Leasing commercial property can yield higher returns than residential property, but it comes with a higher level of risk and a lot more work. Commercial leases are more complicated than residential leases, and because they last for up to a decade, choosing the wrong tenant can be disastrous. Minimize your risk by researching, understanding your goals, and remembering a few fundamental principles. Read on for eight tips about how to wisely and profitably lease commercial properties.
1. Know Your Market
Markets change dramatically from neighborhood to neighborhood. If you’re unsure where to invest in commercial property, calculate the price-to-rent ratio to determine where demand for rental space is strongest. Tenants may be willing to pay higher rents in those areas.
Once you’re ready to lease, look at comps for properties similar to yours in similar areas to identify a rental rate. It never hurts to ask for an outside opinion, either. Ask a real estate agent about the market for your property.
2. Differentiate Between Residential and Commercial Leases
Most residential leases are alike, but that isn’t the case with commercial leases. Most commercial leases are written from scratch by the landlord and the tenant. That’s why they can take longer to finalize.
Negotiating rent is only the tip of the iceberg. Tenants may want specific lease renewal options, while the landlord may want a table of rent increases. The two parties also need to decide how to share various operating costs: property taxes, utilities, maintenance, and cleaning. All of this will need to be recorded and cleared by each side.
3. Know What Lease is Best for Your Situation
When choosing the right lease agreement for your state, you have a few different options. The main difference between commercial leases is how much involvement you, the landlord, want to have and how much you delegate to your tenant.
In a gross lease, also known as a full-service lease, the tenant pays higher rent. With this type of lease, the landlord is heavily involved in the property’s management. The landlord is responsible for almost all the property’s operating costs, including maintenance, cleaning, property taxes, and insurance.
Tenants and landlords can split obligations more evenly between the tenant and the landlord with a modified gross lease. With this lease, the tenant pays rent and is responsible for certain additional costs, such as utilities and maintenance. Modified gross leases are common in office buildings and properties where food preparation requires daily cleaning.
Net lease tips the balance in favor of the landlord. The tenant pays lower rent but is also responsible for property insurance, property taxes, maintenance, and other “net” costs. How many “net” costs the tenant pays depends on whether they’ve signed a single-, double-, or triple-net lease.
With a single-net lease, tenants pay rent plus property taxes. The amount of property taxes they pay is based upon the square footage they occupy. The landlord is typically responsible for all other operating expenses, other than the tenant’s portion of utilities and cleaning services.
The tenant pays rent, property taxes, and property insurance with a double-net lease. As with property taxes, the insurance they pay is based on square footage.
With a triple-net lease, the tenant pays rent, plus all three nets: property taxes, property insurance, and maintenance. The tenant is responsible for most of the operating costs associated with the property. The landlord has minimal responsibilities.
4. Know How to Calculate Rent
There are two main ways to charge rent: a flat payment based on square footage or a charge that’s based on tenant revenue.
Rent based on square footage is pretty straightforward. Research your local market to find out what rates are charged for commercial properties similar to yours, and then multiply by the square footage the tenant is leasing. This type of rent is especially popular for office properties.
Rent based on a percentage of revenue can be calculated a few different ways. The first option is to base rent on a percentage of income above a certain threshold. If tenants don’t exceed that threshold, they pay only the base rent. For example, a lease could call for base rent, plus 10% of revenue over $40,000 per month.
Another method for renting commercial space is to charge a base rent, plus a percentage of total retail income. For example, you could set a small base rent, plus 2–4% of all retail income. In this arrangement, the landlord shares the tenant’s success. If the tenant has a bad month, the rent will be lower.
5. Choose Tenants Carefully
Always review prospective tenants’ financials before leasing to them. Ensure they have enough cash flow to pay rent over the long term and that their business model is sound. Find out what they’ll need from you. Will they need technological or utility-related upgrades? What kind of signage will they have?
6. Know Local Zoning Laws
Zoning laws are constantly in flux, so before entering into a new lease, review all local zoning rules and regulations to ensure your new tenant is authorized to operate on your property. You and the tenant could be hit with fines if they run afoul of local zoning laws.
7. Decide How Much Management You Want to Undertake
Asset and property management aren’t quite the same. Asset management involves a long-term plan — making modern improvements and managing lease rollovers — while property management involves on-the-ground, day-to-day responsibilities, such as maintenance and repairs. In both cases, you can hire professionals or do it yourself. About 75% of real estate professionals think they have what it takes to handle a manager’s duties. Doing it yourself may save you money, but it will be time-intensive.
8. Understand Your Tax Situation
The tax code changes frequently, and those changes can impact how often you should buy and sell assets. You can save money when you sell property and invest in another by using a discount real estate broker and a 1031 exchange. 1031 exchanges have rules and regulations, so consult with a professional to see how tax laws affect your investments.
Ben Mizes is the Co-Founder and CEO at Clever Real Estate, the nation’s leading real estate education platform for home buyers, sellers, and investors.