What is a Commercial Lease Agreement?
A commercial lease agreement is a legally binding contract between a landlord and a business entity in which the landlord agrees to rent property to the business, in exchange for rent. The lease provides the business with the right to occupy the property for the purpose of conducting its operations. A commercial lease agreement is similar to a residential lease agreement and many of the same laws and rules apply.
Commercial lease agreements generally are longer and more complex than residential lease agreements because they include higher-value and more costly consequences than most residential leases . In addition, lease provisions may by law be negotiated more extensively for commercial renters than they are for residential renters. The lease provisions enumerated in this guide are not all-inclusive but instead are some of the most common provisions found in commercial leases.
Commercial lease agreements vary from residential lease agreements in several material ways. When a business leases space for its operations, it is important to have leasing counsel who is experienced in reviewing and negotiating commercial leases. The attorney can help protect the business from overreaching by the landlord. The attorney should also be knowledgable about local ordinances and laws that apply to commercial leases.
Key Aspects of a Commercial Lease
When the tenant and the landlord sign a lease agreement they are creating a contract with legally binding obligations, and as such a commercial premises lease must contain certain lease terms that are required to make it valid and enforceable with respect to the law. Otherwise, you might have problems with your tenant or landlord in the future and may need to spend a lot of time and money on legal proceedings to resolve the issue.
The basic elements that are found in a commercial lease deal with the terms and responsibilities of the parties involved in the lease agreement. They include:
- the terms of the agreement (i.e. the length of time that the property is being leased for).
- the parties involved (i.e. the landlord and tenant).
- the description of the property being leased (i.e. the physical address of the property, the name of the building/complex, etc.)
- the lease end date
- the rent amount, including how often the rent will be paid (i.e. once a month, yearly, etc.), and the method of payment.
Forms of Commercial Lease Agreements
Commercial lease agreements come with a variety of terms and conditions. This is especially true in the case of commercial real estate, where these agreements tend to be much more complex than those for residential properties.
For investors and co-owners, understanding the various types of commercial lease agreements is crucial for effective planning. The following are some of the most commonly used agreements, along with examples that will clarify any inherent ambiguity:
Gross Lease
A gross lease agreement may also be referred to as a flat, full, or fixed lease, as it is characterized by a fixed rental amount. Under this type of agreement, it is the lessor who is responsible for the entirety of maintenance, property taxes, operating expenses, and insurance fees. Example: A leasing agreement in which the lessor agrees to handle the full responsibility of a retail outlet, from utilities to property management, while not passing these costs onto the lessee.
Net Lease
Under a net lease agreement, the lessor passes on all or some of the above expenses onto the lessee; however, the arrangement can be negotiated, and there are three variations of this agreement:
- Single net lease: The lessor is only responsible for the structural maintenance of the property, while the lessee pays property taxes.
- Double net lease: The lessor and lessee share the payment of property taxes and insurance fees, though the latter is usually structured in favor of the lessor.
- Triple net lease: This is the most comprehensive structure of the three for the lessee, as he or she is responsible for all expenses and taxes. Example: A leasing agreement in which the lessee is responsible for all operational expenses such as maintenance, insurance fees, taxes, and utilities.
Percentage Lease
Leasing agreements of this type are a hybrid of gross and net leases, as this structure allows leasers to offset some of the base rent by including a percentage of sales and earnings from the property. This form of lease is common in the retail sector, as these businesses have high cash flow and returns. Example: A leasing agreement in which the lessee is only required to pay a base rate, though a small percentage of gross sales is given to the lessor.
Negotiating the Terms of a Commercial Lease
Entering into a commercial lease agreement will be among the most important decisions your company makes and thus careful negotiation of the terms of the lease will be required. You should be well versed in lease terms such as: duration, rent and other financial considerations, options, landlord & tenant obligations (including repairs and maintenance), use of the premises, assignment and subletting, use of adjoining areas, easements for parking, storage and delivery access, assignments and subletting, alteration and improvements; and renewal and extension of the term. You should also obtain the help of commercial real estate professionals and qualified legal counsel to assist you in the negotiation of these terms.
It is wise to know the fair market value of the property including comparable rents for adjacent properties, so that you are prepared to negotiate and support a rent reduction. Rent reduction is the subject of many negotiations based on factors such as the economic health of the regional or local economy, the condition of the property as compared with others in the area, the number and strength of tenants in the building and others in the neighborhood, the amount of space coverage on the property, and the physical qualities of the specific location and site.
Companies looking to extend their lease should analyze their business needs, including the extent to which the current location supports those needs, the potential for future growth, and whether an alternative location may provide for more favorable lease terms and conditions. If the premises very closely meet your needs, then an extension may be the correct decision and you should review your potential negotiation leverage with your attorney to obtain the most beneficial terms for the renewal/compliance period. If a potential relocation is under consideration, the status of your current lease is among the first items to consider including the remaining fixed term, an extension option or an early termination option. It may be necessary to negotiate with the landlord for one of these extensions or to terminate the lease early if you determine that a relocation offers better terms. In negotiating your extension and/or relocation, keep in mind terms such as rent, operating costs, improvements to the premises and the compliance schedule for improvements, increased flexibility regarding future space requirements, escape clauses (for both sides), and expanded use parameters.
As noted above, the parties can negotiate increased flexibility for both tenant and landlord to make alterations in the premises and surrounding areas without prior consent. Again, consider the costs and benefits to both parties in these negotiations.
Common Mistakes to Avoid
Avoiding Pitfalls in Commercial Lease Agreements
Even the most seasoned business professional is at a disadvantage when entering into the world of commercial lease agreements and property rental. This fact alone leads to some common pitfalls that finance departments often face, leading to unnecessary legal, financial, and logistical consequences down the line. The following are some of the most common pitfalls businesses encounter when signing commercial lease agreements:
Chasing Paper Between Tenant, Owner, and Real Estate Agent
Business owners know that it’s prudent to assign their attorney to a lease agreement, yet they also know their attorney may not be familiar with all of the legal jargon, or worse, where there are gaps in legal protections. Some of the most common pitfalls involve the back and forth between tenant, owner, and real estate agent. For instance, your representative might offer a square footage that sounds good, but when you actually measure the space, the square footage includes closet or storage space you know you won’t use .
Failure to Manage Costs Within the Lease Agreement
Failure to manage costs is another pitfall of commercial lease agreements. You might forget to ask about the possibility of escalation in your rent if your landlord sells the building, or the additional costs that come with renting a traditionally classified "office" space. Failure to manage costs can be a major blow on your bottom line and make your business less viable.
Rent Control Phrases/Covenants Against Opening Similar Businesses
Some tenants still think they can negotiate covenants against "non-compete" agreements on a commercial lease. Many businesses often learn the hard way they cannot open a second location within a certain radius of their main location in a business-friendly area.
Not Enough Leeway for Renovations
Many tenants also play the long game by negotiating for a space they know needs to be renovated, such as a furniture store with a lot of open space that needs some division, or a traditional office space with very little natural light. At this point in the negotiating process, it’s important to have a realistic picture of costs so you know when you’re not getting a good deal.
Legal Obligations and Consequences
Tenant’s obligations under the lease will usually include its liability to maintain and repair the property, compliance with any planning permission and carrying out alterations. The tenant will be expected to permit the landlord, usually with some notice, to enter and inspect the property to carry out work and to do so in a reasonable manner, causing minimum disruption. The landlord will have a similar duty towards the tenant to maintain certain parts of the property. Liability for repairs will vary between the parties and will depend on the particular circumstances. Essential what the parties agree in their lease documentation will be paramount.
There may also be obligations on both the tenant and the landlord to insure. The obligation of the landlord is to insure the property and the outcome of that could be that the premium is then passed on to the tenant. The payment of these insurance premiums may increase from year to year, or even before the annual rent rise. The tenant will also be expected to take out and maintain insurance over its contents.
In recent years, especially with the impact of the Grenville fire tragedy, there has been a big drive by landlords to ensure that their properties are more fire and safety compliant. This may very well be incorporated into the lease, and the landlord may wish to conduct fire risk assessments as part of an annual inspection. This being said, in the context of a lease, unless it is couched in very clear terms, the tenant may be able, on a strictly legal basis, to pass the cost of remedial work back to the landlord, pleading that such costs should be borne by a landlord as part of the landlord’s repairing obligations.
The landlord will expect the premises to be used for the intended main purpose – for instance, as offices or retail property – and for the tenant to comply with any applicable planning permissions. Any breach by the tenant will give rise to a potential claim for damages or a potential, and sometimes very quick, forfeiture of the lease by the landlord.
What to Do Before You Sign a Lease
As with any contractual agreement, businesses should exercise care and diligence before signing a lease agreement. Businesses should follow these steps before agreeing to lease the premises in which they intend to conduct their business:
1. Inspect the Property Thoroughly
Before signing a lease agreement, a business should thoroughly inspect the property to ensure that it is suitable for its needs. Any deficiencies that are not repaired before the lease is executed may not be remedied until after the lease is signed, which can be costly for a business. A potential tenant should take time to inspect the space, check for major deficiencies (such as water damage, mold, or termite damage), and make sure that the space meets state and local building code requirements.
2. Evaluate the Lease Agreement Carefully
Before signing a lease, a business should carefully review the terms to be agreed to. Depending on the structure of the lease (full-service, modified gross, or NNN), the obligations and responsibilities of the tenant can shift significantly. A business should thoroughly understand its obligations under the lease before agreeing to them. The business should note terms that are unfavorably skewed towards the landlord or terms that unduly burden the business, such as overly broad indemnification, repair, maintenance and customization or alteration terms. If a term appears unfavorable, the business may attempt to negotiate a variance before signing the lease. The business should also review the lease to ensure that it complies with any preference the business may have for the space. For example, if the business is to lease the property as the sole tenant it should ensure that the lease does not provide for other tenants to occupy the property.
3. Consult Legal Counsel
The lease is one of the most consequential contracts a business is likely to sign. As such, businesses entering lease agreements should consult qualified legal counsel specializing in commercial real estate leasing law. Commercial leasing laws can vary substantially from state to state and local ordinances can have a significant impact on specific leases. After reviewing the agreement, legal counsel can assist a business by providing edits and revisions to the draft lease that address any unfavorable or unclear terms, and provide the business with piece of mind that the lease complies with applicable laws.
Ending a Commercial Lease
Terminating a commercial lease can be a complex process with implications for both landlords and tenants. Unlike most residential leases, commercial leases often impose stiff penalties for breaking a lease early. Yet there are circumstances where a tenant may want to terminate the lease early or a landlord may find it necessary to terminate the lease due to a tenant’s default.
Tenant’s Ability to Terminate
Most commercial leases provide for termination under limited circumstances (e.g., casualty, bankruptcy or foreclosure). Early termination generally requires payment of an early termination fee payable to the landlord. The amount of the fee is negotiated, but this fee can often be several thousands of dollars. There are federal statutes that provide rights to commercial tenants, such as the Servicemembers Civil Relief Act (SCRA) and the United States Bankruptcy Code. The SCRA provides certain rights to active military members to early terminate their lease where they are ordered on military deployment . The Bankruptcy Code gives certain rights to a debtor in bankruptcy to early terminate a lease if the lease is personally signed by a debtor who is an officer or member of a company. This right is limited, so a debtor should consult a qualified attorney to determine how the Bankruptcy Code applies to the specific facts.
Landlord’s Ability to Terminate
Commercial landlords have fewer options for early termination. Typically, a landlord can only early terminate a lease for serious, repeated violations by the tenant. For example, a lease might allow a landlord to terminate for repeated failure to pay rent on time or repeated failure to maintain the premises in a condition of good repair. A landlord can also terminate a lease if a tenant defaults on sales taxes, personal injury claims or liability. It is critically important that a landlord carefully reviews the lease with a qualified attorney prior to sending any termination notice.