotiable than others. The position of the tenant in relation to the landlord can be a determining factor in how much leverage a tenant has in negotiations and, thus, how much a tenant should expect from negotiations.
However, having legal counsel assist you in the process can go a long way in assuring that you get the best deal possible. Legal counsel can assist you by analyzing the required obligations under the lease, provide advice about your bargaining position, and help you understand how specific terms might affect the operation of the business or rejection of the lease entirely.
Common Mistakes in Commercial Leases
Avoiding Common Pitfalls in Commercial Leasing
New businesses or those without experience in negotiating or renewing commercial leases can find themselves paying far more for their leases than they should. Commercial leases are not just about the rent. A good lease puts in place a proper frame of reference for determining all other costs as well. The risk of having to spend way more on your lease than you ought to comes about because some businesses make assumptions about certain provisions and don’t understand others. Allow me to point out a few common mistakes and how you can avoid them.
Not Getting Your Lease Renewed in Time
Certain leases have minimum notice periods for renewing the lease or giving notice that the tenant isn’t renewing. The liability under commercial leases is so significant that businesses need to give substantial notice. So if the tenant doesn’t give that notice, they risk the liability continuing for another 12 months – or longer. In one case I recall, a tenant paying a base rate of $12,500 per month was liable for another two years after having given no notice, where the landlord legitimately, although wrongly, terminated the agreement. The bottom line is that tenants must read their lease and act at least within the minimum notice periods.
Not Knowing what Happens at The End of The Term
Businesses need to know what happens when the lease ends. Some leases state that the tenant is required to leave the premises in the condition it was in at the start. Others may require the tenant to repaint or do other work before they leave. Many leases also provide that the tenant must remove their fit-out unless the landlord allows them to leave it behind. You would be surprised at the number of times our clients get a nasty shock when they are charged large sums for making good their premises or required to pay for months of rent because they failed to notify the landlord of their impending departure.
Chasing Last Minute Work and Costs
Increased costs can catch tenants out at the end of the lease and some landlords take great delight in pursuing tenants for these costs. The usual suspects are these: A good relationship between a long-term tenant and a landlord can pay off but where you don’t have a long history things can go wrong if the timing isn’t right. The bottom line is this: there are generally less risks associated with leases for longer terms. But some landlords will only offer a short lease, and your business might not want to commit to something long term at the outset either.
Ending a Commercial Lease
At some point, a tenant may want or need to terminate the contract. Exiting a commercial lease can be a complicated process. The most common exit strategies include lease assignment and subleasing. When an assignment takes place, the original party to the lease transfers all its rights, duties, and liabilities under the lease to the assignee. If the original lessee is not released from its obligations under the contract, the original lessee remains secondarily liable for the terms of the agreement. An assignment is used when the business is closing, moving but does not want to assume more space, moving extensively but does not want to assume more space , or terminating an existing lease and signing a lease elsewhere. A sublease occurs when the original lessee transfers a portion of its rights or duties under the lease to another party. The lessee can assign the lease if it continues to satisfy the terms of the original agreement. The sublease terminates when the sublease ends but the main lease continues. A sublease is used when the business is expanding into a larger space, moving but does not want to sublease more space, or terminating an existing lease and signing a lease elsewhere. Unless otherwise stated in the lease agreement, a lessee may not assign his or her rights under the contract without the lessor’s written consent.