What Every Entrepreneur Needs to Know About Commercial Leasing
As an entrepreneur, there comes a time when you'll need to consider leasing a commercial space. This could be an office, a warehouse, a retail store, or any other kind of space necessary for the operation of your business. But commercial leasing is a complex process that requires careful consideration. Here's what you need to know.
Understand Lease Types
There are different types of commercial leases, and it's essential to understand them before signing anything. The three most common types are base year/gross leases (where the landlord pays all property expenses or all expenses up to the expense stop), net leases (where the tenant pays some or all property expenses), and modified gross leases (a mix of the previous two).
NNN Lease (Triple Net Lease): In a NNN lease, the tenant is responsible for paying the base rent and the property's operating expenses. These expenses typically include property taxes, insurance, and maintenance costs (the three 'nets'). This type of lease is usually beneficial for the landlord because it mitigates the risk of unexpected increases in operating costs.
Example: Let's say you are a tenant with a NNN lease for a small shop. Your base rent is $2,000 per month. In addition, you'll also have to cover your pro rata share of the building's property taxes ($300/month), insurance ($200/month), and maintenance costs ($100/month). Your total monthly expense will be $2,600.
Base Year Lease (Expense Stop Lease): In a Base Year Lease, the tenant is responsible for paying the base rent and operating expenses that exceed the agreed 'base year' amount. The base year typically corresponds to the first year of the lease, and the landlord covers all operating costs up to this amount. The tenant is responsible for any increases in operating expenses after this year. It’s important to ensure that if your lease begins towards the middle or end of the current year, that you request that the subsequent calendar year serve as the base year. Otherwise, you may only benefit from a few months of pass-through protection.
Example: Suppose you are a tenant with a Base Year Lease for an office space. Your base rent is $2,000 per month. In the first year (the base year), the operating expenses of the building are $500/month, which is paid by the landlord. In the second year, if the operating expenses rise to $550/month, you as the tenant would be responsible for your pro rata portion of the extra $50/month.
Here is a simple chart to summarize:
Lease Duration and Renewal Options
Commercial leases typically span several years. The duration is an essential factor to consider because it will have a direct impact on your business. A short-term lease provides flexibility, while a long-term lease offers stability. Also, look out for renewal options and understand the terms.
Understand the Costs
Apart from the base rent, there could be other costs such as utilities, maintenance, and Common Area Maintenance (CAM) fees. Get a detailed breakdown of all the costs involved to avoid any surprises later on. Negotiating a cap on annual increases for these additional costs can help keep expenses predictable.
Operating expense caps are a common provision in commercial leases and are used to limit the amount by which a tenant's share of the operating expenses can increase from one period to the next. They can be structured in different ways, and two common types are year-over-year caps and cumulative and compounding caps.
Year-Over-Year Cap: This type of cap limits the increase in operating expenses that can be passed onto the tenant from one year to the next. For example, if the cap is set at 5%, then the tenant's share of the operating expenses cannot increase by more than 5% in a single year.
Example: Suppose the operating expenses in Year 1 are $10,000. In Year 2, the expenses rise to $11,000, a 10% increase. However, with a 5% year-over-year cap, the tenant would only be responsible for an increase of $500 (5% of $10,000), not the full $1,000 increase.
Cumulative and Compounding Cap: This type of cap allows unused increases from prior years to be applied to later years. It is cumulative because it adds up the unused cap amounts from previous years, and it's compounding because it applies the percentage increase to the previous year's capped amount rather than the original base amount. This type of cap is generally more favorable to the landlord, as it allows for larger increases over time.
Example: Suppose the operating expenses in Year 1 are $10,000, and there's a 5% cumulative and compounding cap. In Year 2, the expenses remain the same, so the cap is not reached, and the tenant still pays $10,000. However, in Year 3, the expenses rise to $11,500, a 15% increase. Because of the cumulative cap, the tenant is now responsible for an increase of $1,000, which is 10% of $10,000 (5% from Year 2 and 5% from Year 3), not just the 5% increase that would be permitted in a single year.
The compounding nature of an expense cap in a lease refers to how the cap increases each year based on the previous year's cap amount, not the original base amount. It's similar to how compounding interest works in a savings account or loan.
To illustrate, let's continue with the example from the previous situation, with a 5% cumulative and compounding cap.
In Year 1, the operating expenses are $10,000.
In Year 2, the expenses remain the same ($10,000), so the cap is not reached. However, the cap for Year 2 is now $10,500 ($10,000 + 5% of $10,000), despite the expenses not increasing. This unused cap of $500 is carried forward.
In Year 3, the expenses increase to $11,000. Because of the cumulative and compounding cap, you calculate the cap based on the previous year's cap amount ($10,500), not the original expenses. So, the new cap for Year 3 is $11,025 ($10,500 + 5% of $10,500).
As a result, even though the actual expenses only increased by $1,000 since Year 1, the tenant is still within the cap and responsible for the full amount. This is because the cap has been compounding each year. In both cases, the cap provides a measure of protection for the tenant against dramatic increases in operating expenses. However, the way that protection is structured can significantly affect the tenant's costs over time. As always, it's crucial to understand these details before entering into a commercial lease agreement.
Location Matters
For many businesses, location is crucial. Consider factors like proximity to customers, access to public transport, availability of parking, and other amenities. Remember, a prime location might come with a higher cost.
Know Your Space Requirements
Before searching for a commercial space, take time to assess your needs accurately. This includes square footage, layout, growth prospects, and specific requirements like high-speed internet or special electrical or plumbing needs.
Lease Negotiation is Key
Everything in a commercial lease is negotiable. Whether it's the rent, the duration, or the responsibilities of each party, don't accept the first offer. It's often beneficial to have an experienced real estate lawyer or a commercial broker to help with these negotiations.
Review Zoning Laws
Before signing a lease, ensure the property is zoned for your type of business. Zoning laws can affect various aspects of your business, from operating hours to signage. Ignoring this could lead to costly mistakes.
Inspect the Property
Before signing a lease, conduct a thorough inspection of the property. Look for any structural issues, verify that the HVAC system is working, and make sure all safety standards are met. Consider hiring a professional inspector for an unbiased view.
Get Legal Advice
Commercial leases are legally binding documents that can be difficult to understand. It's highly recommended to hire an attorney who specializes in commercial real estate. They can help you understand all terms and conditions, identify potential issues, and negotiate better terms.
Have an Exit Strategy
Finally, ensure your lease agreement includes provisions for breaking the lease if necessary. This could be due to business failure, relocation, or expansion. Understand the penalties and notice periods involved in this process.
Commercial leasing can be a significant step in your entrepreneurial journey. By understanding these aspects of the process, you can make an informed decision that supports the growth and success of your business. The key is to do your research, understand your needs, and never hesitate to seek professional advice.
