I recently led a seminar on commercial leases for my local Small Business Development Center. I have led two such seminars, and I realized that I could share what we discussed as part of my blog and maybe help many more people.
I expect that this will be a series of posts, perhaps four or so.
What is a lease?
Legally, property rights can be divided into two main rights: the right of ownership and the right of possession. When you own a home or office, you have both of those rights, but when you lease a space you are paying for the right of possession only.
The right of possession generally means that you have the right to occupy the space and prevent others from occupying it. You can use the space in any way you see fit for the length of the lease. But there are caveats that are imposed by the lease that dictate how the space is used and how much you must pay for it.
You will hear certain terms thrown around when discussing commercial leases. Two important terms that you should be aware of are “gross lease” and “net lease”. A gross lease is a lease where the utilities and real estate taxes are included in the rental price. A net lease is a lease where those other expenses are charged to the tenant separately. One is not better than the other, but it is important to understand what is included in your rent.
What do I look for in a lease (or contract) generally?
I always ask myself three questions when I’m reading a contract, and a lease is merely a specific form of contract.
- What does this section mean?
- Why does this section matter?
- How would I improve this section?
I ask these questions over and over again as I review a lease. If you cannot answer one of these questions, you need to dig deeper or talk to an expert. In my experience, there are rarely sections in a contract that have no meaning or effect.
By the way, I missed the most important thing you will learn from this series: read the contract. Again, READ THE CONTRACT. Too many people simply take the broker’s word for what is in the contract and sign away without taking the time to read it. I understand that you may not have the funds to hire a lawyer, but that doesn’t mean you should sign something blindly.
The last thing I look for in a contract or lease is clarity. You should always seek clarity. Any time you see language that says “this will be decided later” or “whatever the landlord needs to make this happen” a huge red flag should pop out in your mind. Every term should be clearly defined. Don’t assume that these things can be ironed out later. Once a conflict starts, you will want to rely on the contract to work through the issues. If the contract is not clear, the conflict may spiral out of control.
The rest of this series will be dedicated to discussing specific terms that occur in commercial leases. I want to talk about what they mean and why you should pay attention to them.
Every lease will define the space that is being leased. It will lay out the space that the tenant controls and the space controlled by the landlord. There should be a calculation of square footage included. This is important for a few reasons.
First, you need to understand how much space you really need. Commercial leases are generally signed for three to five-year terms (we will discuss term later). That means that you need to consider the space you will need today and three years from now. Is your business growing, for example? Better plan on a little more space to grow into. This is not a legal consideration, but it’s a serious consideration nonetheless.
Second, the square footage affects other provisions of the lease. For example, you may qualify for a sign on the outside of the building, if you have enough space. It will also dictate the common area expenses you will have to pay, which are normally calculated based on a pro-rata share of overall square footage. Taxes are also influenced heavily by the square footage of your space. You need to pay attention to how sections on square footage interact with other sections of the lease.
Term refers to the length of the lease. As I mentioned earlier, commercial leases are generally three to five-year leases. Many new business owners want to sign a short lease because they, accurately, realize that it limits their liability in the event the business does not work out. But there is risk in both long and short leases.
A long lease potentially carries high liability for the business owner in the event the business fails. This is also true if the business grows very rapidly and needs more space – this is also a problem, but the best kind of problem. Therefore, by signing a long lease the owner is taking a risk.
But a short lease is also a risk. If you have a retail location, a short lease can be a major liability in the event the business does well. If you have a retail location that is growing rapidly and has a dedicated following, renegotiating your lease can be very difficult. Your landlord can charge you much more to stay in the space, and if you leave your business will likely die. That is a tough spot to be in a year into a business endeavor.
A three-year lease is a good starting spot. Be confident in your business and sign a lease that makes sense for both success and failure.