Real Estate Reactions: What is a Commercial Lease?
What is a Commercial Lease?
Simply stated, a commercial lease is a lease that covers a commercial property (as opposed to a residential property, an oil/gas property, or other leased interest). The lease will deal with different topics and concerns, since the space is being used for business and commerce rather than being used for living/residence.
A commercial lease – just like any other lease – is a legally binding contract between two parties to rent a space.
The commercial tenant, of course, may be anything from a sole proprietorship to a mid-market franchise to a large, multinational corporation. A commercial lease agreement sets out all (or hopefully all… or most) the relevant legal obligations between the parties and grants the commercial tenant certain specific rights.
How Common is it for a Business to Lease vs. Own Property?
It may surprise you to know that many businesses do not own the real property upon which their business is operated! It is in fact very common for businesses to rent or lease their real estate.
Why Would a Business Lease Rather Than Own?
There are many potential reasons for a business to lease rather than own.
First, a business may choose to lease property because purchasing can mean a large, up-front capital investment, and/or locking in a long-term mortgage. A business may not have that amount of liquid cash and/or may not wish to obligate itself to that kind of expense.
Second, owning a property exposes the owner to the potential volatility of the real estate market. If you buy the property and then there is an eminent domain action, or the real estate market writ large falls off a cliff, this could be a big problem for your business. While these scenarios would be somewhere between a major inconvenience to a minor problem for a business that is renting space, the impact to the commercial tenants would be much less severe, and they can often walk away.
Third, owning land is a pain in the neck (and the wallet). It comes with all kinds of maintenance and upkeep, expenses, responsibilities, and various other headaches. If a water pipe breaks in the middle of the night, it’s not someone else’s responsibility to fix – it’s YOURS. If there is a break-in or vandalism event, it’s not someone else’s responsibility – it’s YOURS. If the air conditioner or heater needs to be replaced, it’s not someone else’s responsibility to replace – it’s YOURS. Of course, you can hire a property management company to mess with all of this stuff – but that’s another expense.
Fourth, let’s not forget property taxes. The owner of property is responsible for the taxes. And, as the value of the property rises over the years, so do the taxes!
Fifth, your business is in the business of… well, whatever its business is! it’s NOT in the real estate investment business. Are you a savvy enough real estate investor to know which investment opportunity is a good deal and which is a bad deal? Do you have the time to devote to learning the real estate market, or the appropriate subset of the real estate market? Bolting on a bunch of unnecessary real estate price risk – not to mention tying up a huge amount of capital – may not make sense if you’re not quite certain that you’re barking up the right tree.
How is a Commercial Lease Agreement Different From a Residential Lease?
Because a commercial lease is a fully-customized, legally-binding contract that can have long-term financial and legal implications, it’s critical for the business tenant to understand its rights and obligations under the terms of the lease before signing. While both a commercial lease and residential lease fundamentally function to lease space from a landlord to a tenant, the two types of lease are very different legal documents, because the context of each of these documents is so different from one another.
Some of these differences are:
Commercial leases tend to be significantly longer in duration than the typical one-year residential lease. The term of a commercial lease is usually three to five years in duration, but can sometimes be much longer.
Most commercial lease agreements have varied terms to accommodate different tenants’ needs (a restaurant, for example, will have different needs from a gym, which will have different needs from an auto parts store; and so forth), as well as the needs that arise from a particular site (for example, leases will differ when in the middle of the city’s urban core vs. in the suburbs vs. in a rural small town). Consequently, there is generally no single cross-industry standardized format and agreements can vary greatly from lease to lease.
Commercial and business tenants are often seen as more sophisticated than residential tenants. As a result, there are generally far fewer legal protections for tenants in a commercial lease, and the consumer laws (such as the Texas Deceptive Trade Practices and Consumer Protection Act (DTPA)) that protect individuals and residential tenants generally do not cover commercial lease agreements or the parties thereto.
Commercial lease agreements are often more flexible and negotiable between the parties, with more ability to fully customize the terms – again, arising from the fact that commercial leases are often executed among two commercially savvy, sophisticated parties. These will include the rental amount, the term of the lease, what other costs are involved, what improvements are allowed, what communal areas are included, and many other critical matters.
Because a lease agreement is a legal contract that can be fully customized depending on the needs of the parties, you want to go into negotiations fully understanding your needs. Unsurprisingly, most commercial leases are written with the landlord’s rights, needs, and protections in mind. If you would like to have some of your needs and protections addressed or included in the document, you will need to discuss, request, or negotiate that!
Of course, before signing your lease, you should completely understand its terms and how they may impact your business. Not understanding what you are signing and what your rights are can have serious consequences after the fact.
Description of the Property You Are Leasing
A commercial lease should clearly set out the description of the property you are leasing in addition to what areas of the property you have use of such as parking, restrooms, kitchen areas, and other common areas.
Rent Amount and What it Includes
Commercial rent is typically calculated based on usable square footage. But it is important to understand what is considered in this usable square footage figure. Does the rent include utilities? Does it include your portion of the insurance and property taxes? Does it include any repairs? You may be obligating yourself to these things separately as “other costs” that should be thoroughly understood before you sign the lease since they can quickly add up.
If the lease covers a space that is part of a center or other multi-tenant property, it is common for that lease to provide that the tenant is responsible for some percentage share of common-area maintenance (or CAM). From the landlord’s perspective, charging the tenants for CAM makes a great deal of financial sense. However, since it can theoretically be abused, tenants are often well-advised to request a cap on the year-over-year increase in CAM.
What is a Triple-Net Lease?
A triple net lease (or NNN lease) is a lease that makes the tenant responsible for its share of taxes, maintenance, and insurance. Triple net leases are very commonly used by real estate investment trusts (REITs) and other large real estate investors, because a triple-net lease reduces the variability among properties and allows for the investor to implement a more “pure play” investment strategy.
What Your Lease Should Say About The Term & Termination
As mentioned above, commercial leases tend to be longer-term than residential leases. And, of course, this is what landlords want! Longer-term tenants are more valuable, more stable, better for economic and strategic planning, so on and so forth.
Of course, while some business owners don’t mind this longer lease, many other business owners don’t want to be tied to a longer lease! In some circumstances (especially in an unfavorable market) it may be possible to negotiate the term of the lease.
Landlords may, on occasion, demand increased rent in exchange for a shorter lease term. Depending upon your business goals and objectives, this could be a fair trade.
Two other prominent issues in the arena of lease terms are: (i) termination of the lease – how much notice is required, what fees are payable for termination, and under what circumstances can the lease be terminated and (ii) renewal terms – who can initiate a renewal term of the lease, how many renewal terms are there, what rate of rent will be paid, and how long are the renewal terms for?
What Are the Terms of the Security Deposit?
Your lease should address the amount of the security deposit and under what conditions you will receive this money back. The size of the security deposit is often negotiable, and will vary depending upon the size and quality of the leased premises. If the security deposit is large, this will be another up-front cost to begin your lease, so consider carefully.
What Improvements You Can Make Under Your Commercial Lease ?
A commercial lease should clearly set out what modifications or improvements you can make to the space and who is responsible for paying for them. This will become especially relevant in cases where the business leasing the space has specialized requirements (for example, a steakhouse with high-temperature searing/cooking equipment and high-speed ventilating that will accompany it, or a gym who wants to bolt equipment into the walls).
Both tenants and landlords should be aware of lease requirements to return the space to its original condition once the lease is up, and/or what modifications are permitted under the lease (and what modifications are to be paid for by whom!)
What Is a Use Clause? Should My Commercial Lease Have a Use Clause?
Some commercial leases have restrictive provisions that specify the type of activities that the tenant may and may not engage in on the property. This provision is called a “use clause” and it can be common with retail centers or office centers (but will be less common with more permissive types of property such as industrial).
While a use clause can be very beneficial for a landlord, and is indeed mandatory for some rentals – because it will limit the landlord’s liability as well as protect the value of the property and (at least in theory) maximize rental revenue from the other connected rental sites by preventing uses that tenants or customers of tenants may find objectionable – a use clause may or may not be good for a business owner. One the hand hand, as a business owner, a broad use clause may allow you to expand into other lines of business in the future. On the other hand, a use clause (if the other tenants are required to sign the same or a similar use clause) can prevent obnoxious tenants from moving into nextdoor spaces and driving away your clients.
For example, if you are operating a day-care center, a use clause that says no strip clubs are allowed in any of the sites adjacent is a good thing, because it eliminates one way that you could lose customers.
What is an Exclusivity Clause in a Lease?
Exclusivity clauses prevent a landlord from renting space to a competitor of yours or someone with a similar product. If yours is a customer-facing business of any sort, this is something you will want to be included in your lease. For a landlord, this can add value to the tenant and potentially raise the amount of rent the tenant is willing to pay.
When evaluating exclusivity clauses, pay special attention to the way that the line of business is described. For example, consider the difference between “nail salon” vs “beauty salon” or “liquor store” vs “alcoholic beverage store” and so forth. Be sure to describe your business (and, potentially, future lines of business you may wish to expand into) properly in the exclusivity clause.
Rent Increases in Your Commercial Lease
It is common for a commercial lease to provide for an annual rent increase – sometimes the increase will be tied to an inflation rate, while other times it will be tied to a number specified in the lease itself. While a rent increase is customary in a commercial lease, a business owner should consider trying to negotiate a lower rate of increase or a percentage cap, etc., to ensure that those rental increases don’t become unmanageable in the future.
On the other hand, the landlord will want to negotiate a sustainable rate of rent increase, rather than squeezing every last drop of rent out of the tenant, as this may cause the tenant to move elsewhere, leaving the property vacant. Paradoxically, the result would be a long-term result of lower rent.
Subletting or Assignment Provisions in a Commercial Lease
In the event that you decide to move or your business is not successful, you don’t want to be left on the hook for paying rent for the remainder of the lease term. If you simply break the lease or move out without notice, you could be liable for all of the payments on the entire remaining duration of the lease.
There are two alternatives available to consider in such a situation. One alternative is subleasing or subletting the property (which is where you become something like an “intermediate landlord” where the landlord leases to you and then you, in turn, lease to someone else). The other alternative is an assignment, where you would assign the lease to another person who would “step into your shoes” for the purpose of the lease.
Both a sublet clause and an assignment clause offers the ability to have someone else cover rent for the remainder of the lease term if you cannot do so. Accordingly, reviewing the lease for whether sublease or assignment is allowed, and under what circumstances it is allowed (and whether the consent of the landlord is required), is usually good idea.
Signage Provisions in Commercial Lease
If your business relies on visible signage from the street, you will want to be sure that you are not prohibited from doing this in your lease agreement. Checking with local zoning regarding signage restrictions is also essential.
ADA Compliance Rules in Commercial Lease
If your business is open to the public and employs more than 15 people, the law requires you to comply with the Americans with Disabilities Act and make the space accessible for those with disabilities. Some buildings may be “grandfathered” in as long as significant changes are not made.
Your lease should specify who will be responsible for any changes that must be made for compliance and who will pay for it.
Other Resources – The Series LLC
If you would like to learn more about some of the different options available for real estate investors to protect themselves, you can also listen to our video on the Series LLC here:
Getting Professional Assistance
Because laws change constantly and there are many moving parts in a commercial lease agreement, components should be thoroughly examined from all angles. It is always advisable to get professional assistance before you sign any commercial lease agreement to understand your rights and your obligations. When you are considering a commercial lease, the San Antonio real estate attorneys at the Law Offices of Ryan Reiffert, PLLC are happy to help. Contact us to schedule an appointment.