Commercial Leases: A Few Things to Look Out For
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Although we always recommend that prospective tenants work with a commercial real estate agent (as well as a commercial real estate attorney) when negotiating leases, it is good to be an informed consumer and know some things to look out for when entering into a deal. A typical commercial lease in a market like Greater Nashville is for at least five years during the base term and requires significant startup and maintenance costs beyond the base rent. Starting a brick-and-mortar business is expensive. Oftentimes, it is the only viable way to go, but one should know everything that’s involved and be sure that both the timing and the deal are the right fit for one’s business. The following paragraphs included some things to be aware of during the lease-negotiation stage. This is not a comprehensive list, but does include some key things you will want to focus on, beginning at the letter of intent (LOI) stage.
Lease Structure
What kind of lease is this, anyway? There are multiple, common lease structures you will encounter in the marketplace, and this is one of the first things you’ll want to keep in mind as negotiations begin. Although you can push back and try to negotiate most every aspect of a commercial deal, this is one that is usually firmly in place from the outset. It’s the foundation of the deal that everything proceeds from. Lease structures include:
Triple Net (NNN) Leases: This lease structure has become incredibly common, and there are more of these listed in the Nashville market than any other type. In a triple-net lease, one is paying not just the base rent, but also the triple nets: property taxes, insurance, and common area maintenance (CAM). So, in a typical listing, you’ll see price per square foot (per year); you will see “NNN” (meaning it’s a triple-net lease); and you may or may not see an estimate of what those passthrough expenses will be. Let’s say the NNN are listed, and the number is $10 per square foot, and the base rent is $30 per square foot. To calculate the monthly rent for this space, you would add the base rent and the NNN then multiple by the number of rentable square feet (RSF) and divide by 12. Therefore, if the example space has 2,000 RSF, the formula would look like this:
$30 + $10 = $40 x 2,000 = $80,000/12 = $6,667 per month
Full-Service Gross (FSG): In a NNN lease, not only are you paying the base rent and triple nets, you are also paying for utilities and the majority of the maintenance. In contrast, FSG leases have everything covered. This makes for a very simple formula (price per SF x RSF / 12 = total monthly expenses for the space), and that is one of its advantages. It is very straightforward. But make no mistake, the landlord is going to be sure that he or she is more than covered when it comes to all the expenses and operating costs. This lease structure may be easier for budgeting purposes, but that doesn’t necessarily mean that it’s the best value.
Modified-Gross Lease (MG): Many non-institutional landlords and landlords in smaller markets have some form of modified-gross lease. In an MG lease, it is going to be a kind of hybrid between NNN and FSG. Example: The landlord may pay the property taxes, insurance, and the majority of the CAM, but require that the tenant pay the utilities and most of the maintenance costs. An MG lease is a reminder that when it comes down to it, an owner/landlord can set things up pretty much any way that he or she wants when structuring a commercial deal.
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Base Rent and Length of Term
Base rent is one of the main areas that can be negotiated on. What are the chances that you will be able to get a better rent rate than the one the agent has quoted you? It depends. How competitive is the space to get into? Do they truly have it priced correctly? How badly does the landlord want you and your business in there? It never hurts to try a lower number, and a good commercial agent with a firm understanding of the market knows where the reasonable starting point is going to be. Another factor a landlord is going to consider is preferred term length. If you are looking for a term of one to three years, that could be a non starter, but if you are willing to sign up for seven to 10 years, then that could be a trigger for a few landlord concessions (again, if they really want you there).
Financials
In a commercial real estate market like Nashville, landlords can be extremely cautious and selective about whom they allow to occupy their spaces. More often than not, they are going to want to see some financials: P & L reports, tax returns, credit scores—anything is fair game. They are also going to want some kind of guarantee that they are going to get their money, especially if they’re having to pay out any tenant improvement allowance (TIA) or broker commissions in order to get the deal signed. Don’t be surprised if you are asked to sign a personal guarantee, take out a letter of credit, or put down a fairly large security deposit. All three of these methods of securing a lease are common. Think of it this way: If you were a landlord, and you were considering a new tenant for your valuable asset, especially one that isn’t a corporate-backed, wouldn’t you want some added assurance that the investment was going to pay off? However, as with other aspects of the negotiation, this is a two-street, and prospective tenants are only going to want to give so much in this regard. When negotiating with a landlord, it helps to have someone on your side who is capable of thinking like one!
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Escalation Clause
A rent escalation clause always the landlord to increase the rent rate over time. Every lease has one. The way they are structured, though, varies widely. Some are 2% annually; some are 3%; some are tied to the consumer price index (CPI). Some do not increase annually, but adjust to market rent upon renewal. Look for this clause in the lease you are considering signing. It’s also usually included at the LOI stage, so you will know what the landlord is thinking here early on. If you aren’t comfortable with the escalation schedule consider choosing this as one of the deal terms you push back on.
As previously mentioned, there is much more to a commercial lease than is listed in this article, but these are a few key areas that set the tone and shape a potential deal, should discussions move forward. Always enter into binding contracts with knowledgable advocates working on your side, and if things aren’t seeming right to you, or if you feel like the other side isn’t negotiating in good faith, remember that the deal isn’t done until the lease is fully executed. That stated, more often than not, if you make it past the LOI stage, and you have qualified professionals working hard on both sides to represent their respective clients, then this will result in a deal that is in everyone’s best interests once the ink on the lease agreement dries.
