At first glance, leasing a commercial property may be intimidating. Leases for commercial real estate can run 40-50 pages long, stuffed with unfamiliar industry jargon. Plus, they are often written by the landlord for the benefit of the landlord. The good news is that a commercial property’s lease is almost always negotiable.
In this article, we’ll discuss the main parts of a commercial leasing agreement, the different types of contracts, how lease rates are quoted, and some clauses to watch out for when negotiating a lease for commercial property.
Main components of a commercial lease agreement
All types of commercial lease agreements – including rental office space or for a warehouse for rent – include the same general “boilerplate” components:
This clause identifies the tenant (lessee) and the landlord (lessor) by name, including contact information and a mailing address for rent payment and notice purposes.
This section includes the building address and description of the unit for lease, including floorplans and a site plan of the entire property.
Describes for what purpose the tenant plans to use the commercial property for lease, the type of business, and if the tenant has the right to an “exclusive use” that prohibits other tenants in similar industries from leasing space within the same building.
Term specifies the start and end date of the property rental lease agreement. Term also includes when occupancy (physical possession) by the tenant occurs and if there are options to renew the lease.
Defines the commercial lease as gross or full-service, modified gross, or net lease.
Rate defines the lease cost per square foot, the details of any potential increases in lease rate, and what items or amenities the rate includes.
Amount of security deposit collected from the tenant, how long the deposit will stay with the landlord, and whether interest accrues on the deposit. The clause also defines the landlord’s deductions from the security deposit if the tenant defaults on one or more terms of the lease.
Describes the tenant improvements (TIs) to be made to the space, who pays for them and how, and when construction work will be complete.
Discusses which items require maintenance by the tenant or landlord and any limits that apply to the amount paid by either party.
Identifies common areas shared by all tenants, such as parking areas, sidewalks, lobbies, elevators, public restrooms, and what may or may not occur in a common area without permission from the landlord.
Lists restrictions and permissions for signage such as exterior monument signs, a directory sign in the lobby, and how far in advance of the lease termination date the landlord may install a “for lease” sign outside the tenant’s space.
This section covers what insurance policies the tenant must obtain before taking possession of the space, including liability and business interruption insurance.
The landlord must give the tenant a specified amount of notice before entering the space. This section outlines any exceptions made for routine maintenance or emergencies such as a plumbing line break or roof leak.
Allows or prohibits the tenant from subletting (leasing to another party) any amount of leasing space, landlord notification and approval of a tenant sublease, and any additional terms and conditions of a sublease.
Default or Breach
Describes what happens if the landlord or tenant breaches one or more terms and conditions of the lease, actions that may cause a breach of contract and whether either party can terminate the lease early due to default or breach by the other party.
An addendum can modify or amend the boilerplate language of a commercial lease to customize lease terms and conditions based on the specific situation of the tenant and landlord. For example, a tenant may require additional parking spaces or have the right to terminate the lease early without liability.
Types of commercial leases
Commercial real estate leases fall into three main categories:
Gross lease or full-service lease
Under a full-service or gross lease, a tenant pays a set rate each month. In contrast, the landlord pays for all property operating expenses such as utilities, internet service, building and common area maintenance, taxes, and insurance.
Another way to think of a gross lease is that it gives the tenant an “out the door” price for the leased space. In other words, if the rate for a 10,000 square foot space is $24 per square foot per year ($240,000 annually), the tenant’s monthly check to the landlord will always be $20,000 ($240,000 / 12 months).
A gross lease works well for many tenants because it simplifies budgeting and avoids unexpected repair fees. Gross rents do make it difficult for landlords to pass along expenses for higher-than-normal utility bills or capital repair costs such as a new roof or parking lot repaving.
One typical example of a gross lease is a lease for coworking space. In a shared office space setup, the tenant pays one fixed monthly fee to use the area – although there may be “à la carte” charges for items such as extra hours for meeting room space.
Modified gross lease
As the name suggests, this type of lease “modifies” or changes the terms and conditions of a gross lease. Tenants and their brokers should both understand what modifications are being made to the contract.
Tenants with a modified gross lease pay a fixed rate per square foot and also pay for some charges directly, such as utilities or janitorial. If a building doesn’t have separate utility meters for each suite, a landlord may bill the tenant for its share of services under a modified gross lease.
Let’s look at a modified gross lease for a 10,000 SF space in a building with a total of 100,000 square feet. The annual lease rate is $20 PSF, and the tenant pays for utilities and janitorial:
- Annual rent: 10,000 SF x $20 PSF = $200,000 per year
- Annual utilities and janitorial: $30,000 per year or $3 PSF
- Total lease rate: $23 PSF per year ($20 PSF annual rent + $3 utilities and janitorial), or $230,000 per year, or about $19,167 per month
Based on the example above, the tenant saves over $800 per month compared to the full-service gross lease in the previous section. However, if utility bills increase due to an unseasonably hot summer or cold winter, those savings could quickly disappear.
Under a net lease, a tenant pays a fixed amount as “base rent” plus a pro-rata share of property taxes, building insurance, and common area maintenance (CAM).
The items that the tenant pays – or “pass through” to the tenant from the landlord – depend on the type of net lease the tenant has:
- Single net lease: base rent + property taxes
- Double net (NN) lease: base rent + property taxes + building insurance
- Triple net (NNN) lease: base rent + property taxes + building insurance + common area maintenance
With a net lease, tenants also pay directly for any additional services such as utilities and janitorial.
Now let’s look at how a triple net (NNN) lease is structured.
In this example, a 10,000 SF space is being leased in a 100,000 square foot building at a base rent of $16 PSF per year. Building property taxes are $100,000 ($1 PSF) per year, building insurance is $20,000 ($0.20 PSF) per year, and CAM (common area maintenance) is $300,000 ($3 PSF) per year:
- Base rent: $16 PSF x 10,000 SF = $160,000 per year
- Property tax: $1 PSF x 10,000 SF = $10,000 per year
- Building insurance: $0.20 PSF x 10,000 SF = $2,000 per year
- CAM: $3 PSF x 10,000 SF = $30,000 per year
- Total NNN lease rent paid: $160,000 base rent + $10,000 property tax + $2,000 building insurance + $30,000 CAM = $202,000 or $20.20 PSF
Net leases can be good for the landlord and potentially good or bad for the tenant. Landlords use net leases to pass through building owning and operating expenses to the tenant.
Tenants with net leases may benefit from paying a lower overall lease rate. Yet, they run the risk of total rent costs increasing if property taxes, building insurance, and repair expenses rise.
A single-tenant building such as a bank branch or fast food outlet is often leased on a triple net basis to a tenant. This lease structure allows the tenant to have complete control over how the building operates while providing the landlord with a steady stream of rental income with little or no property management responsibilities.
Remember: definitions may vary
Keep in mind that there may be regional or “market custom” differences between the names used for lease types, similar to how lease rates vary from market to market.
For example, in one market, it may be customary not to include electric bills in a gross lease – but still call the lease “gross” – while in another part of the country, this same arrangement would be a modified gross lease.
As such, leasing brokers need to verify the exact inclusions of a rental rate the tenant pays, regardless of what the lease is called.
How commercial lease rates are quoted
Three main factors determine the rate a tenant pays to lease a space:
- Size of the area – or suite – being leased
- Services provided that are included in the lease payment
- Amenities, features, and class of the building housing the space
Rate per square foot
Lease rates may be quoted on a per-square-foot-basis per month or per year. For example, if a 10,000 square foot (SF) suite has an annual rent of $240,000 the rate per square foot (PSF) would be:
- $24 PSF on an annual basis = $240,000 / 10,000 SF
- $2 PSF on a monthly basis = $240,000 / 12 months = $20,000 per month / 10,000 SF
In both cases, the annual leasing expense to the tenant is the same; it is just written differently.
Market custom – and sometimes the asset class of the space – determines if a commercial lease rate is quoted on a monthly or annual square foot rate. Leasing brokers may work in a market where it is customary to quote office and retail lease rates at a yearly square foot rate, but for rates on industrial space to be quoted as a monthly rate PSF.
Fixed monthly fee
Sometimes tenants and their leasing brokers will find space quoted at a flat monthly fee instead of per square foot.
Often coworking or shared office space is priced at a fixed monthly fee. That’s because the tenant is paying for the space and accompanying services, such as lease term flexibility and the ability to use office space in different buildings operated by the same coworking firm.
It’s always a good idea for users to break down the fee paid to a rate per square foot. This way, tenants and brokers can use the same metric to compare “apples to apples.”
For example, if the market rate for office space is $24 PSF per year, but the fixed monthly fee for a particular unit ends up being $12 PSF per year, users should ask why there is such a big difference in the per-square-foot rate.
Other important leasing terms, conditions, and clauses
Commercial leases are customized to the unique needs of each tenant and property owner. As such, no two lease agreements are ever the same, sometimes even within the same building.
Here are some other essential leasing terms, conditions, and clauses to consider when negotiating a lease:
- ADA compliance requires the landlord or tenant to improve the suite to comply with the Americans With Disabilities Act (ADA).
- Attorney fees and whether the losing party pays.
- Bankruptcy by landlord or tenant.
- Dispute process and whether mediation is required before filing a lawsuit.
- Escalations which allow the landlord to increase the base rent by an agreed-upon fixed amount percentage, usually once a year.
- The expansion clause, which gives the tenant the first right of refusal to lease additional space available in the property.
- Foreclosure process if the landlord defaults on property loan.
- Gross-up of a full-service lease is where the landlord charges extra if operating expenses exceed a certain annual amount.
- Load factor is a ratio that compares the amount of rentable square feet to usable square feet.
- Percentage lease is sometimes found in retail property and requires the tenant to pay a base rent plus a percentage of gross monthly sales over a certain amount.
- The relocation clause allows the landlord to relocate the tenant to a different suite or building at the landlord’s expense, such as during a commercial property sale.
- Renewal or extension clauses give the tenant the right to renew the existing lease at a previously agreed to rate or the current “at the market” rate.
- Rent abatement or “free rent” is used by landlords as a tenant incentive. Rent abatement may include a fixed dollar amount, a specific amount of time where rent is waived, or a credit that is apportioned across the entire lease term.
- Rentable square feet and how much space is unusable due to building core items like stairwells and elevators.
- Security arrangements and after-hours access for the tenant.
- Turnkey means that a unit is move-in ready and that all wiring and plumbing, and cosmetic items such as painting and flooring, are already in place.
- Usable square feet are the actual amount of space a tenant can occupy.
Key things to remember about a commercial lease
Nearly every part of a commercial lease is subject to negotiation. It all depends on the condition of the local market, the tenant’s positioning, and the landlord’s motivation.
- Main parts of a commercial lease include beginning and ending date, type of contract, base rent and escalations, common area maintenance charges, and renewal and relocation clauses.
- There are three main types of commercial leases: full-service or gross, modified gross, and net.
- Net leases can be single net, double net, or triple net.
- Lease rates may be quoted as a fixed fee, at a monthly price per square foot, or an annual rate per square foot.
- Lease rate quotes may vary from market to market.
- Lease type names can be misleading, so tenants and leasing brokers should always ask what is included in the lease rate.
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