The defining characteristic of a commercial real estate asset is that it contains space that is leased to businesses (with the exception of multifamily buildings, where space is leased to individuals). The terms and parameters under which a tenant is allowed to occupy a commercial space are codified in a commercial lease agreement.
Commercial real estate leases are lengthy, complex, legally dense documents that can be difficult to read. But, understanding key clauses, definitions, and parameters are a critical component of the pre-purchase due diligence phase of a commercial real estate transaction. In this article, the common types of commercial real estate leases are described and typical clauses are discussed in detail. Upon completion, readers will have a greater understanding of the structure and terms contained within a typical commercial lease.
At First National Realty Partners, we invest a significant amount of time and effort into reviewing and understanding a property’s leases prior to making a purchase. We believe this is an important ingredient of our success. To learn more about our current investment offerings, click here.
Commercial Lease Types
Let’s begin with a definition of exactly what a commercial real estate lease is.
A commercial real estate lease agreement is a legal contract between a property owner and a tenant in which the tenant is allowed to occupy a defined space in exchange for monthly rent. Beyond the rental rate, the lease contains a number of key clauses regarding things like: how operating expenses are handled, when the tenant is allowed to enter the property, and the term of occupancy.
There are two types of commercial leases, “Gross” and “Net.” The key difference has to do with who has responsibility for paying the building’s operating and common area maintenance expenses.
In a full service gross lease, the tenant pays one monthly rental amount and the landlord pays for the property’s operating expenses like real estate taxes, maintenance costs, HVAC, and utilities. Tenants like this lease structure because it is simple and they only need to make one payment per month. Property owners like this structure because they can charge higher rent under the premise that they need to use some portion of it to pay for operating and maintenance costs. However, this structure also exposes property owners to the risk of rising operating costs. If they go up, they are not able to pass them on to the tenant.
At the other end of the spectrum, a Net Lease structure requires that the tenant pay a monthly base rent amount plus some portion of the building’s operating expenses. There are four types of net leases:
- Single Net Lease: Tenant pays base rent plus one of the property’s major expense categories, usually property taxes.
- Double Net Lease: Tenant pays base rent plus two of the property’s major expense categories, usually taxes and insurance.
- Triple Net Lease (NNN lease): Tenant pays base rent plus all three of the property’s major expense categories, taxes, insurance, and maintenance.
- Absolute Net Lease: Tenant pays base rent plus all of the property’s operating expenses.
Tenants like the net Lease structure because it gives them a bit more control and the base rent amount is typically lower. Property owners like net leases because they can pass some or all of the building’s operating expenses on to the tenant, which lessens their own risk. However, net leases are also more complicated to administer and require a time consuming reconciliation of actual operating expenses versus what reimbursements were received from the tenant.
While these commercial lease types are widely used, the exact terms and structure of a lease is unique to each deal – which underscores the need to read each of them carefully.
Understanding Common Lease Clauses
In a commercial property, the term “lease clause” simply refers to a section or portion of a lease that contains legal language around some topic. Despite the uniqueness of each commercial real estate lease, a large portion of the clauses tend to be very similar. They are discussed in this section.
The “delivery condition” clause describes the required condition of the space at the time the landlord delivers it to the tenant. In some cases, it could be a blank slate and the tenant will handle the build-out. In other cases, the landlord may be required to deliver it fully built out. In either case, the space should be free from any other claims of tenancy.
It may seem trivial, but the identification of the leased premises carries an important legal distinction. It will describe exactly how many square feet are in the leased space and it is usually identified by a unit or suite number. For commercial leases that charge rent and/or operating expenses by the square foot, this is a critically important definition.
Allowable Use of Premises
This clause describes how the tenant is allowed to use the leased space. Depending on the property type, it may contain very broad language that says the tenant is not allowed to use the leased space for any illegal activity. Or, and this is common in retail spaces, it may be more specific about what type of business the tenant can and cannot run. For example, if a retail shopping center leases space to a national coffee chain, the other tenant leases may specifically state that they are not allowed to operate a coffee business. The point of this language is to protect all tenants in the property from unnecessary competition.
The building access clause is exactly what it sounds like. It describes when tenants are allowed to enter/exit the building. The exact terms are defined during lease negotiations, but the typical clause states that tenants will have open access to the property during normal business business hours (Mon. – Fri., 8AM – 6PM), but may be required to use a key card or sign in with security after hours.
This clause can also vary by property type. For example, a retail lease may require different hours and may require the property to be available during them.
Length of the Lease
There are three components used to calculate the length of the lease. First is the lease start date, which is the date that the lease agreement takes effect. Second is the end date, which is the date that the tenant’s obligations under the lease expire. Third, there may be some lease extension options that could extend the length of the lease further.
For example, suppose a lease has an initial start date of 01/01/2020 and an expiration date of 12/31/2025. This equates to an initial term of 5 years. If there are any extension options, the tenant could decide to extend the term for even longer.
Renewals and Extension Options
This clause covers whether or not the lease terms come with any options for renewal. Most commercial leases come with a “base term” and then an option for the tenant to extend the lease beyond the base term at their own discretion.
For example, a tenant could sign a lease with a base term of 5 years and then a single renewal option for another 5 years. This means that the total term of the lease could potentially be 10 years.
When a tenant signs a lease, it is legally enforceable for the entire term. But, sometimes things change. The lease termination clause defines what events or situations under which the tenant could terminate their obligations under the lease. For example, if the tenant goes out of business or the property suffers some sort of catastrophic damage in a storm, the tenant could terminate the lease and no longer have to make rent payments.
The rental rate clause also contains three key pieces of information, the base rent amount, what additional rent is required, and whether or not this rate changes during the lease term.
The base rental amount is typically stated as a dollar per square foot figure, for example it could be $10 PSF. Depending on whether the lease has a gross or net structure, the tenant may be responsible for some amount of additional rent, which is usually their pro-rata share of the building’s operating expenses. This is also expressed as a dollar per square foot. For example, the base rent could be $10 PSF and the additional rent could be $1.25 PSF.
Finally, a typical commercial lease may also include a “lease escalation” which represents an increase in the base rental amount over time. For example, the base rent could start at $10 PSF, but it could rise by 3% annually.
Holdover At Lease End
If a tenant continues to occupy the leased premises beyond the lease expiration date, they are considered to be a “holdover” tenant. If they continue to pay – and the landlord accepts – monthly rent, they are a legal occupant of the space and courts and/or local laws can determine the length of the lease.
If they do not continue to pay rent, they are considered to be trespassing and the property owner has the right to begin eviction proceedings.
The lease should specify exactly how a “holdover” situation is managed.
Common Area Expenses
Certain property types, especially office buildings and retail spaces, have many tenants that share common space like lobbies, parking lots, elevators, landscaping, and hallways. There is a cost associated with maintaining these parts of the property and it is usually shared by all tenants who lease space in it. The Common Areas Expenses clause will define what the common areas are, how much they cost to maintain, and how that cost is divided between tenants.
In most cases, each tenant is responsible for their pro-rata share of the operating expenses based on the amount of square footage they lease in the property. For example, suppose that a tenant leases 5,000 SF in a 50,000 SF building, which equates to 10% of the total leasable area. As such, they would be responsible for 10% of the total operating expenses. These are reimbursed as part of their monthly rent payment.
Security Deposit & Conditions For Return
The security deposit clause outlines two key pieces of information, the amount of the deposit and the conditions under which it will be returned.
The amount of the security deposit is a negotiating point between the tenant and landlord and can vary from one lease to another, but it is typically expressed in months of rent. For example, a security deposit could be 1 month of rent and it must be paid to the landlord prior to the tenant taking possession of the space.
The point of the security deposit is that it is used to repair any damage to the occupied space once the tenant leaves. As such, this clause needs to describe exactly how it will be held for the duration of the lease and what conditions are required for its return. Typically, the landlord will complete an inspection of the space once the tenant moves out and note any damage. Based on the results of the walk through, the landlord may return all or some of the security deposit.
Tenant Improvements / Modifications / Fixtures
Moving a business is not cheap. In addition, certain companies may have specific requirements for their space based on their brands or their type of business. For example, a technology company may need high speed internet and advanced video conferencing capabilities. Or, a grocery store may need industrial grade refrigeration systems and loading docks for deliveries.
These types of improvements – and their cost – is negotiated as part of the lease. In order to incentivize a tenant to lease a space, the landlord may offer to pay for some or all of the cost. Or, the costs may be the responsibility of the lessee.
This clause will also define what happens to the improvements when the lease expires. Often, they revert to the landlord, but the terms of the lease will specify what happens.
This clause is particularly relevant for retail and office leases and it will define what type of signage is allowable. These rules will often come from a combination of the branding for the property and the local rules and ordinances that govern signage. This clause may go so far as to specify the size of the sign, the colors, the wording, how it will be lit, and where it will be located on the property.
For example, suppose a large law firm leases the majority of the office space in a downtown office building. They may want their name and their signage located at the top of the building for all to see. This will be negotiated in the lease.
Repairs and Maintenance
In a commercial space, things break and this clause in the lease will describe who is responsible for repairing them. In most cases, the responsibility falls on the landlord, but it may vary by lease type. For example, retailers who sign a triple net lease may be responsible for handling their own maintenance. Or, business owners who sign a standard office lease may look to the landlord to make the needed repairs.
The sub-lease clause will specify whether or not a tenant is allowed to rent some or all of their space to another business during the term of the lease. In many cases, it is allowed, but the landlord must provide their approval first.
Practically, many tenants don’t sign a lease with the intent to sublease the space. But, over a term of many years, their needs may change, which could cause them to want to sub-lease it. For example, suppose that an accounting firm leased a large amount of office space with the idea that they would expand into a new market. But, the expansion didn’t work as planned and now they don’t need as much space. To save money, they could sublease the excess to someone else.
This may be one of the most important clauses in the lease. It defines what constitutes an “event of default” and what can be done to “cure” it. While the language mostly is geared towards the tenant, it is possible for the landlord to default as well.
On the tenant side of the equation, they could default by missing lease payments, using the space for a purpose that is not allowed, or doing something else that violates the terms of the lease. Tenant default cures include things like collection of past due rent payments plus late fees and even eviction.
The landlord could default if they do not provide access to the property during the required times or do not make requested repairs. Such behavior could be cause for the tenant to “cure” the default by terminating the lease.
Insurance & Liability
This lease clause will outline how much insurance the tenant is required to carry and where potential liability may lie in the event of an unexpected incident.
Tenants are required to provide insurance to protect both themselves and the landlord in the event of an incident. For example, in a retail center, it is possible that a shopper could slip and fall in a store, which results in a personal injury. In such an event, liability insurance would protect both the tenant and the property owner from financial penalty in the event of a lawsuit.
Finally, in the event of a dispute between the landlord and the tenant, this clause in the lease will determine how it is resolved. Often, it will require that each party seek their own legal advice before any additional steps are taken.
In an effort to avoid a full blown lawsuit, the lease may state that disputes are to be resolved through binding arbitration with a third party mediator.
Summary & Conclusion
A commercial lease is a lengthy, complex, legally dense document that outlines the terms and conditions under which a property owner will lease space to a tenant/business.
From a commercial real estate investment standpoint, it is critically important to understand the key terms of tenant leases and to build them into a financial model for the property. For example, if a lease has 3% annual rental increases and requires the tenant to reimburse the landlord for the operating expenses, these parameters need to be built into the model.
From a potential tenant standpoint, it is important to understand the terms of the lease as offered and to negotiate on points that will result in a favorable outcome. For example, it may cost $100,000 to complete the interior buildout of a space to meet the tenant’s needs. A tenant could negotiate to split this cost 50/50 with the landlord in return for signing a 5 year lease.
Finally, each lease is different. So, although it can be time consuming and somewhat tedious, leases must be read in full and a note must be made of the key terms. This process is often referred to as creating a “lease abstract” and it helps investors understand where the risk lies in a transaction.
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