Some Things You Should Know
by Christian S. Peek CCIM
Commercial leasing is one of the most interesting and least well understood areas of commercial real estate. The topic of commercial leasing could easily fill the shelves of an entire library. However, for the purposes of this article we will address a few of the basics of what comprises a useful "win-win" lease for both Tenants and Landlords leasing existing small to medium sized office and retail space.
It is important to understand some of the basic building blocks" of a good commercial lease contract. Without a concrete understanding of these specifics significant "gray" areas can exist that are ripe for misunderstandings and conflicts between Landlords and Tenants.
Getting The Easy Stuff Right:
The introductory section of a standard commercial lease will define the Lessor and Lessee (Landlord and Tenant respectively) and the property to be leased. A description of the property and a statement of its size is usually found in this section. In that the amount of the lease is usually a function of the size of the property multiplied by an annual "dollar per square foot" figure, it is important that the method used to determine the size of the space be agreed to by both parties.
Size quotes on commercial lease space of the type we are discussing are often based on an exterior measurement of the described space along the perimeter of the exterior walls. Many Tenants, however, can assume that this describes the interior floor space available to them and may base their space use plans on an expectation that there is (for example) 3,000 sq ft of interior usable sq ft, whereas, in fact, after eliminating foyers, stairwells and adjusting for exterior walls the actual space may be 10% to 15% less than expected. While this may seem a small amount of difference, available usable space is often critical to the how efficiently the Tenant can run their businesses and is not trivial to the Tenant. It is important to make sure everyone understands the basis of measurement in quoting available space.
Indexing Leases for Inflation with Escalator Clauses:
Any good lease whose term is longer than a year should have some provision to increase the lease amount annually by some agreed to index at some point in the lease, to allow the Landlord to keep pace with inflation and the potential increased costs of maintaining the space. The most common method is to index the lease amount to a rise in the Consumer Price Index or "CPI". In that there are several CPI's published annually by various government and financial institutions it is important to agree as to the specific one being cited for indexing the lease. Tenants should be wary of leases that use CPI to define the upper boundary of how much a lease can increase but set a high baseline (say 6% or more) for the minimum amount of increase. There can be a significant difference in rent at the end of five years for a lease indexing at a minimum of 6% annually versus one that would index at 2-3% annually by following CPI increases.
As a caveat, however, it should be noted that special circumstances can sometimes cause a lease to have no indexing provisions and to be set at a flat rate across the term. This may include situations where the Tenants are making significant improvements to the space or properties that have been difficult to lease.
Who is Responsible For What:
This is probably the area where most disputes can occur. A good lease should state explicitly and unequivocally what the mutual responsibilities of both the Landlord and Tenant are in maintaining the lease space. While there can be an infinite variety of arrangements regarding these issues most lease structures fall into the following categories.
A "net" (sometimes called a "net, net net") lease is one where the Landlord has the fewest responsibilities. Under this scenario the Tenant is responsible for property taxes, property insurance, and all maintenance in addition to utilities. This type of lease is most often seen in, new construction where warranties on the major expense (ie HVAC) items exist; shopping and professional office centers; and in situations where the Tenant is a "national credit" or institutional Tenant that has executed a very long term (10 to 20 year) lease and wants to be absolutely sure the maintenance items are attended to promptly rather than at the Landlord's convenience.
A "gross" lease occupies the opposite end of the spectrum. Under this arrangement the Landlord is responsible for all maintenance items including janitorial service and items as basic as light bulbs and toilet tissue. Typically, this type of lease is most often seen in government leases (especially federal). This type of lease while disdained by many Landlords because of the maintenance and support headaches involved can often be an excellent source of revenue because the Tenants in these situations are willing to pay well above and beyond the costs of implementing this level of service in exchange for not having to concern themselves with these details.
The majority of leases for small to medium sized commercial spaces lie along the continuum between the two extremes of "net" and "gross" leases. The most typical lease structure is where the Landlord is responsible for the roof and structural elements (bricks and sticks) in addition to "major maintenance". Major maintenance is usually defined as maintenance on heating and cooling systems, exterior plumbing and exterior electrical systems.
The Tenant is usually responsible for utilities (if separately metered), annual service checks on the HVAC system(s) (up to some preset annual amount), and interior maintenance (including exterior glass and doors). Items such as property taxes, property insurance, and exterior grounds maintenance are subject to negotiation depending on the space and specific lease deal. Concrete and specific language identifying which party is responsible for maintaining which items can head off many potential disputes.
Zoning and Use Factors:
Incredible as it may seem there are often situations where leases are executed prior to any determination being made by the Landlord or Tenant that the Tenant's intended use is allowed within the Zoning District applicable to the property. In many cases if the Tenant's use is not specifically stated as an inherently allowed use in the Zoning Code and no provision has been made to get a special exception or other variance for the intended use, the enforceability of the lease can be open to question and the term may be subject to the Tenant's (or the Building Inspectors) whim on a month to month basis.
It is important for both the Landlord and Tenant to understand the specific requirements of the applicable Zoning Code and to have an very explicit statement in the lease as to the Tenant's intended use and that this use is allowed within properties zoning. As a side note it is important to require the Tenant, as a condition of the lease, to keep current all permits and licenses necessary for conducting their business.
Who Am I Leasing To?:
This question is not as simple as it seems. In many cases if the lease is not personally guaranteed by a signatory to the lease the only guarantor is the Corporation identified as the Lessee. Corporations like anything else come in a variety of grades from "prime" to "poor". If the Landlord is going to be doing significant, special purpose improvements to the space and the corporate Lessee is a new or unknown quantity it will often make more sense to have the Tenants pay for retro-fitting the space and to abate the rent for some number of months equivalent to the retrofit cost rather than spending this money upfront on the bet that a brand new or otherwise questionable corporate Tenant will perform.
There have been situations in which to evade a Lessor (among other creditors) a corporation would transfer all its assets to another corporation and essentially become a valueless corporate "shell". After vacating the premises, when the Landlord sued for breach of contract there were no significant corporate assets to attach. While Landlords usually have less to worry about with "national credit" tenants (although there are notable exceptions to this rule) there needs to be a notation in the lease that if the business or corporation signing the lease changes hands that the Landlord must be notified in writing of this occupance and approve the lease transferring to this new Tenant.
In this brief discussion I have only been able to touch on a very few of the aspects of what comprises a good commercial lease. If any readers have specific questions about the advisability, applicability or legality of a specific lease or lease clause they are encouraged to contact an attorney who specializes in real estate and/or contract law.
By Christian S. Peek CCIM
Associate Vice President
Long & Foster
Commercial / Industrial Division
June 28, 1996 Christian S. Peek All Rights Reserved