The Skinny on Leases
A lease is a lease, right? You let me occupy your space, and I pay you for it, right? Well, yes…and no.
The length of the term, the added-on costs and the degree of responsibility for the leased premises—these provisions distinguish a commercial lease from a residential lease. They’re also the provisions that can make the difference between success and long-term struggle. If you’ve had any experience with leases in the past, your new commercial lease may look like a piece of cake. In today’s unsettled real estate climate when the “experts” say commercial real estate is hitting rock bottom, landlords are desperate to fill their vacancies, and they’re practically “giving it away” with all kinds of concessions and incentives.
Renting new space for your business now may actually be a minefield for the future.
First, the term of the commercial lease is typically far longer than a residential rental. The obvious reason is that all businesses need stability: your students and the community at large need to know that you will operate in that location continuously, and that their payments for future services will not be lost. That works for the landlord, too. He or she knows that the space will be occupied and cared for over time. A residential lease may be for one or two years, with a possible renewal for another term, but a commercial lease usually extends for at least five years, probably renewable for another five years. Some commercial leases may last as long as 20 years.
The rent, however, will not remain the same through the entire term. The landlord will want to build in increases; the tenant will want to keep those increases manageable and predictable. What to watch out for is the mechanism for calculating the changes in rent over the course of the five, or 10 or longer term of the lease, and you should be prepared to negotiate that. Increases may be specified in the lease as dollar amounts or expressed as a percentage of the base rent. They might even be tied into the tenant’s gross receipts or profits.
Here are some of the risks: Given the state of the commercial real estate market, landlords may offer highly favorable rentals for the immediate future, but they may be counting on a quick rebound and build in steep increases. Or they may foresee your success and propose to become “partners” in your business by tying increases to your earnings. If you negotiate successfully for specified dollar amounts, you will have certainty, but in reality, there is no certainty that your business can pay that amount in year five. And no one knows what year 10 will bring.
You may prefer, therefore, to opt for a shorter term at a favorable rate, putting off renewal, and renegotiation and possibly another move until the economic climate has settled. Make sure the lease provides for options to renew, paying very careful attention to how the renewed rent is calculated and give serious thought to how much time you will need to make a decision about renewing, so that the notice provisions in the lease are realistic and give you sufficient time to relocate, if you have to.
Second, as you engage in negotiation over the length of the lease and consequent rent increases, keep in mind that the base rent is only the beginning of your financial obligations to the landlord. What other expenses are included or added-on? Are they negotiable?
Commercial leases typically include payment of business or “occupancy” taxes and increases in real estate taxes. Landlords are eager to shift such payments to the tenant, so you have to know how much those taxes are likely to be immediately and in the future, over the course of the lease. Be clear with the landlord if you operate as a not-for-profit entity; the tax liability for the property could change, to everyone’s advantage. Utilities are not likely to be included in the rent, unlike a residential rental, and a commercial lease may also shift costs like water and sewage to the tenant (not-for-profit or otherwise!). Short-term concessions by a desperate landlord may be attractive but deceptive. Today’s bargain may not be much of a bargain a year from now, when you’re confronted with a bill from the landlord for expenses you didn’t know you were supposed to pay.
Occupancy of commercial space may also require significant renovation, which is usually not the responsibility of the landlord. Unless the landlord offers to “build to suit” or the space is perfect as is, you will have to create the space you need to conduct your business, installing sprung floors, for example, or expanding existing bathroom facilities. Expect the lease to require that any renovation be conducted in accordance with applicable building regulations, and completed in compliance with building codes. You may need the consent of the landlord, as well, and you may have to promise to restore the space at the end of your tenancy. Hiring a contractor who will comply fully with building department regulations and obtain required permits will cost more, much more, than letting work-study kids rewire the office or install flooring.
While the residential tenant will have to supply his own light bulbs, he also has the luxury of calling the landlord to fix a bathroom leak. The commercial tenant is usually required to maintain the premises, which often means calling her own plumber or exterminator, hiring a private cartage service for garbage pick-up, or installing a security system all at her own expense.
Third (although this may actually be “first”), don’t assume that the space can be used for your purposes, or for all aspects of the business you propose to operate. There may be zoning restrictions, environmental restrictions or restrictions imposed by the neighborhood business association. Is the space zoned for the café you’d like to have on premises? What about the concession you’d like to offer to a dancewear supplier? If the commercial space is contained in residential space (say, a storefront leased by a condominium), will the residents complain about the strollers in the morning or the high schoolers congregating outside before after-school classes?
Do the due diligence.
Don’t rely on the landlord or the landlord’s broker to provide complete and up-to-date information. The tenant who hasn’t done his homework may not be aware of added-on real estate taxes or business association dues or responsibility for the boiler. Curing a default under a commercial lease may not be a simple matter of offering a check for whatever the landlord claims is due. The landlord has the right to bring an eviction proceeding in the event that the tenant fails to comply with any provision in a lease. And ignorance of the terms of the lease is not a defense. The landlord may decide he can get more rent or a less troublesome tenant and opt to terminate the lease.
Do the research yourself, or have your broker or your attorney find out everything that can reasonably be known about the space, the landlord, previous tenants, zoning, and present and future tax structure. Have your attorney order a title report or lien search to find out about applicable taxes, whether there are mortgages covering the premises, or mechanics’ liens. Don’t forget to ask your accountant to analyze the tax impact of the proposed rental, and to calculate depreciation of any capital improvements you may have to make to help you determine whether this rental is advantageous. And of course, do not sign a lease without having your own attorney review it.
Becoming fully familiar with the property will strengthen your negotiating position. Traditionally, the landlord-tenant relationship hasn’t been symmetrical, but today’s market is different. A qualified tenant is more valuable to a landlord with empty properties than ever. Become a knowledgeable tenant as well.
Knowing what is knowable allows you to make an informed decision. After all, you have a choice of signing the lease…or not!