Leasing Basics 101 for Commercial Tenants
For most businesses, the costs of a commercial business lease is the largest expense line item aside from payroll. Thus, it is critical that a prospective tenant be as informed as possible about the leasing process and relevant market conditions before signing their lease or a lease renewal amendment.
Landlord lease forms are typically fairly one-sided, and tenants that decide not to engage a commercial leasing attorney just to save some legal fees will risk the perils of being “penny-wise and pound-foolish”.
An attorney well experienced in commercial leasing should be engaged to review and negotiate the language of the lease document. Generalist attorneys may offer to review your lease, but only those that regularly negotiate leases (a specialized practice) will be able to apply the level of insight and experience required.
Commercial Leasing 101
Any business owner that prepares to lease space (office, retail, warehouse, hospitality, etc) or renew an existing lease should do the following:
- Engage the Services of a Tenant-rep Broker
- Engage the Services of an Attorney Experienced in Commercial Leasing
- Understand the Terms and Conditions of the Lease Agreement or Amendment to be Signed
- Know the Most Important Lease Terms
- Understand the Potential “gotcha’s” in the Lease Text that May be Overlooked
Except perhaps for the smallest of leases (well under 1000 sq ft), it is highly advisable to engage the services of a tenant-rep commercial lease broker. A good broker will possess the market data, information, relationships, and experience necessary to help you get the best terms out of a prospective landlord.
Even better, the broker’s fees are typically paid directly by the landlord, so there’s no immediate out-of-pocket cost to the tenant. While it is true that the broker’s commissions (almost always paid by the landlord) are built into the rent rates, it is also true that tenants who don’t enlist the aid of a broker will very rarely, if ever, see a corresponding reduction in their rental rates. Additionally, the absence of a tenant broker’s representation will almost always guarantee the loss of economic opportunities in the negotiation.
Additionally, a broker will add efficiency to the process (and lessen a tenant’s “down time” and frustration) by narrowing your search to available and appropriate locations and properties that make sense for your business. Obviously, a suitable location is especially critical for a retail operation that requires favorable road exposure and the benefit of traffic building neighboring tenants.
Cooperation and dialogue between the tenant’s broker and your leasing attorney will yield efficiencies in the process towards expeditiously getting to a mutually agreeable and satisfactory lease agreement which sufficiently protects the tenant’s interests as consistent with the leverage realistically brought to bear given then current market conditions.
Your search criteria for a commercial leasing attorney should consider the volume of experience that the candidate attorney possesses in the relevant category of property – retail, office, warehouse, medical, hospitality, ground leasing, etc. Your broker will likely be a good resource for recommendations of attorneys that he or she has successfully worked with before. Most large law firms have partners and teams dedicated to real estate practice. However, these days there are more and more “boutique” legal practices (smaller firms and solo practitioners) that specialize in real estate matters, and can offer equally competent representation and experience at substantially more competitive rates.
Commercial space leases (for retail, warehouse or office, etc.) are a whole different animal compared to residential leases, and they contain many important provisions (which don’t appear in residential leases) that have can have significant economic and practical impact on the user of the space.
When you locate available space that meets your needs, the first document that ought to be agreed upon is a letter of intent. The letter of intent, while by its terms is usually not binding, serves to “crystallize” the mutually agreeable economic terms that are the basis of the deal. The letter of intent also provides a structured, more efficient path for the negotiation of the actual lease document. Additionally, the willingness of a prospective landlord to sign a letter of intent helps to “smoke out” a serious opportunity with a landlord that wants to proceed to an acceptable and documented lease. Otherwise, you might be spinning your wheels with a landlord agent that really has no real intent to facilitate a lease to your operation, or is just wanting to have you for safety “in the wings” while actually negotiating a deal with another prospect.
As to be expected, the successful negotiation of favorable lease terms depends in large measure on your relative leverage (or lack thereof) with the landlord. Some of the important variables to consider are:
- The area of your leased space vs. the area of the building/complex
- How long the term of your lease will be
- Your creditworthiness and operating history
- The current leasing market (i.e., significant vacancies vs. limited supply of space).
- The relative prestige of your brand to the landlord – especially important for retail space
- Whether the landlord is an individual, regional or national property owner
In a “tenants’ market” you (and your broker) can effectively push for landlord concessions like more interior improvements funding dollars, some months of free rent at the front end, renewal and expansion rights, and better overall rental rates. Conversely, a tight market with limited space availability will cause landlords to more likely adopt a “take it or leave it” posture.
Often, various “submarkets” within a large metro area (i.e., central business districts vs. outlying regions vs. development corridors) can display widely different market conditions. When negotiating it is important that the tenant guide their expectations by the reality of the current market environment (the broker can help inform the tenant in this regard). Doing so can greatly enhance the efficiency and likelihood of getting to close on a given lease deal. It can also help the tenant to avoid excessive, frustrating and unfruitful negotiation cycles.
As already noted, the important lease terms available for negotiation will vary considerably based on the relative size of your space vs. the size of the entire property. Thus, a “single user” tenant looking to occupy an entire structure will have more weight toward getting beneficial landlord concessions including prominent signage.
Established, creditworthy businesses (with longer history of operations, household names, greater net worth, and audited financials or publicly traded stock) will have more clout in negotiating with landlords. Conversely, start-ups are at a decided relative disadvantage. Nonetheless, many beneficial changes in the proposed lease text can often be had just for the asking given the initial landlord form agreements tend to be quite one-sided. Never, never just simply sign the lease document that is handed to you by the landlord.
The many details appearing deep in the lease text, while appearing to be just “boiler-plate” language, can have a very dramatic impact on the tenant later on during its tenancy. Some of the fundamental terms contained in most any commercial lease are:
Rent (Base + Additional Rent for passthroughs of operating expenses) – make sure that your business can afford, and appropriately budget for, the total rent due including all scheduled escalations during the term!
Full Service vs Triple Net Rent
Full Service vs Triple Net Rent as the difference relates to whether the landlord covers all operating expenses (taxes, insurance, utilities) for the first year – “Full Service”, or whether the tenant is in all cases responsible for paying landlord its allocable share of all operating expenses - “Triple Net”. Single users of an entire building are more likely to pay Triple Net Rent (“NNN”), and NNN rent terms are tending to be the trend generally. Tenants will want audit rights to ensure that landlord calculations of operating expenses passthroughs are correct (and not overstated).
Premises is the exact location of your space and the area being leased. Note that Rentable Square Feet (RSF), on which the rent is based, is always larger than Usable Square Feet (USF) that nets out the “core factor” - stairwells, elevator banks, bulkheads, and columns. USF is the actual space that you will have available for your operations.
Term (duration of lease) + renewal right. If you are not sure about the viability of your business model, or your future needs for the space, it is advisable to seek a shorter term (approximately 3 years) with renewal rights. Anticipation that rents may come down in the future might also be a reason to seek a short rather than longer term. The lease should also provide for a pre-rent commencement period in which the tenant’s contractors can build interior improvements on a rent-free basis (in the absence of landlord’s providing of “turn-key” space). The landlord may instead take on the responsibility and expense for the interior build, with rent then starting no earlier than tenant’s entry into the completed space.
How many months worth? This will depend upon the creditworthiness and operating history of the tenant entity, and whether the landlord will require a personal guaranty of the rent obligations by principals of the business. Note that the extent of personal guaranties can sometimes be capped or reduced periodically during the term. Also, sometimes the security deposit can also be provided not just by cash, but by the tenant’s posting of a letter of credit.
Improvement Allowance and Base Building
Especially in more tenant favorable markets, landlords are willing to provide the tenant with greater funding for the buildout of interior improvements to suit tenant’s needs. Longer terms, and higher quality (more expensive – Class A) space, generally translate into more landlord dollars for tenant’s buildout. “TI Allowances” are based on RSF, and can also vary substantially depending on the particular building and the local market – some class “C” properties may offer only $12-$20 per RSF, while Class A office space in the central business district can reach $80+ per RSF. Obviously, TI allowances are ultimately recovered in the applicable rental rates. In the case of newly constructed properties, the tenant will want to ensure that there are very specific requirements on what initial buildout (Base Building) the landlord is providing before any tenant dollars or TI allowance are used to make that space ready for tenant’s operational use.
Use and Exclusive Clauses
Exclusive restrictions are most important to retail tenants, but sometimes do appear in office leases. If a retailer wants to guard against near-by competition in the shopping center or strip mall it will seek the protection of an exclusive clause. The negotiation of exclusive provisions can often become quite involved and complex, particularly for leases in larger retail properties. Also, comprehensive exclusives become less available the larger the mall or center. A clear understanding of the intended and permitted use of the space is also very important. For example, sometimes zoning that would allow a general purpose retail operation will not allow use as a doctor’s office, or as a yoga or exercise studio. Thus, the tenant needs firm representations from the landlord that tenant’s intended use will be permitted by applicable zoning and land covenants.
Assignment and Subletting
Assignment and Subletting rights are absolutely critical, especially for longer term leases. The tenant needs flexibility to assign or sublet to a succeeding user of the space in case tenant needs to close that retail location, or downsize its office “foot print”. Additionally, the ability to transfer (sell) a business can be severely hampered if landlord consent is required to allow a successor entity to use the space for the remaining duration of the term.
Effective review of a commercial lease requires attention to the many detailed provisions therein, as well as the need to address the absence of tenant protective provisions in the landlord’s offered first draft of lease. Careful thought should be given to the future direction your business may take, and resulting flexibilities that need to implemented in the lease document.
Among some of the important, “secondary” terms to be considered in your lease are the following:
Tenants shouldn’t wait until close to the end of the term to negotiate a renewal – this completely removes their leverage to viably consider a relocation instead of a renewal. Understandably, the tenant’s option to relocate, and thereby exercise leverage against a landlord towards getting competitive rental rates, is lessened in the case of retail space where the user has developed location goodwill. The lease should provide for the renewal election (and express determination of renewal rent rate) to happen at least 9 months to one year in advance of the end of the term. Many times an express renewal rental rate can be provided for in advance instead of pursuant to a fair market rental determination and arbitration.
Right to Expand is critical for tenants that anticipate rapid growth, and/or want flexibility over the longer term. If a tenant can’t get additional, much needed expansion space in its current building, it may have to consider an unanticipated and inconvenient relocation.
What is the cost to tenant for after hours demand for climate control? This, along with provision for standard hours for HVAC at no additional charge, should be specifically provided for. The cost for after hours HVAC (on demand), especially for 24x7x365 users, can be a very substantial add-on expense.
Cosmetic alterations like painting should not require the landlord’s consent. In other cases, the landlord’s consent for non-structural alterations in the premises should not be unreasonably withheld, conditioned or delayed.
Environmental, ADA, code compliance
Tenants should seek landlord warranties regarding compliance. Although, if the interior build is pursuant to the tenant architect’s drawings this responsibility (at least as to the leased space) will be with the tenant.
Rent Abatement for Interruption in Use
In the event of a casualty (fire, weather damage, etc) that renders tenant’s space unusable rent should abate, and the landlord should be required to promptly and diligently rebuild. Also, rent abatement should be available in the event that services/utilities are interrupted for an extended period. I highly recommended that the tenant procure business interruption insurance (and this is often required by the landlord).
Eliminate Removal/Restore Obligation on Tenant
Watch out for any such removal requirement (at tenant’s expense) of the improvements in the space that triggers upon tenant’s departure. This can be a major and unexpected budget item.
Risk of Subtenancy
If you are a subtenant you run the risk of getting kicked out of your space if the prime tenant (your sublandlord) doesn’t make its own rent payments to the prime landlord. While not universally available, you can seek to get a non-disturbance agreement from the prime landlord to protect your continuing occupancy.
The above lease terms and points are just a sampling, but represent some of the most critical issues impacting a tenant’s occupancy and use of its space. An experienced commercial leasing attorney will be on the look out for, and can assist with, the negotiation of these and other points toward arriving at appropriate concessions and compromises with your landlord.
All prospective business tenants are well advised to seek the help of a tenant broker and an experienced commercial leasing attorney before entering into a lease commitment. The “devil is in the details” when it comes to your business’s lease document, and relatively innocuous looking fine print may later have unexpected economic and operational consequences down the road. Your leasing attorney can also be a great asset in later years when dealing with interpretations of the lease and other issues that come up with your landlord.
About The Author
Lars Andersen is an independent practice attorney with over 23 years experience in commercial leasing and a wide variety of business entity transactions. He may be reached at 703-349-1251, and via email at firstname.lastname@example.org. Please note that the above article is informational only, and should not be construed as legal advice with respect to your situation or matter – if such advice is required the services of an attorney should be engaged.