Commercial Leases Flashcards
If you choose to specialize in commercial leasing when you get your real estate license, you’ll have a couple of options. Would you rather represent landlords or tenants?
Landlord Representatives
Landlord representatives work with the landlords of commercial properties. Their responsibilities include:
Learning about the features of the property and the landlord’s requirements
Marketing the property to potential tenants
Finding qualified tenants to rent the space
Negotiating the terms and details of the lease(s)
Depending on their size, commercial buildings may be able to accommodate many different tenants. If you secure one landlord client with this type of property, you have many units to fill and therefore many opportunities to secure commissions! But because landlord representatives tend to have more opportunities to earn fees, the fees may be smaller compared to tenant representative fees.
Tenant Representatives
Tenant representatives work on the other side of the deal. They work with business owners and managers to meet their real estate needs. Tenant representative duties include:
Helping businesses find available commercial spaces that meet their unique needs
Explaining various fees that the tenant will be responsible for
Explaining the different contract clauses involved in leases
Negotiating the terms of leases in the interest of their tenant clients
Any tenant client you secure will likely be renting just one property. This can mean fewer opportunities compared to landlord representatives, but the fees you earn will likely be higher to account for this.
Commercial Leasing Agent Qualities
Whether they represent landlords or tenants, commercial leasing agents need (cue Liam Neeson voice) a very particular set of skills. Licensees in this space need to prioritize building a great reputation and strong relationships within the business community. Any agent’s network is among their best assets, but in the smaller world of commercial leasing, it’s even more important.
A great commercial agent will have a solid understanding of all the clauses and contract details that could come into play in commercial leases. When the tenant is a business, all sorts of unique needs are surfaced. What sorts of improvements and alterations will the space need? Who pays for what, and who maintains it? As sharp as you’ll be as a licensee, you’ll need to be ready to recommend that leases be reviewed by the parties attorneys.
Agents who specialize in commercial leasing will also need to be prepared for more drawn out, complicated transactions. They have to be patient since commercial deals tend to take longer than the process of, say, a regular ol’ person signing a lease for an apartment. If you’ll recall, residential leases are usually quite standard. Commercial leases, since they often involve much larger amounts of money (and longer terms and more variable needs), call for more negotiation. If you’re up for the challenge, this could be the perfect niche for you, Anthony!
Commercial Leasing Agents
In the last chapter, you learned about types of leases that create various leasehold estates. They’re defined by things like their duration, landlord consent, and renewal processes.
We talked about these estates (periodic, for years, at will, at sufferance) in the context of residential leasing. However, note that they can be created by commercial leases as well.
In this chapter on commercial leases, we’ll focus on another set of lease categories: leases based on money, or how rent is determined. The following types of leases are more often used to describe commercial leases. They also have the potential to overlap, with a single lease containing features of multiple lease types. It all depends on the specific provisions of the lease and the needs of the businesses involved. Your first step is to understand each category separately.
Types of Leases Based on Rent
Rent will be calculated differently for each of these lease types:
Gross lease
Net lease
Percentage lease
Variable lease
Brace yourself, I’m about to unlease my knowledge of leases! (Am I trying too hard, Anthony?)
Leases Based on Rent
Let’s get the yuckiest one out of the way and start with gross leases.
Gross leases really aren’t that gross. A gross lease is a lease in which the tenant will be responsible for the payment of a fixed monthly charge, while the landlord is responsible for paying all operating expenses. Operating expenses include things such as taxes, insurance, property maintenance, etc. They’re the costs associated with keeping a building up-and-running. Gross leases are also called full-service leases.
Gross is a financial term that refers to a total cost. In a gross lease, a tenant pays a total, fixed cost for rent. Most residential leases are gross leases. A tenant at an apartment complex, for example, often pays the same exact amount in rent each month. They don’t get separate bills for property taxes or insurance. The landlord covers those expenses. And before anyone goes writing a thank-you note to a landlord for footing the bills, note that these expenses should be accounted for in the rental rate.
Commercial leases commonly take the form of gross leases, too. They are used for some office and industrial properties. Many commercial tenants like full-service leases for the same reason residential tenants do: They don’t have to worry about unexpected or variable costs. It’s all taken care of in one lump sum. For this reason, the rental rate on a gross lease may seem high compared to leases that charge separate fees for operating expenses.
Expense Stop
In some circumstances, operating expenses can be higher than expected. In a gross lease situation, the landlord is expected to pay for those expenses. Some landlords include an expense stop in the lease terms to protect themselves from being solely responsible for unexpected or particularly high costs.
An expense stop is the maximum amount that the landlord will pay for operating expenses. If expenses rise above that cap, the tenant will have to pay the rest.
EXAMPLE
Zied has a gross lease for the retail space out of which he runs his gardening supply store. The landlord has an expense stop of $50,000 per year. When the annual operating expenses turn out to be $60,000, the landlord pays $50,000 and Zied pays the remaining $10,000.
Gross Lease
Net leases are used for many commercial, retail, office, and industrial properties.
A net lease is a lease in which the tenant pays a base rent rate plus all or part of the operating expenses. These leases can be helpful to property managers because they shift the responsibility of insurance, taxes, and maintenance to the lessee.
Three Types of Net Leases
There are three different types of net leases:
A single-net lease: rent + one property expense
A double-net lease: rent + two property expenses
A triple-net lease: rent + three property expenses
Each added “net” requires a tenant to pay for an additional expense that may have otherwise fallen on the landlord.
An illustration of a soccer goal that lists each type of net lease and what it is composed of.
Image description
Single-Net Lease
A single-net lease (or simply a net lease) requires a tenant to pay a base rent plus property taxes. The single-net signifies the need for the tenant to pay for a share of the property taxes.
Double-Net Lease
A double-net, or net-net, lease charges for property taxes and insurance in addition to the base rent. The name reflects the number of charges for which a tenant is responsible: the property taxes are the first net, and the insurance is the second net.
Triple-Net Lease
Our last type of net lease is the triple-net, or net-net-net lease. It requires the tenant to pay a prorated portion of ALL the operating expenses for the property. A triple-net lease calls for the payment of base rent, property taxes, insurance, and maintenance expenses. In some cases, a triple-net lease will even require a tenant to help pay the interest on the lessor’s loan.
The additional payments for maintenance and other operating expenses comprise the third net that the lessor must pay.
The expenses that a tenant must pay can be either fixed or variable. For example, the property taxes owed will, more or less, be the same every month. However, the maintenance costs will probably change over time.
Net Lease
Got that down? Before we go on to the percentage lease, let’s compare what you’ve just learned.
Gross Lease
A gross lease is a lease in which the tenant pays a flat rate for rent that covers all property expenses. This is also known as a full-service lease because the rent cost covers a full set of living-related services. Gross leases are commonly used for residential properties.
Net Lease
In a net lease, the tenant pays a fixed amount of rent plus an additional (often variable) amount for property expenses. The tenant shares in paying for the costs of the property. This is more common in commercial real estate.
A chart that compares what is included in a gross lease and each type of net lease.
Image description
Gross Lease vs. Net Lease
A percentage lease is most commonly used for retail properties.
A percentage lease is a type of (usually commercial) lease in which the tenant pays a base rent amount and a percentage of their business profits to the landlord. So, a percentage lease varies depending on the amount of income the rented property generates.
Math Skill: Calculating Rent for a Percentage Lease
To calculate rent costs under a percentage lease, let’s take a look at the formula:
Fixed rent + (Overage x Sales rate) = Rent
Overage = gross sales
Sales rate = percentage of sales applied to the rent
Let’s say a candy store has a percentage lease for their storefront. Rent is $3,000 per month plus 2% of gross monthly sales. The candy store’s gross monthly sales are $50,000. What is the monthly rent? 🍭
Step 1: Insert the known variables
The fixed rent is $3,000 (we know that). We also know 2% of the $50,000 in sales will be added in with the fixed rent cost. Let’s pop those numbers into the formula!
Answer: $3,000 + ($50,000 x 2%) = Rent
Step 2: Solve the equation in the parentheses
Because the good ‘ol order of operations says so, we should solve the part of the equation within the parenthesis first. Don’t forget to change that percentage to a decimal.
$50,000 x 0.02 = $1,000
Answer: The amount based on sales that will be added to the fixed rent is $1,000.
Step 3: Add the fixed rent and the percentage of monthly sales
$3,000 + $1,000 = $4,000
Final answer: The candy store’s monthly rent is $4,000.
Percentage Lease
A variable lease is a leasehold agreement in which the base rent changes. Simple as that! It can take the form of a graduated lease or an index lease.
A variable lease allows lessors and their property managers to create long leases while ensuring a property remains profitable and competitive. If a tenant wants a 20- or 50-year lease, a property manager might end up losing a lot of money due to inflation, rising utility costs, etc. Variable leases help account for that by allowing more flexibility.
You can see why variable leases aren’t really a thing for residential properties. Those lease terms rarely last for more than a year. If the tenant wants to renew for another lease term, the landlord is free to offer that at a different rental rate.
“But Ace, I still don’t get what graduated and index leases are!” I can hear you saying from the other side of the screen. Let’s take a closer look at each of these, shall we?
Variable Lease
This type of lease is one that has just received its diploma from the Leasing Academy. 🎓
I’m kidding, Anthony! A graduated lease is a lease in which the rental rate increases over time in specific increments. This is also referred to as a step-up lease.
This type of lease is often used to entice tenants with smaller rent payments at the beginning of the lease. Graduated leases can be advantageous to the owner (or lessor) of the property because it allows them to raise the rent as property values increase while still locking in a single tenant for a long period of time.
Escalation Clause
Graduated leases should include an escalation clause, which is a clause in a lease allowing payments to increase by a specific factor. The escalation clause secures a lessor’s right to increase payments.
EXAMPLE
The Business Company, Inc. is the tenant in a graduated lease for a term of 20 years. The lease stipulates that the rent payments will increase by 5% every year. The 5% increase is included in the escalation clause of the lease.
The landlord is happy to lease to The Business Company, Inc. with a graduated lease. The landlord knows the rental costs will stay competitive as the years go by because of the routine increases.
Graduated Lease
An index lease is an agreement that also allows for a graduated increase of rent at periodic intervals; however, the increases are relative to an economic indicator, such as the Consumer Price Index (CPI). The CPI is a monthly index of the prices of general commodities and is used to calculate national inflation levels.
Instead of increasing at fixed intervals by fixed amounts, as in a graduated lease, the amount by which the rent increases depends upon variations in the specified index. Consequently, the amount by which the rent increases could change.
An index lease has benefits: If the increase in rent is connected to an economic factor, that provides protection for the lessee (there will have to be a real reason for rent increases) and also allows the lessor to ensure their property remains profitable by responding to economic trends.
Escalation Clause
Just like graduated leases, index leases should include an escalation clause to secure a lessor’s right to increase payments. In an index lease, the stipulations in the escalation clause should be directly related to a specific economic factor.
Lease Recap
And that’s all for leases based on rent! Nice work, Anthony. Let’s review. The leases defined by how rent should be paid are:
Gross leases
Net leases
Percentage leases
Variable leases
Graduated
Index
A chart that shows what the tenant pays for each type of rent-based lease.
Image description
Index Lease
The final two types of leases I want to introduce are not defined by how rent is paid, but rather, what the tenant is leasing.
Ground Lease
A ground lease, also known as a land lease, is the lease of bare, undeveloped land. These leases usually last for very long terms, like 50 years or more. This accounts for the fact that the lessee will be performing construction (making improvements) upon the land. Building on the land and recouping that investment takes time.
In a ground lease, the owner grants the tenant a leasehold interest in the land only.
Ground Lease Uses
Ground leases are most often used in the development of commercial property. It can be an attractive alternative to purchasing land because it reduces the amount of money needed for obtaining the property (no down payment!), thereby freeing up more cash for investing in the construction of new buildings.
Ground leases can provide commercial developers access to well-located land that might not otherwise be available for purchase.
Ground leases are also used for agriculture or mining. A party who is able to farm or mine will lease land from another party who might not want to pursue that.
Improvements
So, what if a tenant has a ground lease and constructs a new building on it? Who owns the building: the tenant or the landlord?
Great question! Upon expiration of a ground lease, the land, as well as any construction on the land, reverts back to the original landowner.
The ground lease may also have a provision for the structure on the leased land to be destroyed before the land reverts back to the owner. This is why leases are so important. It’s necessary to have the terms laid out before any agreement is made so all parties know what they are agreeing to.
Shell Lease
A building shell lease (or simply, a shell lease) is a type of commercial lease that involves renting an unfinished building. Unlike a ground lease, which just includes the land, the lease will include the use of a building. Unlike traditional commercial property, the interior of the structure will be unfinished.
The tenant of the shell lease will be responsible for finishing the building’s construction. This is a significant expense, but allows the tenant to make the exact improvements they want for the building.
Certificate of Occupancy
Whether a tenant starts with unimproved land or an unfinished building, they must be sure to have a certificate of occupancy before allowing people to use the building.
A newly finished building must pass final inspection by the city or other municipality. If the local authority deems the building safe and inhabitable, they issue the certificate of occupancy.
Leases Based on Property Type
Decisions about property improvements and maintenance are simpler when the occupant is the owner. But such decisions must be made for leased properties, too. A good commercial lease will be very clear about who is responsible for which repairs, what kinds of improvements are allowed, and who will get the bill. 💸
Common Area Maintenance
Landlords may charge their commercial tenants for common area maintenance (CAM). This is a regular fee paid in addition to the base rent. CAM charges fund the maintenance of common areas that tenants of a building share. For a large office building that serves multiple companies, this would include things like the lobby, elevators, parking lot, etc.
Common areas are typical in retail properties, too. It makes sense for businesses to be clustered together for the convenience of customers. A retail area will often feature an anchor tenant, which is generally the largest and most popular business that brings customers into the shopping center.
Tenant Improvements
The improvements that tenants make to their rental property can be big or small. The more significant improvements are especially important for tenants and landlords to agree on.
Improvements are usually handled in one of the two following ways:
Improvement allowances: The tenant negotiates to receive a cash allowance from their landlord. The tenant will use this money to pay for construction costs.
Turn-key projects: Just like a “turn-key house,” the property is all fixed-up and ready for the occupant, who needs only to turn the key in the front door. The improvements are handled completely by the landlord. The tenant can move in and have use of all the amenities and features they need for doing business.
In either situation, the property manager should be clear about which improvements will be deemed trade fixtures and which will not. Remember, a trade fixture is specific to the tenant’s business and goes with them when they move out. Improvements that are not trade fixtures will stay with the owner of the property after the lease ends.
Commercial Property Improvements and Maintenance
We’ve covered a lot in the world of leases, Anthony. Let’s put these in the perspective of residential and commercial properties (something you’re an expert at by now) to help sort them.
Residential
Residential leases are usually:
Gross leases
Shorter in term (People move a lot!)
Fairly uniform and non-negotiable
Commercial
Commercial leases are usually:
Net, gross, or percentage leases
Longer in term (It takes a long time to establish a business!)
More specific and negotiable
More financially serious in that they involve big business ventures and more money
I ReLEASE You
Whew! That’s a lot of leases! Let’s review:
A table lists the unique qualities of four different types of leases.
Image description
It’s important to note that these lease types are NOT exclusive. A lease could be a net lease and a ground lease, or a graduated lease and a periodic estate. Mixing and matching is normal (and very stylish).
We have covered a lot of information about leases, haven’t we? Let’s play a little game to review.
Lease Recap
Certain clauses are commonly found in commercial leases. These clauses may be up for negotiation since commercial leases are so pricey, long-term, and specialized to the business. Let’s take a look at what each of these means for the tenant and landlord.
Escalation Clause
Remember, this is the important clause I mentioned in relation to variable leases. If the cost of utilities, property taxes, etc. rises, the landlord doesn’t want to get stuck with the price hike while their tenants continue to pay the going rate from several years ago. An escalation clause gives the landlord permission to pass those price increases along to the tenants by raising the rent.
You’ll want to read an escalation clause carefully to determine a couple of things:
How often can the rent be increased? The timing and frequency of rent changes should be specific and reasonable.
Is the increase pre-determined or based on an index? As you now know, pre-determined increases over time create a graduated lease. Changes to the rent based on an index rate like the CPI create an index lease. If it’s an index lease, check for specifics on how much the rent will change in response to the index, whether there are maximum increase limits, whether rent may be adjusted down if the index dips, etc.
Tax Clause
A tax clause is similar to an escalation clause. It’s just more specific: If property taxes increase (nevermind utility and maintenance costs), the tenant will have to pay more in response.
A tenant who is paying base rent plus taxes (ah, yes, a classic net lease) will have to pay for any increase in those property taxes.
Services Included Clause
I’m not playing any tricks on you with this one, Anthony. It means exactly what it sounds like.
The services included clause identifies which services will be included in the rental price or additional fees that the tenant pays.
These might include the services of a front-desk receptionist or internet access.
Assignment and Subletting Clause
Lastly, parties to the contract will need to understand the assignment and subletting clause if applicable. This clause gives the tenant the right to assign or sublet the space under certain circumstances.
Commercial leases can last for several years, and business needs can change quickly. That’s why this clause is advantageous for tenants. If they need to move or close shop, they can have another tenant take over their lease and rent payments. Landlords may not be the biggest fans of this clause since it affords them little control over who their new tenants may be. (At least someone will be paying the rent!)
It’s wise to recommend that clients have their attorneys review this clause and all other clauses within a commercial lease.
Commercial Lease Clauses
All good things must come to an end, Anthony. So it is with life, and so it is with this chapter. But before you go, let’s review some of the important terms, concepts, and principles you’ve learned along the way.
Key Terms
Here are the key terms you learned in this chapter:
escalation clause
a clause in a lease allowing payments to increase in relation to a specified factor or index
graduated lease
a lease in which the rental rate increases over time in specific increments
gross lease
a lease in which the tenant will be responsible for the payment of a fixed monthly charge, while the landlord is responsible for paying all operating expenses; aka full service lease
ground lease
the lease of bare, undeveloped land; aka land lease
net lease
a lease in which the tenant pays a base rent rate plus all or part of the operating expenses
percentage lease type of (usually commercial) lease in which the tenant pays a base rent amount and a percentage of their business profits to the landlord
triple-net lease
a type of lease requiring the tenant to pay a prorated portion of ALL the operating expenses for the property
Key Concepts & Principles
Here are the concepts and principles you’ll want to master from this chapter.
Commercial Leases Based on Rent
Gross lease
Net lease
Percentage lease
Variable lease
Ground Leases
A ground lease, also known as a land lease, is the lease of bare, undeveloped land. These leases usually last for very long terms, like 50 years or more. This accounts for the fact that the lessee will be performing construction (making improvements) upon the land. In a ground lease, the owner grants the tenant a leasehold interest in the land only.
Upon expiration of a ground lease, the land, as well as any construction on the land, reverts back to the original landowner.
A building shell lease (or simply, a shell lease) is a type of commercial lease that involves renting an unfinished building.
Tenant Improvements
Improvements are usually handled in one of the two following ways:
Improvement allowances: The tenant negotiates to receive a cash allowance from their landlord. The tenant will use this money to pay for construction costs.
Turn-key projects: The improvements are handled completely by the landlord. The tenant can move in and have the use of all the amenities and features they need for doing business.
In either situation, the property manager should be clear about which improvements will be deemed trade fixtures and which will not.
Commercial Lease Clauses
Escalation clause: An escalation clause gives the landlord permission to pass operating cost increases along to the tenants by raising the rent.
Tax clause: If property taxes increase, the tenant will have to pay more in response.
Services included clause: The services included clause identifies which services will be included in the rental price or additional fees that the tenant pays. These might include the services of a front-desk receptionist or internet access, etc.
Assignment and Subletting Clause: This clause gives the tenant the right to assign or sublet the space under certain circumstances. If the tenant needs to move or close shop, they can have another tenant take over their lease and rent payments.
Recommend that clients have their attorneys review all clauses within a commercial lease.
Chapter Summary
