Entering Into a Commercial Lease Agreement - A Guide From a Broker
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Committing to a lease for 3, 5, 7, or 10 years is a monumental consideration for a business. Whether that is moving into the first property or from one location to another, entering into any commercial lease agreement can be stressful, time-consuming, and requires adequate research and qualified commercial real estate brokers, attorneys, and possibly even engineers to determine the most suitable location(s).
More often than not, owners get excited about finding the new lease location and move too quickly when reviewing the business points of the lease agreement. Also, some owners feel they do not need the assistance of an attorney for the lease agreement review. Not using a qualified real estate attorney is one of the biggest mistakes a business owner can make when considering a new lease or any binding contract for that matter. If your real estate broker starts to play attorney, fire them. Licensed real estate brokers and agents are NOT allowed to do anything other than fill in the blanks in promulgated forms. Any specific language has to come directly from their client or their attorney.
Remember that your real estate broker is there to help you negotiate the best terms possible and provide the most flexibility and protection for the client. This article mainly covers lease agreement concerns with some overlap into the physical considerations for site location as they may relate to the lease agreement.
Understanding that you/your employees, and your customers will be in the property every business day for years, it is prudent to do some homework on your future landlord.
Financial Wherewithal - This can be difficult to ascertain, but some digging can produce details on the structure of the ownership within the landlord’s entity and who is involved. More research can give you an idea of the financial fitness of the owners.
Testimonials - By researching the owners online, you can find any past legal problems, complaints, etc. Visit with some existing tenants if possible, and you will learn quickly how the landlord treats their tenants and maintains their property.
Rental Rate and Operating Expenses
Rental rate and operating expense is the first, and most important, of the lease considerations for business owners. However, it can get somewhat complicated as you have to consider your operating expense reimbursements and repair and maintenance exposure when projecting your rent obligations for the lease term.
Rental Rate, NNN, Gross or Modified Gross…or other? - Understand what the quoted rental rate is as it relates to the operating expenses.
Rental Rate - This seems straight forward, but when trying to understand your effective rental rate, be sure to include any rental abatement during the lease and increases called for in the rental schedule. NOTE - If your landlord ties rate hikes to an index (i.e., CPI), be sure you have a grasp on the historical and projected trends for same.
Gross Lease (Full Service) - An actual Gross Lease covers everything, including base rent, electrical, HVAC services, property taxes, property insurance, and janitorial services. This lease might also include, if offered, security, trash, etc. The Gross Rental Rate covers these costs, but the landlord can generally recover these costs as the lease progresses. These reimbursements are typically based on the tenant’s prorate share of the property. NOTE - You may be able to negotiate a cap on the increases for the landlord’s controllable expenses.
NNN or Triple Net Lease - A real NNN Lease specifies a base rent and then passes thru all of the operating expenses to the tenant. These can include property taxes, property insurance, Common Area Maintenance (CAM), security, utilities, etc. While compared to a Gross Lease, the overall rent could be the same, but a NNN lease can be simpler to understand when identifying and quantifying the tenant’s exposure.
Modified Gross Lease - This type of lease is a hybrid of the Gross and NNN leases as the there is a Rental Rate with some additional pass-throughs to the tenant for some of the property expenses.
Operating Expenses - Make sure you ask for an accounting of the landlord’s expenses to understand your baseline moving forward.
Property Taxes - This is the most significant operating expense for a property owner and in states like Texas, can be the most volatile. Consequently, property owners work hard to protect themselves from increasing taxes. Be sure you know what the landlord’s property tax is, both currently and historically, if possible.
NOTE - If you are leasing a new building, be sure the landlord bases projected taxes on a full assessment of the property values. Even if the property is older, it may be under-assessed or recently traded. Don’t let this sneak up on you as it can be a significant expense.
Property Insurance - Understand that the insurance that you pay the landlord for in the lease is not your liability coverage, but a reimbursement to the landlord for his cost to insure the physical aspects of the property (i.e., Wind, flood, fire, vandalism). You will be required to carry your Liability Insurance at your sole cost and expense.
Common Area Maintenance (CAM) - The CAM covers the expenses related to maintaining the property and can include landscaping, trash pickup, security, utilities, administration, management, etc. NOTE - You may be able to negotiate a cap on the controllable portion of these expenses.
Square Footage and Growth Options
At this point, you most likely know the size of the space you need, and the landlord has this area available. It is crucial to understand what you are paying for, and that you can grow over time in the property is equally as important.
· Rentable VS Usable - If you lease, say 10,000 SF in an office building, and there is a 20% add on factor, you pay for 10,000 SF (Rentable), but only get 8,000 SF (Usable) space. The extra 20% covers all of the common areas in the building.
· Recourse on Area Discrepancies - If the space you lease ends up being less than the landlord indicated, be sure there a provision in the lease to reduce your rent accordingly or at least address same.
· Renewal Options - Do you have renewal options in the lease to guarantee that you can remain on the property?
o There are renewal options at market rates, possibly not to exceed a specific percentage increase
o There are also renewal options at fixed rental rates, although more difficult to secure
o NOTE - Renewal options only benefit the landlord, so remember this when negotiating
· Right of First Refusal (ROFR) - A right of first refusal on adjacent lease space only helps the tenant; however, this can be a game-changer when the tenant is growing. Having this option would allow you to take on additional lease space in the event the landlord receives a Bona Fide offer from a 3rd party to lease said space. There are usually short response times to accept or reject these opportunities, so be aware.
· Early Termination Option - Landlords are not generally too accepting of options that could unexpectedly shorten the term of the lease and leave them with vacant property. However, occasionally, options to terminate the contract some date earlier than the agreed lease expiration can be negotiated. Renegotiation generally involves a penalty to be paid to the landlord along with advanced notice of up to one year. This penalty could include unamortized commissions and buildout, along with 3-6 months of rent, or more, depending on the outstanding term on the lease.
TIP - The shorter the term with the most renewal options, the better. If you can lock in an agreeable rate in your renewal options, you can preserve flexibility if your business were to grow or downsize.
Tenant and Landlord Responsibilities
Throughout the lease, the tenant and landlord have their responsibilities for repair and maintenance. It is essential to understand your obligations to avoid costly repairs.
HVAC Systems - Repair or replacement of HVAC systems can be extremely expensive. If you are in a Gross Lease, the landlord is likely responsible for the HVAC - but be sure. If the tenant is expected to maintain and repair these systems, try to negotiate a cap on these expenses. Another option is to have the landlord cover total system replacement or at least a portion. Another option has the tenant covering costs up to a certain amount and the landlord beyond that amount. NOTE - If you have exposure for repairs to the HVAC system, be sure to have an inspection done of the units with your contractor BEFORE you sign the lease.
Lighting - If you are in an office building, be aware that the landlord may have wording in the contract, which lets them put the replacement of non-standard bulbs within the tenant’s leased property.
Common Areas - While usually not a concern in Gross Leases, other lease types may hold the tenant responsible for repairs to the parking areas, storage yards, overhead cranes, or other items - even for special-uses.
· Allowed Uses - Be sure there are not any restrictions on the property through CCR’s, owner rules, or city zoning, which could prevent you from running your business.
· Conflicting Uses - Be aware of any adjacent uses which present a nuisance through sound, odor, foot traffic, parking, etc. In Industrial applications, railroad crossings can become an issue as rail cars block access.
· Specific requirements - These could prevent you from being able to use the space, and are generally not a reason to get out of the lease. Examples of this are non-standard electrical, substantial parking, specific phone/fiber providers, including your allowed use per permit by the local city or county offices.
· Types of Parking Understand your parking requirement for reserved, unreserved, and visitor parking.
o Reserved - This is usually a numbered space reserved for one specific person only, and almost always involves the tenant paying extra per month for the use of the area. It is covered parking as a rule - either with a carport or in a structured parking garage.
o Unreserved - Unreserved parking can be in a garage, covered or uncovered, and usually is on a “first-come, first-served” basis. Walk the garage as it can be quite a distance.
o Visitor - These spaces are generally located at or near the entrances and may or may not be covered. Walk these spaces as well during peak hours to ensure there is adequate parking for your visitors.
· Parking Ratio - As for the parking ratio for the building, this will generally be in an x/1000 number. For example, if you have 1,000 SF, and the proportion is 4/1000, then you will have four spaces allowed.
· Parking Costs - What is the cost of your parking? Reserved parking is almost always an extra charge monthly and can be costly, at anywhere from $100 to $400 per month per space.
Security can mean a lot of different things to different people. Get the scope of the landlord’s security service in writing, if possible. Protection can range from periodic visits to the property at random times by an unarmed guard, to 24 hours staffed front door access by a licensed police offer. NOTE - Ask about the security video monitoring, if they record 24 hours a day, and if they keep records of the feeds.
VERY IMPORTANT -
- USE A QUALIFIED LICENSED REAL ESTATE ATTORNEY WHO IS KNOWLEDGABLE OF YOUR LOCAL LAWS
- USE A QUALIFIED LICENSED REAL ESTATE BROKER WHO UNDERSTANDS YOUR NEEDS, IS KNOWLEDGABLE OF YOUR MARKET AREA AND HAS A SOLID TRACK RECORD WITH RELATED REFERENCES.
- TAKE YOUR TIME TO UNDERSTAND YOUR OWN NEEDS FOR SPACE, NOT ONLY CURRENTLY, BUT IN THREE TO FIVE YEAR INTERVALS AS WELL
About the Author
Eric Hughes, Founder and Partner of Centermark Commercial Real Estate, has over 27 years of Industrial and Office real estate experience in Houston, Texas, and the surrounding market area. Centermark Commercial Real Estate is a commercial brokerage firm specializing in Office, Industrial, Retail, and Land transactions. Centermark’s two principals have over 50 years of combined brokerage experience in the Houston market.
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