Lease Agreements between Landlords and Tenants – Part 8
Lease Agreements – Part 8
In Part 7 of this series we covered some of the special lease issues related to owner associations. In this Part 8 we’ll discuss some aspects of and issues related to commercial property lease agreements.
Importance of Leases
The value of an income property is affected by the leases for that property. Leases are often the most important factor in determining the value of an income property, both residential and commercial. The value of a lease is determined primarily by (1) the length of the lease term, (2) the rents specified in the lease, (3) options to extend or renew given in the lease, (4) the financial qualifications of those executing the lease and/or those co-signing/guaranteeing the lease, and (5) the adequacy and enforceability of the lease document.
The above factors are much more important for commercial leases than for residential leases because of the (1) longer lease terms, (2) the multitude of possible variations in the way that rents are determined, (3) the complex options often included, (4) the fact that many commercial tenants will be limited liability entities which make co-signers or guarantors imperative, and (5) the fact that there are often significant differences among lease agreements for tenants within a multi-tenant commercial property. The last is particularly so when the property has a variety of types of lease space including perhaps general office space, retail merchandise stores, food service establishments, and even medical/dental offices.
Commercial Leases
Commercial lease agreements generally have the following clauses that are usually not part of a residential lease:
- Permissible business use of premises
- Non-competition
- Signs required or allowed
- Insurance requirements
- Hazardous use issues
- Indemnity clause
- Lock-out provisions and liens
- Multi-year rent increase schedule
- Renewal and/or extension options
- Common area expense contribution – triple-net or variation thereof
Commercial leases will usually cover the following issues that are usually not part of a residential lease:
- Tenant’s trade name
- Size of leased premises
- Complex rent schedules
- Multi-year rent increase schedule
- Option to renew or extend
- For retail, sometimes percentage of sales
- Common Area Maintenance (CAM) charges
- Use of building name restrictions or prohibition
- Tenant improvements – landlord build-out, standard allowance, or tenant cost; mechanic’s liens
- Ownership of attached fixtures and/or removal requirement
- Required and/or prohibited business hours
- Choice of law jurisdiction
- Environmental responsibility
- Plans and/or other exhibits
The typical length of commercial leases and the often included options for extensions or renewals beyond the original term mean that some issues are more important for commercial landlords. Assignment and bankruptcy are two examples of such issues.
In addition, commercial leases often include the following subsidiary documents because the tenants are often corporations or other limited liability entities:
- Corporate authority or special resolution authorizing the lease
- Personal guaranty(s) making one or more individual corporate directors, officers, or shareholders or LLC managers or members liable for the lease.
Commercial lease rental rates are usually advertised and written into leases on the basis of cost per square foot per annum, although a total monthly rent is often used for small spaces. When specified on the square foott/annum basis. One must, of course, multiply the rent by the square footage (including any common area share), and divide by 12 in order to determine monthly rent.
Commercial Lease Definitions
There are basically three types of commercial leases – Gross, Net, and Percentage. In practice, leases often include one or more attributes of one or more of the three basic types.
Gross Lease – In a gross form of lease the tenant pays a fixed amount of rent for all services associated with his leased premises including maintenance costs, property taxes, and insurance. In other words your monthly rent would be the single amount specified in the lease, including any annual increases. Small office spaces will sometimes be on a gross lease, with the rent sometimes including cleaning services.
Net Lease – In a net form of lease the tenant pays a fixed amount of base rent plus a share of one or more categories of expenses. This is the form most often used in commercial leasing. There are variations of net leases, sometimes referred to as N, NN, and NNN, depending which of expense categories are included. A commonly used version is the triple-net (NNN) lease whereby the tenant pays a fixed amount of base rent plus a share of property tax, insurance, and operating expenses (hence, NNN). The percentage share is usually the same percentage as the tenant’s leased space bears to the total available space, usually including common area. Not only is the base rent usually subject to annual adjustment, but the NNN contribution is usually adjusted annually following calculations based on previous years’ expenses.
In order to avoid misunderstandings and disputes it is also important the calculation of leased premises be defined, preferably within the lease agreement itself. A tenant can become upset when he measures the lease space after signing the lease and finds that his assumption that the dimensions provided by the landlord are measured from the outside surfaces of walls rather than the actual useable inside wall-to-wall dimensions. Similarly, when the NNN costs include a percentage of common areas (such as restrooms, patios, and parking lots) this must be adequately disclosed to the potential tenant.
Because of the issues mentioned above, the net charges can vary drastically depending on the type of property (including both building construction and common area design), the age of the property, the current condition of the property, the way in which common area is measured, and the manner in which the property is managed. Furthermore, the NNN cost is often 20 to 30 percent of the base rent. Accordingly, in order to minimize misunderstandings and future disputes and in order to win in the event of a dispute, it is important that all NNN issues be clearly defined in the lease agreement.
As an example, assume that the tenant is to pay 10 percent of net charges. Must he only pay 10 percent of roof repairs, which, depending on the condition of the property, might be zero during his entire lease term? Or must he pay 10 percent of a completely new roof installation, which might be thousands of extra dollars in the year it is done, because the roof was essentially shot when he signed the lease agreement?
Obviously, how the NNN is defined will significantly affect whether your asking rent is competitive in the area market. In fact, for knowledgeable potential tenants it may be more important than the base rent.
Percentage Lease – In a percentage form of lease, usually only used for retail center space, the tenant pays a fixed amount of base rent plus a share of property tax, insurance, and operating expenses as with a general NNN lease, the share usually the same percentage as the tenant’s leased space bears to the total available space. In addition, a percentage of sales revenues are part of the rent. The percentage may be calculated based on gross sales or as otherwise defined and the potential tenant must be provided adequate explanations of how percentage is calculated and what business accounting records may be required for the landlord to determine the percentage part of the rent.
A landlord must thoroughly understand all terms and conditions of the lease agreement being used. The lease should be continually improved as deficiencies are noticed and as new problems are encountered.