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Introduction to Commercial Leases | Part 1

This is a four part article focusing on Commercial leases.

Virtually every aspect of a lease is negotiable and is a potential concession. Whether representing the owner or the tenant, you will need to understand the negotiating point of view of all parties and the significance of each clause and/or concession.

A user’s (tenant’s) main objective might include:

  • Obtaining a reasonable, fairly calculated rent
  • Receiving maximum services for goods
  • Predictable and fair operating costs
  • Expandability of space for future needs
  • Fitness or adaptability for tenant’s use
  • Lease clauses that provide maximum flexibility concerning renewals or ability to assign or sublease

An owner’s (landlord’s/developer’s/manager’s) main objective might include:

  • Attracting and keeping high quality tenants
  • Ability to finance construction (if necessary)
  • Protection of property improvements
  • Shifting or balancing risks
  • Ability to regain possession

The common objectives of all involved parties typically include:

  • An accurate completion of the transaction
  • A binding, clearly-worded lease document
  • Financial heath of all parties

Requirements of a Valid Commercial Lease

The requirements of valid leases are similar to the requirements for valid contracts. Despite the wide variation in the length and complexity of commercial leases, valid and enforceable leases usually contain the following elements.

Names of owners and tenant: All parties to the lease should sign the document.

Description of property: Acceptable descriptions include street address and recorded plats in urban areas, and the government rectangular survey system and metes and bounds in a rural area. The lease also should include a brief description of the improvements.

Consideration: This requirement usually is met by the tenant’s promise to pay a rent and the owner’s inability to occupy the property during the lease term.

Legality of objective: The objective of the lease must not violate any federal, state, or local law.

Offer and acceptance: These are statements to the effect that the owners agree to lease the property for a specific period of time and that the tenants agree to pay a certain amount of rent periodically to occupy the property.

Written form: In most states, leases for longer than one year must be in writing.

A commercial lease may call for:

 

  • A fixed amount of contract rent over the entire lease term, called a fixed lease
  • Rental payments that change, or step up, by set amounts or percentages at given dates (step leases)
  • Variable levels of contract rent based on changes in an index (indexed leases)
  • Variable amounts of monthly rent based on a percentage of the tenant’s gross sales receipts (percentage leases)
  • Periodic changes in contract rent based on lease language

Types of Leases

The expense terminology in leases identifies who is responsible for the payment of operating expenses. Under a gross lease, the owner pays all the expenses associated with the operation and maintaining the property. The tenant pays the owner a gross amount for rent. From this amount, the owner then pays the operating expenses (property taxes, insurance, maintenance, utilities, janitorial and security costs).

In a net lease, the tenant pays all or some of the operating expenses. However, the lease terms should be examined carefully, as the definition of net leases varies from market to market.

For a given level of rent, owners clearly prefer to pass on as much responsibility for operating expenses to tenants as possible. However, the extent to which owners and tenants share the payment of operating expenses depends on what currently is standard in the market in which the property is located, and on the relative bargaining power of the two parties or what was negotiated.

In an absolute net lease, the tenant pays all the expenses related to operating and maintaining the entire leasehold interest.

Lease Clauses that affect Cash Flows 

Many commercial leases contain alternative treatments of operating expenses. These alternatives may require owners to pay operating expenses up to a given amount (Expense stops), allow owners to pass some of the cost of operating the property through top the tenant (expense pass through), or allow the owner to charge the tenant(s) for some of the increase in the cost of operating the property.

Expense Stops

With some commercial leases, the owner may add and expense stop clause. In this situation, the owner pays operating expenses up to a specified amount, usually states as an amount per square foot (psf) of rentable space in the building. Psf expenses in excess of the expense stop are passed through to tenants based on their pro rata share of the building’s rentable space.

For example, an office lease may state that a tenant will pay $18 psf per year in rent and that the owner will pay all operating expenses associated with the property – so long as expenses not exceed $4 psf of rentable area. If the building has 50,000 square feet (sf) of rentable area, then this clause obligates the owner to pay the first $200,000 in annual operating expenses ($4 X 50,000).Any amount over $200,000 will be paid by the tenant based on the percentage of the building’s rentable area or the square footage that the tenant occupies. This clause effectively limits – or stops – the owner’s operating expense exposure at $200,000.

Expense stops benefit owners by limiting their exposure to the risk of operating expenses being greater then expected. These stops also allow owners to forecast costs based on predictable expenses. Owners give tenants something of value in exchange for the expense stop clause. This something of value can be lower contract rental rate if competitive leases in the market do not contain expense stop.

 

Expense Pass-Trough

Operating expenses frequently are paid by the owner and then passed-through to the tenants. This is especially true in the multi-tenant office building and shopping centers. In retail properties, a tenant’s share of these expenses pass-through is based on the gross leasable area (GLA) of the tenant’s store as a proportion of the GLA of the entire shopping center. In office properties, the pass-through s based on the tenant’s rentable area as a percentage of the building’s total rentable area.

As with expense stops, owners give tenants something of value in exchange for the expense pass-through. This something of value can be lower contract rental rate if competitive leases in the market do not contain pass-through.

Common Area Maintenance

Common area maintenance (CAM) charges area a common expense pass-through in shopping center leases and other multi-tenant situations. These are the costs associated with maintaining the common area of a property, such as hallways, lobbies, grounds and parking lots. These costs usually are calculated on the percentage of rentable space that the tenant is occupying. CAM clauses benefit owners in that when maintenance costs increase, the increase is passed on to the tenants. Tenants also benefit, at least in theory, to the extent that monies collected for CAM are cannot be driven by other property expenses.

Tenant Improvements

Owners often incur re-tenanting expenses when leases expire and vacant office and retail space must be made ready for occupancy. As an example, the re-leasing of office space often requires that substantial changes be made, such as removing or adding walls, raising ceilings, and altering electrical capacity. In fact, many office and retail leases provide a tenant with an improvement allowance. This lease provision obligates the owner to incur a prespecified dollar amount of expenditures to improve the space to the new tenant’s specifications.

Tenant Improvements and Tax Benefits

Responsibility for payment of tenant improvements can provide tax benefits. Generally speaking, if the owner pays for the improvements, these costs are expensed over 39 years. If the tenant vacates and the improvements are torn out, the owner may write off the remaining amount at that time.

If the tenant pays for the improvements, and the changes simply 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 39 years or when the tenant vacates the property.

© Copyright 2008 Jennifer MacKay. All Rights Reserved.

Introduction to Leases - Part 2

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