One of the largest expenses a small business will incur is related to its lease. Because commercial leases are such a large expense and are typically long-term commitments, it is imperative that business owners know exactly what is included in the documents they are signing. Below is a brief description of some of the leases available and many of the common provisions in commercial leases.
Most commercial leases fall into two categories: a gross lease or a net lease. A gross lease includes the base rent and property taxes in a lump sum – generally an amount per square foot per year. For example, Class B office space may lease for $24 per square foot per year. So, 2,000 square feet of space would cost $48,000 per year or $4,000 per month.
On the other hand, a net lease has two components. First, there is a base rent price for the lease space. Second, there is at least one “net” component of the lease. The net component typically includes things such as the tenant’s pro rata share of the building taxes, insurance, or common area overhead. Using the office example above, the base rent may be $18 per square foot per year and the net portion may be $6 per square foot per year. However, the “net” component is subject to change year over year. So, while the base rate might remain $18, the net portion may rise to $7.50 per square foot per year if one of the net components becomes more expensive. Often the “net” component is described as additional rent.
At first glance, the term of a lease is a straightforward concept. However, there are several dates which the landlord and tenant must consider. For example, the parties should include: 1) the date the tenant can gain possession of the premises, 2) the date the tenant’s obligation to pay rent commences, 3) whether the tenant has the authority to extend the lease if the commencement date does not occur on time, 4) the date the lease will terminate, and 5) whether, and on what terms, the tenant has the option to renew the lease.
Additionally, the tenant should consider when the lease term commences. Does it occur when the lease is first executed? Or does it occur when the tenant’s obligation to pay rent begins? Or could it be when the tenant takes possession of the premises? At the very least, the tenant should ensure the obligation to pay rent does not begin until the business has obtained possession of the leased premises.
Types of Additional Rent
There are many expenses which a landlord may include as additional rent. Some of the most common examples are:
- Real estate taxes and assessments
- Water and sewage
- Building insurance
- Common area maintenance
In particular, tenants should consider which utilities the landlord has an obligation to pay. In some leases, the landlord may only pay water and sewage and the tenant is expected to cover the remaining utilities separately. Other landlords may cover a majority (or all) of the utilities, including electricity and internet service. The tenant should carefully examine which utilities are included in rent payments so as to establish an overall estimate of expenses related to the lease.
Percentage rent clauses typically occur in retail leases. Under a percentage rent clause, the tenant pays a percentage of its gross revenue to the landlord as additional rent. The theory is that the landlord’s operation of the leasehold helps result in the gross revenue the tenant enjoys through use of the leased premises.
These clauses usually include provisions for the percentage a tenant is required to pay, threshold revenues which trigger the percentage payment, and any offsets or credits the tenant may have related to the threshold value. Because this payment is triggered through tenant sales, the landlord retains the right to audit the tenant’s financial statements and books.
Assignment and Sublease
Most commercial leases contain some prohibitions regarding assignment or sublease of the rental space. Assignment is the transfer of the entire leasehold to another party. Subletting, on the other hand, is the rental of a portion of the tenant’s lease space to a third party. In most cases, this provision is written so that the landlord grants written authorization for the assignment or sublease and the landlord will not “unreasonably” withhold such authorization. This gives the tenant some ability to change the lessee, but still provides the landlord the opportunity to properly review the qualifications of the proposed assignee or sublessee.
Damages to the Premises
Another important consideration relates to catastrophic events to the building. Living on the Texas Gulf Coast, hurricanes and flooding instantly come to mind as a cause for such an event, but could also include fire, tornadoes, or some other act of God. Tenants should consider:
- Which party is required to restore the premises after an event,
- Whether the party has the option or the obligation to restore the premises,
- The manner in which insurance proceeds are held or distributed if the premises are not restored,
- Whether the landlord is required to expend additional money if the insurance proceeds are not enough to restore the premises,
- Whether the tenant can terminate the lease after the event.
Imagine the tenant’s predicament if the premises are destroyed, but the lease requires the tenant to continue to pay rent.
Commercial leases are complex legal agreements with a number of potentially trick clauses. The provisions listed above are the most common which give tenants issues. However, many other provisions can potentially prove costly to tenants. If you would like to have a commercial lease reviewed, please contact the Law Office of Mark Smith.