Commercial Lease Pro

Glenn J. Rigdon asked:


While many people do not consider the possible use of a ground lease or land lease, ground leases offer a great way to retain a long-term ownership interest in real property that can significantly benefit heirs, while providing a current income stream. Vacant land that an owner may not be able to develop on his own can also reach its full development potential sooner using a ground lease. Most ground leases are negotiated with a provision that calls for the short-term development of the land, and once developed land owners / landlords have a relatively small risk of loss.

In Las Vegas, ground leases are used periodically but they have not been a mainstay in the real estate market. Given the cash crunch caused by the “Recession of 2008,” however, more land owners are considering them. Waiting for an end user to purchase a property, when most cannot get bank financing, can be costly. A ground lease provides and alternative to waiting that appears to be promising in the current economic climate.

Establishing a base return rate for a ground lease is not as difficult as one might imagine. Discovering the current market value of a property to be leased is the first step, and it is usually accomplished via an appraisal. With regard to the rate of return, if you were to sell a property for cash and invest the proceeds with as little risk as possible, you have established a base or minimal return figure. The near risk free rate paid on government treasury bonds is usually the base rate. Since more risk is associated with a ground lease than with holding government bonds a risk premium is usually added to the base rate.

One of the biggest issues associated with a ground lease in Las Vegas, as elsewhere, is position or subordination. If a developer is going to borrow money to improve a site, the lender generally wants to be in first position. Since the underlying land owner sees this request for subordination as a way to separate him from the land asset, and the bank feels its investment is larger and should be superior to the underlying land owner, some ground leases fail to materialized due to this security issue. Ground leases are most attractive to land owners when no financing is required for the development of improvements.

Another difficulty establishing a ground lease is the provision regarding rental adjustments. The Consumer Price Index (CPI) adjustments is often built into building leases, and at times CPI adjustments are adopted in ground leases. CPI adjustments provide the tenant with some assurance that they will not be caught up in a revaluation due to an explosive land market. The downside of using a CPI adjustment for the land owner is that the land may dramatically increase in value over time and the land owner will be stuck with the contract terms negotiated based on a much lower value.

Once established, the sum of the net present value of the income stream from a ground lease plus the discounted value of the remainder are the basis for value. So poorly structured ground leases can destroy the value of a parcel of real property.

Thus, ground leases can be detrimental to an owner or tenant if not well crafted. I have personally evaluated a real property encumbered by a 99 year lease with a 60 year term remaining that provided the leased fee owners with a return so low that their heirs could not afford to pay the tax bill. I can’t think of anything worse than being conveyed an asset worth several million dollars that just costs you money every month and that will likely not provide you with a benefit during your lifetime.

The opposite side of the coin is a lease that favors the owner so much that the tenant cannot afford to pay the monthly rent. Driving your leasehold tenant into bankruptcy is also not the best scenario for a long-term lease relationship.

Under certain circumstances a ground lease can be beneficial to both a landlord / owner and a tenant. Recent market changes in Las Vegas have opened land owners to the possibility that a ground lease may be a valuable tool to get a deal transacted. Great care must be taken to develop terms and legal provisions (with the aid of your attorney) that will remain reasonable over the life of the lease. Thus, the use of a ground lease in Las Vegas is being considered by owners and developers as a serious alternative to traditional land sales.

FrankWoodford asked:


As a professional landlord, we all want to achieve the perfect landlord/tenant relationship. Why? Because it makes for easier work.

You see for any investor, new or experienced, when you invest in a rental property you want to be able to keep it sustainable. Never empty. Never cutting into your profits. But always working for you.

That is why picking the right lease is so important – especially in commercial real estate.

Pick the wrong one and they could end up looking elsewhere. You need to get it right.

So ask yourself this question: what do you need out of your lease agreement? Simple. A guaranteed rental income, plus the means to control the costs of your property.

And your tenants? They will want to be able to peg their rental costs as closely as possible. Why? Because no one wants to pay above and beyond if the property is not worth it.

You need to prove it’s worth pursuing.

To help you choose, we have compiled together a list of the UK’s 3 top commercial real estate leases:

The Gross Lease

This is sometimes described separately from the full service lease, but their differences are not that much. Essentially what they both involve is the landlord/owner taking full responsibility for all the building expenses: taxes, insurance and maintenance.

All your tenants will pay is a fixed rent, which can be used to pay for the expenses that may incur.

A point to remember here is that costs increase over time. And if costs increase, so will your expenses. That is why it is important to keep yourself covered by including an escalation clause in your lease. This enables you to increase the rent owed from your tenants, so that their fees will continue to cover the costs.

Of all the commercial leases, this is probably the least favourable to you as an investor. Here your tenants only have to pay the rent, the rest is on you as their landlord and if some expensive maintenance is required, it could leave you with negative profits.

The Triple Net Lease

This type of lease requires the tenant to pay a significant share of the expenses, as well as the taxes and insurance related to their rental unit.

The triple net lease is commonly used in multi-tenant industrial and retail properties, and works quite favourably for you – the landlord. Why? Because their expenses will vary: electricity, plus the taxes, maintenance and insurance can all work to boost your profits.

This admittedly though, makes many tenants resistant to enter into this type of lease. It gives them no control over the increases in their expenses, and prevents them from budgeting their costs. It is completely shared, even down to the cost of roof replacement.

The Modified Net Lease

Is essentially a compromise between the gross lease and the triple net lease.

Here, how the property is maintained is decided between you and your tenant. As the landlord, you will take most of the responsibility, but your tenant too will also be in charge of caring for certain aspects of the property.

And the taxes and insurance? That will be your tenant’s job too.

This type of lease is great for industrial, retail or multi-tenant office properties. It is uniquely versatile in its flexibility, and allows you to both come to an equal agreement on what is required of each of you.

And we have to admit, it is very promising.

Of all the real estate commercial leases, the modified net lease works to benefit both your interests, allowing you to control and generate a positive cash flow, whilst giving your tenant an element of control that will boost their confidence as a successful company.

What more can you ask for?

Jennifer Mackay asked:


This is a multi part article which will focus on Commercial leases.

Negotiating commercial leases often times is not for the faint of heart. It is with this in mind, that we will attempt to shed light on the various aspects of commercial leasing. In this article we will examine topics including: terms, clauses, negotiating and requirements for these types of leases.

There are many aspects of a commercial lease that to the layman or inexperienced, often are confusing, and when read aloud sounds like “garble-garble-warble-goo-be-goo?”

Understanding the terms used in commercial leases and the position of those holding the lease will help when negotiating the lease. If you are not an experienced commercial real estate negotiator, it is suggested that you contact a professional commercial real estate agent and/or legal advisor prior to entering into any commercial real estate lease.

Let’s start with a few basic concepts…

There are always two sides involved in a lease: The tenant and the owner. While the owner may be represented by a Management Company or law firm who draw up the lease, often tenants are self represented.

Each side in a lease has objectives for obtaining leased space:

A tenant’s objectives may include:

Obtaining a lease with a reasonable rent payment Maximizing their exposure to the consumers Calculable and expected operating costs Ability to Expand for future needs and growth

An owner on the other hand has significantly different objectives which may include:

Obtaining and keeping high quality tenants Maximizing the return on their investment Protecting their investment property through risk shifting And the ability to regain possession of the property should the tenant default

While both sides of a lease have differing objectives, there are some commonalities as well. Items such as:

Establishing a clearly worded, binding contract Protection of the financial investment both sides will/have incurred And the ability for both sides to be profitable

Types of leases

There are many types of leases that are employed in leasing commercial property. Let’s examine a few common lease types such as:

· Gross lease – This type of lease is where the owner will pay all the expenses associated with the operation and maintenance of the property. The tenant pays the owner a gross or fixed amount for rent. From this rent, the owner will pay the operating expenses (property taxes, insurance, maintenance, utilities, janitorial and security costs) for the property.

· Net Lease – In this lease type, the tenant pays all or some of the operating expenses as expressed in the Gross lease. This type of lease provides the owner with the ability to pass on as much responsibility for operating expenses to tenants as possible. This type of lease varies based on location and the local market as well as the bargaining or negotiation ability of the two parties (owner and tenant).

Absolute net lease – This lease type requires the tenant pay all operating expenses related to the operation and maintenance of the property. Percentage lease – A lease of property in which the rental amount is based on a percentage of the volume of sales made by the lessee (the tenant). Usually this type of lease will stipulate a minimum or base rental plus a commission on the volume of sales and is regularly used for retailers

Considering the complexity of the various types of leases, you might conclude that entering into a commercial lease unprepared is comparable to stepping off a cliff. And you’d be correct!

Prior to entering into a contractual agreement to lease a commercial property, it is of paramount importance to your business success that you understand the terms, type and financial implications of the lease.

What makes a lease valid and enforceable?

Valid leases are similar to valid contracts. Aside from variations in length, complexity and financial considerations, enforceable leases typically contain the following:

· Identification of the owners and tenant: Each party to the lease should sign the document. It is also recommended that each page of the document contain the initials and date of each party.

· A Description of the property to be leased: Descriptions of the property will include the street address (including the unit or store number if applicable), any recorded plats as applicable, the government rectangular survey system as well as the metes and bounds in a rural area. Any property improvements should also be included in the description of the property for lease.

· Financial consideration: This requirement is often met by the tenant’s promise to pay rent and the owner’s inability to occupy the property during the lease term. Often times, the first step in leasing a commercial property is by submitting a Letter of Intent (LOI) and is some times accompanied by financial statements outlying the intended tenants ability to pay or liquidity (access to cash or funds).

· The legality of the objective: When leasing a commercial property, the objective or proposed use of the property or lease must not violate any federal, state, or local laws.

· Offer and acceptance: Basically, these statements identify that the owners agree to lease the property for a specific period of time and that the tenant agrees to pay am agreed upon amount of rent periodically to occupy the property as identified in the lease.

· The written lease: In most states, leases for longer than one year must be in writing. It is highly advised that all leases be in a clearly worded, easily identifiable document.

The lease and your Cash Flow

Some lease clauses have the ability to affect the lessees’ cash flow. These clauses contain alternatives for the owner to pass some operating expenses on to the tenant. Some clauses may limit the payment of operating costs (called Expense stops), while others provide the ability for the owner to continually pass on some of the current or increasing operating costs of the property (Expense pass through) to the tenant.

Before we examine these items, let’s understand the simple calculation of the rent. Typically, commercial rents are expressed in price per square foot (ppsf) and are calculated annually. Those new to commercial leasing are often surprised by the initial price of this type of property. What they fail to realize is that the total price is then divided by 12 (the number of months in a year). Example: a 1000 sf space is being leased at $18.00 per square foot or $18,000 per year ($18×1000). The actual amount of rent per month then is $1500.00 ($18,000/12).

As mentioned previously, operating expenses such as real estate taxes, maintenance, repairs, trash removal, salaries of the landlord’s employees, and costs of building improvements frequently are paid by the owner and often passed-through to the tenants. This is typically true in multi-tenant office buildings and shopping centers. In retail properties, a tenant’s share of these pass-through expenses is based on the gross leasable area (GLA) of the tenant’s store.

Expense Stops

Expense stops allow the owner to pay a portion of the operating expenses up to a specified amount, usually based on a price per square foot (psf). Excesses of the expense stop are then passed through to the tenant based on the amount of rentable building space the tenant is occupying.

Here’s an example: A lease for an office may contain a clause that states the tenant will pay $18 per square foot per year in rent and that the owner will pay all operating expenses associated with the property – as long as the expenses do not exceed $4 per square foot of the rentable area.

If the building has 50,000 square feet of rentable area, with this clause the owner is required to pay the first $200,000 in annual operating expenses ($4 per square foot X 50,000 square feet). If there are any additional expenses required to operate the building that exceed $200,000, the tenant will be charged the overage based on the percentage of the building’s rentable area or the square footage that the tenant occupies.

This then limits – or stops – the owner’s operating expenses at $200,000. To further illustrate this: if the operating costs of this property are $220,000 annually, using the example above you could expect the rent to be an extra $.40 per sq ft ($20,000/50,000). The adjusted monthly rent then becomes $1533.33 ($.40×1000 sf / 12) since the owner is paying the initial $200,000.

Expense stops typically benefit owners by limiting their risk exposure to operating expenses being greater then expected. These stops also allow owners to forecast operating costs based on predictable expenses. Often, owners will in turn offer tenants something of value in exchange for the expense stop clause such as a lower contracted rental rate if other leases in the local market do not contain expense stops.

Common Area Maintenance

The common area maintenance (CAM) charge is a common expense pass-through in shopping center leases and other multi-tenant situations. These are the costs associated with maintaining all common areas of a property, such as: hallways, lobbies, grounds and parking lots. These costs usually are calculated and based on the percentage of rentable space that the tenant is occupying. CAM clauses benefit owners by passing through increases in costs of these expenses to the tenants.

Tenants also benefit, from CAM costs in that monies collected for CAM expenses are not driven by other property expenses, a standard of upkeep and general maintenance will ensure the property remains in satisfactory condition and alleviates the tenants from paying for the maintenance of the common areas.

Tenant Improvements or build out costs

Owners will often incur expenses when leases expire and vacant office and retail space must be made ready for new occupancy. These additional expenses are known as build out costs. As an example, the re-leasing of commercial space may require substantial changes be made to the interior, such as removing or adding walls, raising ceilings, and altering electrical capacity. Many commercial property leases provide a tenant with an improvement allowance. Some leases may require plans for the alterations been submitted by a general contractor with any and all work to be performed by a contractor employed by the owner. This lease term/clause obligates the owner to incur a pre-specified dollar amount in expenses to improve the space to the new tenant’s specifications.

Tenant Improvements may provide tax benefits

The responsibility for payment of these improvements may provide tax benefits to the owner or the tenant. If the owner pays for improvements, these costs may be expensed over a number years. When the tenant vacates and the improvements are removed, the owner may write off the remaining amount at that time.

Likewise, if a tenant pays for improvements, and the alterations maintain the value of the property, the tenant may write off the costs in the year the improvements are done. If the improvements increase the value of the property, the tenant may write off the cost over a given number of years or when the tenant vacates the property. Always confirm any tax incentives and benefits with a qualified tax professional before incurring extra costs.

Summary

As you can see, leasing commercial space can be very complicated. To potential new commercial lessees’ understanding these complexities is imperative for a successful business to prosper.

Obtaining professional guidance in both negotiations and the legalities of a lease may save a commercial tenant not only short and long term monies that may be re-invested into the business, but also provide them with protection by obtaining an enforceable lease.

© Copyright 2008 Jennifer MacKay. All Rights Reserved.

Tim Dillard asked:


If you are considering an investment into commercial real estate, Houston is an excellent choice. Within this bustling city, there are numerous commercial investment options to choose from. Which one will be the best for you? Many find that a triple net lease for sale will bring them the greatest return on their dollar with the least amount of effort.

But a triple net lease is not right for everyone. If you are checking out the opportunities as a shopping center developer, Houston is known for having a lease that could suit your needs.

The first step in choosing your best investment opportunity is to understand precisely what a triple net lease is. In the case of this type of lease, the renter assumes the monetary responsibility for the maintenance, taxes and insurance in addition to the monthly rental amount.

This kind of lease is generally a very long term agreement, with some contracts going as long as 50 years. Because of this, it is very important that you weigh both the advantages and the disadvantages of a triple net lease for sale before you decide to make this type of investment in commercial real estate Houston.

The advantages of this kind of lease will benefit both the landlord and the tenant in many ways. The landlord can expect the maintenance of his property to be done by his tenant, leaving very little work on the part of the landlord for the upkeep of the site. In most cases, the renter will have a vested interest in keeping the property in good condition, since this will make his retail site more attractive to potential customers.

On the flip side, a tenant can enjoy many of the freedoms of ownership including regular repairs and updates to the property as he sees fit. However, he does not have the burden of the initial investment into commercial real estate Houston the way the owner of the property does.

There are risks involved in this kind of lease. A tenant may not provide proper upkeep, costing the owner of the property more money in the long run. There are steps that you, as the owner, can take to reduce many of these risks. If a triple net lease for sale sounds like a possibility, talk to a real estate agent and attorney today to see if this is the best choice for you.

Matt Fay asked:


A commercial real estate brokerage, or real estate brokerage house, is a firm designed to assist clients in their commercial real estate transactions. You will find various services available at a commercial real estate brokerage. Some specialize in a specific facet of real estate, such as office, retail or industrial properties. Some offer leasing only while others are strictly investment, and then there are those that offer both commercial leasing and investment. However, a quality brokerage house will have some level of all services available to a client.

It is suggested that a client look for a commercial real estate brokerage house that provides multiple levels of service. Some of those service levels include:

INVESTMENT & USER ACQUISITION: Buyers are represented by the commercial real estate brokerage with the goal of best location, price and terms.

•Determination of Client needs.

•Compilation of properties that meet acquisition criteria.

•Identification of those properties that best meet established goals.

INVESTMENT SALES: Owners are represented by Arizona commercial real estate brokerage with the goal of maximizing asset value.

•Aggressive, credible, strategic pricing.

•Preparation of custom designed marketing materials.

•Qualification of prospects.

LANDLORD REPRESENTATION: Landlords are represented by Arizona Commercial with the goal of maximizing net operating income.

•Market planning assistance.

•Marketing plan formulation and preparation of materials for print and web.

•Presentation to local, regional and national tenant prospects.

•Brokerage community meetings, mailings, personal presentation.

•Tenant qualification.

TENANT REPRESENTATION: Tenants are represented by Arizona Commercial with the goal of top sites and the best economic terms.

•Determination of Client needs

•Financial analysis of prospective locations

The reason you want a real estate brokerage that offers all of these services is so that they can grow with you, and it is also an indication of their level of commercial real estate knowledge.

For instance, if you start a business and are looking for a new location you will want to have your commercial real estate broker knowledgeable in retail leasing. Then as years pass, you might find that you need a manufacturing location that is also suited for a shipping facility. If your brokerage house has a wider range of services available, they will be able to assist you in this.

Then if a few years later your operation has grown to a point where you need to build a custom facility that can handle manufacturing and shipping, and that can also facilitate administrative offices and a retail storefront, then you will be entering into a new real estate field. This field would be called “built-to-suit,” land investment and development, or investment sales (depending on what was available and what option was right for you).

By dealing with a commercial real estate brokerage house who offers these services, you most likely would not have to search for a new broker each time your business grew. You would already be working with a company that was familiar with the markets in which you’re entering, and best of all, would already know you. This would lend to a certain level of comfort and trust in the transaction process that was already established from previous projects.

Matt Grimes PC asked:


Leasing commercial property in London is a whole different ball game from leasing commercial property in other areas of the United Kingdom. There are many pitfalls which leasers may miss if they are not familiar with this area of the market. If you are looking for a commercial property London then contacting a local property agent in London will ensure you are aware of the best locations and the kinds of price variations to expect in the area, as well as any other useful tid bits insider knowledge can get you. This will make sure that you get the best deal for you and that you are aware of the benefits and pitfalls from other local businesses before you take up residence.

So here is an overview about each major type of commercial property. The main areas of the commercial property market are shops, industrial units, and offices.

Industrial units in the commercial property sector are most often available on flexible contracts and as a less competitive commercial property area you can come across some quite good lease deals. If you are thinking of leasing industrial property in London you will expect to pay the premium for the capital city location which is also why it is extremely important to find a commercial property specialist who can help you benefit from their expertise and assistance you in negotiating the best deal, they can even draw up a contract on your behalf.

Leasing commercial property in the form of retail shops is an extreme factor when assessing the possible success or failure of your business. Knowing your commercial property’s location inside out is essential as choosing the wrong location can mean instant stigma attached to your property. This can be a good thing, such as a commercial property Covent Garden address, or it could be bad if you are in an unpopular area with a high crime rate.

A further popular use of commercial property is the classic serviced office space. London is full of serviced office space and it is a really popular route to pursue as a serviced office provides a whole range of different benefits. Serviced office space London is popular firstly due to only having to pay one total sum of money for the rental of your serviced office which includes all bills such as electricity, heating, internet, cleaning, and manned reception. This not only saves hassle but makes sense as you have less need to use up precious time sorting out all those mundane bills. It means there are no unwanted hidden charges and you can focus on the more important things, like work! It is also great not to have to worry about cleaning, like the windows or emptying bins, as in a London serviced office all this is done as part of the deal!

Sam Hawking asked:


So, you’re leasing a property. Why pay for commercial property services when you’ve done it all before?

After all, a lease is a lease is a lease – isn’t it?

Well, sadly not. No two leases are the same, so you must protect your commercial interests and nail down the rights and responsibilities for both parties.

The landlord’s responsibilities are likely to include:

• Maintenance and repairs of the building

• Management of common areas such as grounds, staircases and hallways

• Insurance of the building

While the leaseholder’s obligations may include:

• Keeping the inside of the property in good order

• Behaving in a ‘neighbourly’ manner

• Payment for services, eg maintenance and repairs, building insurance etc

• Payment of ground rent

• Payments into a reserve fund for any scheduled major works, eg external decoration

• Restrictions on certain activities without the landlord’s consent

As a guiding principle, the landlord is not obliged to provide any service that is not specified in the lease, and the leaseholder is not obliged to pay for anything that is not specified in the lease.

How confident are you that your property lease really covers all these angles? If you leave room for doubt, you may well regret it further down the line!

And when you’re taking up a lease…

Leasehold contracts are designed primarily to protect the commercial interests of the landlord.

Which means it’s up to you, the leaseholder, to challenge the terms that don’t suit you. And as the landlord has an army of commercial property consultants at his disposal, he’s probably not too worried about that.

If scouring acres of small print is your idea of fun, then go ahead. (Enjoy!) But if you prefer to live your life and leave the mind-numbing mumbo-jumbo to the professionals, you really should talk to your property consultants.

It’s vital that you understand your lease conditions before you buy. These are questions like:

• Will you have to pay ground rent?

• What service costs are you expected to pay?

• Will you have to pay into a reserve fund for future building works?

• Is the property subject to conditions of use (eg commercial or residential restrictions)?

• What obligations does the landlord accept?

With so much at stake, you can’t afford any grey areas. So ask your property consultant to look through your contract and pick out all the gremlins.

10x Marketing asked:


Many of us homeowners are familiar with the downturn of the real estate market and the negative impact it has had on our homes and lives. As many families suffer through the fear and uncertainty associated with foreclosures, there is another unfortunate reality becoming apparent in the real estate market. Commercial real estate is suffering as are those employed as a Commercial real estate agent. As tenants struggle to even find ways to pay their rent so they can stay in their offices, the market begins to struggle as the rent goes down and values for buildings go down as a result. It is a very difficult cycle to break.

While we may feel the positive impacts of an economy turning around soon and home foreclosures are showing signs of leveling off, this is not true for the commercial economy. While many thought that because commercial leases are so long term this would help protect this industry that does not appear to be helping them as much as forecasted. Because of the fact that most landlords feared trying to find new tenants, they listened to tenant demands to lower the rent. This dramatic downturn means that in many areas the value of buildings have gone down significantly.

This dramatic and unfortunate downturn in the commercial real estate market will not be cured overnight. Investors and bank that heavily finance this market might be facing some heavy losses before the upswing occurs. It is a reality that many of the mortgaged properties in both commercial real estate and in the housing market are worth less than the current mortgages on the properties. In the commercial real estate market this will be a more difficult reality to overcome.

The government may step in to provide a package that will help investors; banks and the commercial real estate market survive. There are often things that the government can do to help things along. However, it won’t happen quickly and it won’t happen overnight. The upturn to this market may take many years to recover – some estimates put it at 2017. That is a lot of years that commercial real estate agents and properties face of some trying times. It’s an unfortunate cycle that we find ourselves in with businesses struggling due to lower spending on the part of most consumers and then high unemployment making it hard for people to spend that money to begin with. Will it ever end?

I often wonder if there will be a day when we don’t hear or read negative news regarding the economy. You have to wonder if we heard a little more positive feedback if that would help things turn around. Yes, my house may be worth less today than it was a year ago but things will turn around. The economy is going to get better, people will get jobs again and the real estate market will be strong once more. Let’s all take a good look at the positive aspects that still exist, we may find ourselves not worrying so much about the doom and gloom of the current day but looking forward to a brighter tomorrow.

Jennifer Mackay asked:


In our last article we discussed: lease objectives, the common types of leases, what makes a lease enforceable, cash flow, expense stops, common area maintenance as well as the tax benefits of improvements.

As we move on in this article, we’ll discuss additional lease types and become familiar with lease additional clause, strategies and identify common terms used in commercial leases.

Ground Lease

A ground lease is as lease for land alone, and is typically a long-term net lease. Ground leases are where land ownership is retained by the owner of the land and improvements are owned by the tenant.

These leases can typically be found in areas with a shortage in highly desirable land, and may be traditional in other areas. Following the end of the lease term of a ground lease, title to the land and improvements reverts to the lessor/property owner.

Step Leases

Step Leases allow contracted rents on long-term leases to change by preset amounts or percentages which will occur on predetermined dates. These preset amounts or percentages are called escalations.

While the lease payments vary over time and the term of the lease, the actual payments are calculated and disclosed prior to the signing of the lease agreement.

The most common types of costs involving escalations may relate to real estate taxes, insurance, utilities, operations, and maintenance.

Real estate professionals representing the tenant can provide historical trend information regarding these types of escalation so that increases can be predicted and informed decisions can be made prior to a lease signing

Indexed Leases

Indexed leases are those where the contracted rent is tied to movements of a pre-specified financial index; such as the consumer price index (CPI). Here’s an example: If the current year’s consumer price index increases by 3 percent, then the next years lease payment will increase by 3 percent.

Additional lease clauses

Several other options and clauses are designed to protect the needs and concerns of the owner and tenants and should be negotiated carefully and with diligence.

Lease Renewal Options

Commercial leases often grant a tenant the ability to renew a lease for a pre-specified period of time following the initial lease expiration. However, the rate at which the lease may be renewed is specified in the initial lease contract. A renewal option is often of value as it eliminates the need for a tenant a new location for the business prior to the expiration of the current lease. Even though the tenant is not obligated to renew the lease, hence the term ‘option’, the tenant is not bound by the lease to remain and may decide to find another location for the business if either the business requires it or the tenant so desires.

Expansion and Relocation Options

As businesses grow, it is essential to that growth commercial leases provide a tenant the right to occupy additional space in the commercial structure.

The rental rate and specified period of this space should be negotiated prior to the initial lease signing. Often, the owner will agree to give a tenant the right of first refusal as space becomes available in the building. If additional contiguous space cannot be provided in a reasonable time frame for the tenant, an owner may agree to relocate the tenant within the building or shopping center within a specified time period. These additional lease clauses should be negotiated and worded carefully.

Financial impact of lease clauses

After a decision has been made to lease commercial space a commercial real estate specialist may be enlisted to prepare a financial report which quantifies the potential tenant’s lease costs and which compares and contrasts alternative leases.

As outlined previously, the final lease terms will be dependent on current local market conditions and the negotiation skills of all parties involved.

Before analyzing the financial implications that a lease imposes on a tenant we need to upgrade our vocabulary to include commonly used terms. These terms and definitions may vary from market to market.

Base (contract) rent: This is the specified, pre-defined contract dollar amount for periodic rent (monthly payments). Escalations are based on this amount.

Total effective rent: This is the base rent once it has been adjusted to include concessions, allowances and costs that will become the responsibility of the tenant (such as operating expense pass-through).

Total effective rate: This is simply the total effective rent divided by the square footage.

Average annual effective rent: This is the total effective rent divided by the total years of the lease term.

Average annual effective rate: This is the average annual effective rent divided by the square footage.

Cost analysis

Now that we have defined some common terms we are able to understand how to analyze the financial impact and actual cost of a lease:

From the tenants perspective

In many commercial leases, the base rent does not necessarily equal the effective rent. An in-depth analysis of this will include all costs to the tenant such as concessions, allowances and other additional costs.

Here then is a basic formula for calculating a tenant’s effective rent:

The base (contract) rent + (Additional Costs – Concessions and/or allowances) = The Total effective rent paid which will be paid by the tenant.

From the owner’s perspective

This same analysis is covered from the owner’s perspective and will also include all costs to the owner:

Here then is a basic formula for calculating effective rent from the owner’s perspective:

Base (contract) rent – (Net additional costs – Concessions and/or allowances) = The owner’s Total effective rent as income.

Alternative Strategies

We’ve seen how the negotiation of a commercial lease can not only affect a prospective tenants’ and owner’s cash flow but also how complicated the process may be. When a prospective site located and analyzed correctly, the site may or may not satisfy the financial requirements of a prospective tenant.

With that in mind, let’s look at some alternative strategies for commercial leasing:

Sublease

A sublease is a separate lease in which the tenant may lease all or part of the leasehold interest to another tenant while retaining liability for the property and primary lease to the owner.

There are however risks to subleasing which an owner may not be willing to accept. These risks include:

Re-lease risk: The length of time it will take to find a sublease is unknown. Rental rate risk: It may be necessary to sublease at below-contract rent. Tenant quality risk: It may not be possible to find a high-quality tenant. Lease-term risk: A sub-lessee may want a shorter or longer lease than that of the primary lease. Lease agreement risk: A sub-lessee may want concessions, allowances, and other features that are not provided in the primary lease. Tenant improvement risk: The sub-lessor may have to pay build out costs for the sub-lessee.

Assignment

An assignment of lease is where all of a tenant’s leasehold interests in a property are transferred to a third party. In general this will release the original tenant from any and all responsibility of the remaining terms of the lease at the time of assignment.

Build to Suit

Build-to-suit development as those in which an owner agrees to develop or finish a property built to the specifications of the prospective tenant.

The costs for the improvements may in part be assumed by the prospective tenant and may be in the form of an increased effective rent.

A build-to-suit strategy will most likely involve a prospective tenant with significant financial capacity and strong creditworthiness.

Sale-Leaseback

A sale-leaseback is a strategy in which an owner purchases land, builds a structure on the land for their own use and in turn sells the entire property to an investor, and retains a long-term net lease.

Many companies use this strategy to convert their equity in real estate to working capital where it hopefully can generate a higher return from the operation and cash flow of the business.

Summary

While this article, appropriate title Introduction to Commercial leases does not encompass every aspect of all commercial leasing implications, it hopefully has provided those with a less then working understanding of commercial leases the knowledge and information needed when dealing with a commercial lease entity.

There are many different ways to structure lease transactions, clauses and financial implications in commercial real estate leasing.

An important item to remember is that many lease clauses will be applied to a cost to either the prospective tenant or the owner.

Commercial leases should be reviewed carefully by trained professionals or others fully qualified to negotiate and analyze both the short and long term implications of the lease and the financial responsibilities of all parties concerned.

Careful and diligent lease negotiations and analysis will provide both a prospective tenant as well as an owner the ability to profit and be successful in their individual endeavors.

© Copyright 2008 Jennifer MacKay. All Rights Reserved.

jeff rauth asked:


In my daily dealings with small business owners I see entrepreneurs struggle with the question of whether to lease or own their buildings consistently. The idea of owning can be very appealing, especially now as interest rates are still low (historically), new loan programs are popping up like 90% non SBA financing, commercial second mortgages and 30 year fixed programs. And, building bargains seem abundant as real estate values continue to take a beating.

This question is certainly not new. Businesses have contemplated this for years – in good times and bad. The decision can become complicated quickly as objective (financial, space needs, etc.) and subjective factors (business image, growth plans, pride of ownership, etc.) combine. Forces outside of the business owner’s control, such as the general economy, interest rates, future real estate values, further obscure the issue.

The most thought of advantage of ownership is the potential appreciation. However as we are seeing now, appreciation is not always guaranteed.

Historically, financial experts have broken down the question by quantifying the factors such as the difference between the down payment/monthly mortgage vs. lease payments (among many others factors such as tax rate, tax benefits, interest rate, inflation, depreciation, expected holding period, expenses, etc). The point is to come up with an estimate of the buyers Internal Rate of Return on the down payment injected into the purchase.

Internal Rate of Return is commonly discussed, analyzed and dissected. Many factors can be manipulated, such as the anticipated appreciation rate inflation rate etc, to come up with different projections.

Some of the major pros and cons of ownership include:

Pros

• The creation of equity

• Monthly mortgage payment is usually lower than comparable lease payment

• Potential future rental income

• Assisting owners with wealth/retirement

• Building an asset that will assist in securing business lines of credit and other forms of loans

• Pride of ownership

• Stability

• Control

• Business image

• Not being exposed to increases in rental market

• Not being exposed to whims of landlords

• Dramatic tax benefits

Cons

• Property management responsibilities

• Interest rate exposure on adjustable mortgages and/or if mortgage balloons

• Opportunity costs of down payment not being in a more liquid asset, or being used for business operations

• Decrease in functionality of building

• Building value subject to market conditions

• Length of time in selling building

• Decrease in space flexibility

These types of analysis can be very useful and give a clear perspective on a complicated issue. But, for most small business owners in general and in our economy, the question really boils down to cash in hand and long term plans.

First of all, can the business really afford to inject 10% or 20% into a facility? Equity is hard to “tap” in commercial real estate. Many businesses need that capital for daily operations. Secondly, what is the difference in the potential mortgage payment vs. lease payments? Is owning going to increase cash-flow for the business (as it commonly does)?

Long term plans. Owning can be the wrong strategy for companies with strong growth potential/ expansion plans as selling on the short term can be expensive and difficult. Also, companies seeking venture capital may want to shy away due to how real estate ownership affects their balance sheet.

So, without oversimplifying the issue, the economy seems to be making purchasers think more of “now”, how holding real estate affects their business immediately vs. traditional long term hold IRR type mentality. Many buyers are discovering that despite concerns over the market, ownership still makes a lot of sense for their business and personal wealth.