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Understand the Dangers of Commercial Leases

A commercial lease for office or retail space is a serious commitment for your business. They are typically long-term contracts lasting at least five years, the rent is often your second-biggest monthly expense after payroll, and the rights and limitations in your lease agreement have major effects on your ability to expand, contract and relocate your business.

Companies large and small can make major mistakes when planning for new space and negotiating the lease – these are the most common.

1. Not Allocating Enough Time

Conventional wisdom in the commercial real estate industry is to allow six to 12 months to complete a deal for less than 10,000 square feet and nine to 18 months for larger deals. The lead time is required for the various complicated steps in any business relocation – finding the right business attorney, due diligence of possible locations, negotiation of the lease, planning and design of your new space with an architect and engineer, bidding out and awarding the construction work required to customize the space (known as a “fit-out”), obtaining construction and business permits, and completion of the fit-out itself.

Just as important, the lease commencement date needs to take these steps into account. Otherwise, you’ll be paying rent for the new space before you’ve moved in. You’ll also need to coordinate your plans with your current landlord by giving sufficient notice of your move and negotiating a rent deal for any period that you remain in your current space beyond the term of your current lease (known as a holdover).

2. Insufficient Planning

Closely related to the lead time issue is the failure to adequately plan your new space. The way you want to do business should drive the location and design of your space; your real estate shouldn’t determine how you do business.

You need to think about how much space you need and whether you need any specialized space (reinforced floors for heavy equipment? a data center? backup power?). An experienced architect and a good tenant broker/representative can help your senior management consider all the right issues, including:

  • How will you coordinate moving all your business functions, particularly technology and your employees?
  • Who will make decisions about the ongoing project (a committee or one person)?
  • What corporate image do you want to project, and what kind of office space will convey this image?
  • What ratio of collaborative office space vs. private office space makes sense for how your business is run?
  • What is your budget?
  • What space plan makes sense for possible growth? (e.g. How much additional space might be needed in the next three to five years? Or is there a possibility of downsizing?)

3. Lack of Representation

There is no such thing as a “standard commercial lease.” Landlords – the building owners and their property managers – do not have your best interests in mind when they draft a lease, and business real estate deals have none of the legal consumer protections of apartment leases. The financial terms and legal provisions of most commercial leases are specialized and hard to understand, and most business people lack the background to effectively review and negotiate a lease agreement.

You’ll need an experienced commercial real estate lawyer admitted in the state where the property is located – preferably one who has dealt with your landlord (or your landlord’s lawyer) in prior deals. You should also seriously consider engaging a tenant broker/representative – a consultant that represents only commercial tenants (and NOT building owners or property managers) in leasing deals. A good tenant rep will know the condition of your market (like the current “market rent” per square foot in your city), the present and future vacancies in the buildings you are considering, and the best way to deal with the landlords of those buildings.

4. Lack of Due Diligence

The physical and legal condition of your company’s space can significantly affect your business operations, and you need to protect yourself with an investigation of the facts. In addition to reviewing the proposed lease, your real estate lawyer should also:

  • Confirm that the building’s zoning will permit your company to conduct its operations as intended.
  • Engage a title company to produce a report of the building’s liens, mortgage lenders and any pending legal claims.

In addition to planning and designing your new space, your architect and engineer should inspect the building’s electrical, plumbing and HVAC systems and review the space’s compliance with building codes, fire and safety regulations, and disabled person access laws. Your architect should also confirm that the leased space actually contains the square footage stated by the landlord.

5. Not Understanding Crucial Lease Provisions

Term

This is the length of the lease – the commencement and termination dates. Like everything else in a commercial lease this not as straightforward as you think.

  • Does the term start when you sign it or only after you commence operations in the space (i.e. when the fit-out construction has been completed)?
  • Even if rent isn’t payable until you move in, is your business on the hook for building insurance and maintenance charges starting at the signing?
  • Near the beginning of the lease, you’ll see a clause entitled “Term.” This clause describes the length of your lease and specifies the starting and ending dates.
  • How can the Term be extended – does it happen automatically or only after a party gives notice?
  • Are there circumstances when you or the landlord can end the Term early?

Calculation of Rent

The calculation of rent and other tenant charges in most commercial leases is complicated and can result in some unpleasant surprises during the lease term if the terms aren’t fully understood at the beginning.

Some of the common rent structures are:

  • Single net lease or net lease: The tenant pays only its portion of the utilities and property tax (calculated by the percentage of space leased in the building), while the landlord pays for all maintenance, repairs and insurance.
  • Net-net, or double net lease: The tenant is responsible only for its portion of the utilities, property taxes and insurance premiums for the building (again, based on the percentage of space leased in the building), with the landlord paying all maintenance and repairs.
  • Triple net leases: Tenant pays its portion of all costs of the building, except the landlord is generally responsible for structural repairs.
  • Full service gross, or modified gross lease (also called modified net lease): The tenant and landlord agree to split structural repairs and operating expenses (property taxes, property insurance, common area maintenance and utilities), with the tenant’s portion called “base rent.”
  • Percentage lease: Used almost exclusively for leases of retail space, this type of lease means some portion of the rent is calculated as a percentage of the tenant’s customer sales at the property.

In addition, you need complete clarity on how and when rent can be increased – both on an annual basis and cumulatively over the entire Term.

Security Deposit

Unlike a standard apartment lease, a commercial landlord can demand more than 2 months’ rent in cash. It can be whatever amount the landlord thinks it needs based on the creditworthiness of your business. If you are a brand new business without an operating history this will be a big issue for the landlord.

The landlord can also demand a security deposit in the form of a Letter of Credit issued by a bank. With an LC your bank sets aside a portion of your cash so that the landlord has an easy remedy if you breach the payment obligations under the lease (the landlord doesn’t need to sue you in court).

Improvements and Alterations

If the new space needs to be renovated or customized for your operations (a “fit-out”), the lease needs to specifically address these issues. You’ll need to negotiate who does the space design work, who does or manages the construction, whether there are hard deadlines for completion and who pays for it. It is also important to reach agreement on any rent payment obligations during the fit-out.

Parking and Signs

Day-to-day details can also be important in the lease. Does renting space in the building entitle you to a certain number of parking spaces? Do you need to pay for additional spaces if you need them. Where can you install signs identifying your business? Do they need to be designed in a certain way?

Disputes

If your business and the landlord get into a dispute, how will it be resolved? Is there a required period of negotiation? Do the parties need to submit the dispute to mediation (usually cheaper than court) or can the parties sue each other immediately? Are rent obligations suspended during a major dispute? Can you withhold a portion of the rent that reflects the cost of the disputed issue?

6. Not Focusing the Lease Negotiations on Key Business Issues

Prospective tenants should not focus only on the rent and other payment terms – other key lease provisions can be much more significant to the future of your business. It’s also important to be aware of State or City specific factors. For example, a qualified contract attorney in NYC will be much better suited to answer your questions than an attorney in Oregon. It’s important to ask and resolve the following questions:

  • How much notice does the landlord entity need to give if it wants to relocate your space to another part of the building?
  • Can you sublet or assign part of the lease if your business contracts?
  • Can you acquire additional space in the building if your business expands?
  • Can you cancel the lease and move to another building if there’s insufficient available expansion space?
  • Can you extend the term if you want to stay in the building?
  • Can you assign the lease to a buyer of your business?
  • Is the lease still valid if your business has a change of control?

7. Underestimating Negotiation Leverage

A tenant representative will understand the current condition of the real estate market in your city and the current situation of your particular landlord. For example, does the landlord need tenants? Is it about to lose a major tenant which will cause a significant vacancy in the building? Or does the landlord have a fully leased building for the indefinite future? Without this information, your company won’t understand how much negotiating leverage you may have and the range of incentives your landlord may be willing to offer to sign a new tenant.

Landlords will commonly agree to:

  • Periods when no rent is payable (so called “free rent”).
  • Periods of discounted rent.
  • Contributions to the costs of the tenant’s fit-out of the space.
  • Make certain improvements to the building that the tenant wants or needs.
  • A cap on annual rent increases (including the portions tied to building expenses).

In addition, landlords can often be persuaded that no personal guarantee will be required from the tenant’s owners or major shareholders to back up the payment obligations in the lease. Or if a guarantee is required at the beginning of the lease, landlords will sometimes agree that it expires a few years into the initial term once a you establish a reliable payment history.

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