3 Things to Know When Negotiating a Commercial Lease
Today’s guest post is by Evan Tarver, a small business and investments writer for Fit Small Business, fiction author, and screenwriter with experience in finance and technology. When he isn’t busy scheming his next business idea, you’ll find Evan holed up in a coffee shop working on the next great American fiction story.
4 Things to Know When Negotiating a Commercial Lease
Commercial leases typically have longer terms than residential leases and have more tenant and landlord clauses. Whether you’re working with a broker or negotiating yourself, it’s important to fully understand a commercial lease before you sign as it can have a significant impact on the success of your business.
Below are the top 4 things you should know about commercial leases that’ll help you negotiate more favorable lease terms:
1. Your Commercial Property Parameters
Before you start negotiating your lease it’s important to fully understand your commercial property parameters. This is because the needs of your business will dictate the types of properties you can lease as well as the terms you can negotiate. Your commercial property parameters should include the following:
- Ideal customer or employee pool (including location)
- Commercial property zoning
- Desired property size (rentable space and usable space)
- Maximum monthly lease budget
- Accessibility (foot traffic, vehicle traffic, and parking needs)
By defining each of these commercial real estate parameters, you’ll know the exact type of property you need as well as what you can and can’t negotiate. For example, if you’re a restaurant, you might be able to negotiate landlord build-outs, which are improvements made by the landlord – such as upgrading kitchen appliances – at potentially no cost to you.
2. Lease Types and their Associated Costs
Most people aren’t aware of the fact that there are typically 3 different types of commercial leases. These leases include a full-service lease, net lease, and a modified gross lease. The major differences between these 3 are the costs and fees associated with them as well as the types of businesses who typically sign them.
The Types of Leases
Understanding these different types of leases will give you greater negotiating power. For example, a full-service lease is the most common type of lease for commercial office buildings. This lease is all-inclusive, meaning that the landlord is required to pay for expenses such as utilities, property taxes, insurance and repairs out of the rent he/she receives from the tenants.
By contrast, a net lease can either be a single, double, or triple net lease and is most commonly used for restaurants and retail. Depending on the type of net lease, the tenant will be required to pay for a pro-rata share of property taxes, property insurance, and common area maintenance fees (CAMS) if it’s a multi-tenant building. If there is only a single tenant, the tenant will be responsible for those expenses.
A compromise or a hybrid between the full-service lease and the net lease is the modified gross lease. This type of lease is most commonly used for multi-tenant office buildings. Typically, the landlord is responsible for the major expenses and the tenant is responsible for their directly related expenses. For example, the landlord may pay real estate taxes and insurance and the tenant may pay janitorial and utility expenses for their specific space. The landlord usually has the right to expense pass-throughs using a base year.
Costs Associated with Your Lease
Of course, the type of lease above will largely dictate the costs associated with your monthly commercial lease payment. Still, it’s important to understand the general costs associated with a commercial lease so that you can better negotiate your terms.
The common types of monthly expenses associated with a commercial lease include:
- Rent (based on a price per square foot)
- Pro-rata property taxes
- Pro-rata property insurance
- General repairs and maintenance
- Utilities and janitorial services
- Tenant build-outs (improvements made by the tenant)
While these costs are dependent on the type of lease, some of the costs can potentially be negotiated with the landlord. Of course, certain costs like janitorial services and utilities can’t be negotiated unless you decide not to use the services. It’s important to remember which types of costs are typically associated with each lease type. This will help you better estimate your monthly costs as well as determine whether it’s more cost effective to buy real estate or lease the space.
3. Common Commercial Lease Terms and Clauses
When negotiating a commercial lease, it’s important to be familiar with the lease terms and clauses you might encounter. These terms and clauses will typically dictate the length of your lease, the total monthly costs, annual rent increases, lease terminations, and more. Understanding these terms will help you negotiate a more flexible and cost-effective commercial lease.
The key commercial lease terms that you should become familiar with include:
- Use clause – Determines the types of businesses that are allowed to use the commercial space. This is particularly important if you expect to sublease in the future.
- Length of lease – Commercial lease terms typically range from 3 – 10 years.
- Assignability – A lease is required to be assignable in order for the tenant to sublease the space. An assignable lease can be included in the potential sale of your business.
- Escalation – Commercial leases will often have escalation clauses that let landlords increase rent annually, around 3% a year.
- Build-out credits – These credits give the tenant the chance to make improvements at the expense of the landlord.
- Termination clause – Clause that allows a landlord and/or a tenant to terminate a lease if certain criteria are met.
4. Benefits of Leasing vs Buying Commercial Real Estate
Ultimately, negotiating a commercial lease is only a good idea if leasing commercial real estate is more cost effective than buying a commercial space. Since each space is unique you’ll want to run a cost-benefit analysis on the difference between renting and owning the space.
Some factors to consider when weighing the options of leasing or buying commercial real estate include:
- Tax benefits of owning the space
- Down payment available to purchase the space
- Will you outgrow the space?
- Being responsible for maintenance of the property if you own it
- The freedom to alter the property if you own it
Overall, a commercial lease can be confusing and it’s important to adequately prepare when negotiating one. In order to negotiate favorable lease terms, you’ll want to know your property parameters, lease types, potential costs, potential lease terms and clauses, as well as the benefits of leasing vs buying commercial real estate.