Nov 4, 2020

This is the third installment of my series on commercial leases. I have noticed a general uptick in businesses (primarily new businesses) signing leases in my area. This series aims to cover the major issues that generally come up when reviewing a lease. If you need more specific help, please feel free to contact me.

Security Deposits

Most people understand what a security deposit is, but frequently, there are some misconceptions about how it should be used.

As a tenant, you will have to pay a security deposit. Generally, the amount is equal to one or maybe two months’ rent. The deposit is meant to be held by the landlord and applied to any unpaid expenses incurred by the landlord in connection with the tenant. The most common use of the security deposit is to fix the damage that the tenant left when they vacated the space. It can also be applied to any unpaid rent.

I think the biggest misconception about security deposits comes from landlords assuming that they get to keep the deposit. I have seen many conflicts arise because a landlord willfully withholds a security deposit after a tenant vacates a space. The fact is that if the tenant is not in default, the assumption is that the security deposit should be returned. If any of the deposit is used to repair damage, I think the repairs should be well documented so that the tenant knows exactly where their money went. This would really cut down on conflict.

Common Area Expenses

Common area expenses are paid in addition to rent for the upkeep of the common areas of the building. The landlord has to maintain the outside areas of a building, like parking lots and sidewalks, and it has to maintain shared interior space like bathrooms. Therefore, landlords generally charge additional fees to cover these expenses.

The normal way to divide common area expenses is to total the expenses and divide them among the tenants based on their pro-rata share of the floor space. The share is usually a percentage of the tenants leased space as compared to the entire building. Therefore, if you lease 20% of the building, you pay 20% of the common area expenses.

This system may or may not be fair depending on the building. If, for example, you run an insurance office next door to a restaurant, it might not be fair to divide the cost of garbage removal based on square footage because the restaurant most likely generates much more garbage than the insurance office per square foot. However, if the tenants are similar, a standard percentage is usually easiest.

The important thing to understand as a tenant is what your actual costs will be. If you are told the rent will be $1,000/month, that likely does not include common area expenses or taxes. Therefore, you will need to know those costs in order to actually budget for the cost of the space.

Taxes

Taxes are usually divided like common area expenses, with each tenant paying a pro-rata share. Normal tax costs cover the standard real estate taxes for the building. This number can change from year to year based on the tax assessment so it’s important to understand how the building is being assessed.

But tax cost can (and usually does) include the cost of any special assessments or costs imposed by a governmental agency. Like many other costs associated with owning a building, the individual tenants may not reap many benefits from special assessments because of the short-term nature of their leases. Therefore, paying special assessment taxes is usually a cost with very little gain.

Just like I mentioned with common area expenses, as a tenant you need to know what the costs of renting the space will be. Rent normally does not include these additional costs so you need to budget for these items, as well.

Insurance

All leases require the tenant to obtain insurance. This is more than just renter’s insurance. They will want the tenant to obtain liability insurance to cover any claims that may occur on the premises. This is a standard provision. Normal insurance coverage is $1,000,000 in liability coverage. Personally, I think this amount is extremely high for most businesses, but it’s the standard commercial policy.

The tenant will need to add the landlord as an additional insured on the policy. Again, this is standard. The landlord doesn’t want to have to pay for an injury that occurs in your space. If someone is to fall in your space, they will likely sue everyone. This isn’t because personal injury attorneys are evil. Rather, it’s just how the system works. Therefore, everyone will want insurance coverage.

Standard commercial policies are not very expensive, and frequently they include provisions that are a benefit to the tenant. For example, many policies include coverage for theft and fire, and some cover errors and omissions, as well.

Next Time

In my next article on commercial leases, I plan to cover use, maintenance and repairs, and subleasing. Please feel free to contact me with any additional questions.

Oct 7, 2020

I started this series on commercial leases one month ago. My goal is to cover all of the major issues in a commercial lease over the course of four posts (or maybe more). If you have any specific questions, please feel free to contact me for more information.

Buildout

Buildout tends to be a big topic for tenants looking to rent space for their business. By buildout, I mean the process of reconfiguring the space to suit the needs of the new tenant. Some buildouts are small, maybe moving a wall or adding a door, but some can be huge like installing a kitchen.

Sometimes landlords will do the buildout for the tenant. Generally, when this happens the landlord adds some cost to the rent every month, meaning that the tenant will pay for the buildout over the length of the lease.

I actually like this system for many new businesses, because it defers the cost of renovation for the tenant and works a bit like financing from a bank. Buildouts can cost quite a bit. Large expenses can swamp a small business early in life. By spreading the expense out, the business can more effectively manage its cash flow.

But landlord buildouts are not always a good deal. I recommend that tenants get an estimate of what the buildout will cost and seriously consider the additional rent they will pay. Sometimes the landlord is gouging the tenant on the cost of the buildout.

For example, I represented a tenant that wanted a fairly small buildout for a commercial office. He wanted some walls moved and some glass doors added. Nothing insane, but it wasn’t cheap, either. The estimate for the work was around $18,000. The landlord wanted to add an additional $600/month for the buildout. On a five-year lease that added $36,000 to the cost of the lease (not including the increase in rent every year, which was a percentage increase). The landlord wanted to charge double for the buildout. We decided it wasn’t worth that price tag and the client went elsewhere.

Options

An option allows the tenant to extend the lease at its termination. Generally, there is a period of time where an option is allowed, something like not less than 90 before the end of the lease but not more than 180 days. During that window, the tenant has the right to inform the landlord of its desire to extend the lease for a predetermined length of time. Sometimes the added time is a new term, and sometimes the added term is shorter.

Normally, the extension comes with an increase in rent, which the tenant should plan for. Otherwise, the same terms that applied to the first lease remain in full force and effect.

I consider these provisions to be a benefit to the tenant. It gives the tenant a lot of flexibility. Landlords shouldn’t mind them, either, since they encourage tenants to stay more than one term. They can easier be a win-win situation.

When possible, I encourage tenants to ask for an option. There is usually very little risk for the landlord to agree to an option up-front, whereas once the tenant has been in the space it’s harder to negotiate extensions on term because the landlord might believe that it can get more rent from another tenant.

Arbitration Clauses

Arbitration clauses are becoming very popular in virtually all agreements I review. These clauses normally call for some version of AAA arbitration. Essentially, each party chooses an arbitrator to hear the case and those arbitrators choose a third arbitrator to break ties. This all sounds great in theory, but arbitration doesn’t work for everyone.

Arbitration can be very slow. The process is somewhat unwieldy and there is no central body, like a court, to moderate disputes in the process. Frequently, parties would be happier having the matter heard by a local judge. Despite most people wanting to avoid litigation, arbitration does not necessarily save time or money.

If you are signing a lease with an arbitration clause, I urge you to read it and understand the timelines and requirements it imposes. These provisions usually contain specific deadlines for demanding arbitration and choosing arbitrators. Don’t assume that the other side is familiar with the requirements, either. I find that these provisions are included by lawyers without much discussion with clients.

Next Time

In my next post I plan to discuss security deposits, common area expenses, taxes, and insurance. I post these articles monthly so if you have a burning question before then, please do not hesitate to contact me.

Sep 9, 2020

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.

1. What does this section mean?
2. Why does this section matter?
3. 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.

Important Terms

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.

Square Footage

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

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.