8 Commercial Real Estate Lease Clauses to Know
A commercial real estate lease is a contract between a tenant and a property owner that entitles one to lease a specific space in return for a set monthly rental payment. A lease agreement can be lengthy and incredibly dense with legal language, which can make such agreements challenging to read.
For individuals considering a private real estate investment, there are eight terms—or clauses—that should be identified in every commercial lease to aid in the investor’s overall comprehension of the arrangement.
1. The Leased Premises
A commercial property can contain many different units or leasable spaces, which makes it important to identify exactly which space the tenant is entitled to occupy. The space is usually identified by a unit number and is accompanied by the number of square feet that it comprises.
The language of the lease may also differentiate between the leased premises and the common areas, which can be used by all tenants.
2. The Lease Term
The lease obligates the tenant to pay rent for a certain period of time, and the legal language will contain the start date and the end date. The start date is the date that the tenant must start paying rent, and the end of the lease is the date after which the tenant no longer has to pay rent. The duration in between is the lease term.
Aside from the base lease term, the lease may also contain a provision for lease extension options. For example, it could say something like, “…the lease has a base term of 10 years with two (2) five- (5) year extension options…” This means that the tenant, at his or her discretion, has the option to extend the lease term by those increments once the base term expires.
3. The Rental Payment and Expenses Reimbursements
For the privilege of occupying the identified space, the tenant is required to pay a specified monthly rental amount. Depending on the type of lease, it can be one single payment or two—and the difference has to do with the property’s operating expenses.
In a Net Lease structure, the tenant is responsible for paying some or all of the property’s operating expenses. For this reason, their base rent payment tends to be higher.
In a Gross Lease structure, the base rent amount tends to be lower. But, the tenant has to pay an additional amount to cover their proportional share of the commercial building’s maintenance costs. In this case, the lease will specify the base rental amount, the tenant’s share of operating expenses, and the total amount due each month.
This clause will also indicate the amount of the required security deposit (if any), as well as whether the rental amount will increase at regular intervals.
4. Permissible Uses
A typical lease for a commercial space contains language about the acceptable use(s) of the leased premises, and there are two parts.
Nearly all leases contain some sort of language specifying that the tenant is not allowed to do anything illegal within the leased premises. Often, the lease will outline which types of illegal activities are expressly prohibited, such as gambling, firearms manufacturing, or activities related to the production or distribution of illegal drugs.
The other type of prohibition focuses not on the law, but on the other tenants of the property. Retail leases in particular may specify a type of business that a tenant is not allowed to operate, in order to protect the interests of the property’s other tenants. For example, if a retail shopping center contains a coffee shop, the other tenant leases may state that they are not allowed to operate a coffee shop.
A co-tenancy clause is particularly prevalent in retail leases wherein smaller tenants rely on the traffic created by larger tenants to generate their own sales. If such a clause exists, it states that the tenant is entitled to some sort of rental relief should the total occupancy of the property fall below a specified level for a certain period of time. This clause is particularly favorable to the tenant, and should be understood thoroughly when present.
6. Events of Default and Rights to Cure
A lease is a legal contract. As such, there are consequences to violating the terms of it. The typical language in a commercial lease identifies what constitutes an event of default and what happens when it occurs.
An event of default can be as simple as a tenant missing a certain number of lease payments. But it can also happen if the tenant fails to abide by other key terms of the lease—for example, if the tenant is found to be operating an illicit business, or fails to maintain the leased space adequately. The lease will specify exactly what constitutes an event of default.
If the tenant is found to be in default, the lease will also specify the consequences. In most cases, this can range from relatively minor to major repercussions. On the minor end, a tenant could be assessed late fees, or the amount due could be subject to interest charges. The tenant would be given a specified period of time to “cure” the default—that is, to make it right. And if the tenant fails to do so, the consequences can become more severe, including eviction.
7. Tenant Improvement Allowance
This is particularly common in leases for retail and office buildings. Tenants may have specific needs when it comes to the interior buildout of the leased premises. For example, they may need certain shelving fixtures, flooring, or paint colors to properly represent their branding. The cost of these improvements may be partially absorbed by the property owner as an incentive for the tenant to sign a lease.
The lease will specify exactly how much tenant improvement allowance the property owner is offering, often expressed as an amount per square foot, as well as when it will be paid.
8. Assignment or Sublease
If a tenant runs into financial difficulty or if it turns out they have leased more space than they need, one of the first options for solving this issue is to sublease the space. However, not all leases allow this.
Sublease clauses specify whether or not it is allowed for a given space and lease agreement. If it is, it will also specify the terms under which the tenant may sublease their property. Often, the tenant must obtain the approval of the property owner, but there may be additional conditions outlined, as well.
Another option is for the tenant to assign his or her lease to someone else. Again, the language in this clause will specify whether or not this is allowed—and, if it is, it will also outline the conditions under which it is allowed. Usually, it will also require the property owner’s approval.
Why Does It All Matter?
In the realm of commercial real estate investing, familiarity with the specific terms within a tenant lease is a matter of cash flow and risk management.
It is important for cash flow because a financial analyst needs to review each lease and then forecast the cash flow that the lease will produce as part of a financial model for the property. To do so accurately, analysts need to be familiar with the lease term, rental rate, square footage, lease escalations, and expense reimbursements. They will plug all of these factors into their model to produce a cash flow forecast for the entirety of the investment holding period.
From a risk standpoint, lease specifics also matter as part of a robust risk management program. For example, suppose that the leases for five tenants all expire around the same time. As part of an active risk management program, the property owner needs to develop a plan for negotiating lease renewals or finding new tenants. This will allow the owner to get ahead of any potential issues and address them before they impact the cash flow of the property.
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