The reading level for this article is Novice
The information, ideas and suggestions contained in this section deal with the management of legal issues and are not to be construed as legal advice. The author is not an attorney and is not qualified to provide legal advice. The author and the publisher, Peoples Income Tax, Inc., assume no responsibility for decisions made by readers of this book based on information contained herein, or for omissions of information. You should seek the advice of a qualified attorney to provide information or answer any questions you may have that involve the law and/or legal issues.
Doing Your Homework
Signing a lease for an office is a decision that will greatly impact your business. A good choice can dramatically improve your success, but a mistake could be disastrous. You must not take this chore lightly or rush through the process. Information and knowledge are power and to be on equal footing with the landlord, or more likely the landlord’s leasing agent, you must educate yourself in the rules of the leasing game and obtain as much information about the property, the landlord and the local market conditions as possible. Much of the information should have been obtained during your site selection process (covered in Chapter 2). Additional information needed to negotiate a lease might include the following (partial list):
1. History of the Premises:
a. How long has the premises been vacant?
b. What were the terms and rent for the previous tenant? (Try to locate tenant and ask.)
c. What has the cost been for utilities? (electricity, heating & air conditioning)
2. Current Status of the Premises:
a. How many other spaces are vacant?
b. What are the other tenants paying for comparable space? (rent and other charges)
c. What special conditions or restrictions has the landlord imposed on other tenants?
1) Hours of operation requirement
2) Percentage rent
3) Signage restrictions
4) Parking restrictions
d. What special concessions has the landlord made for other tenants (past and present)?
1) Rent abatement allowances made?
2) Build-outs paid for?
3) Options for renewal granted?
4) Standard lease provisions waived? (e.g.: required hours of operation)
e. Outside events that may impact premises (e.g.: road work, competing new centers)
f. Financial status of the landlord
g. Future plans of the landlord (e.g.: might the premises be sold?)
Types & Characteristics of Landlords
The ease with which you can negotiate a favorable lease will depend, in part, on the type of landlord who owns the premises. The following are examples of some of the types of landlords you might encounter and their general characteristics:
Individual Owner/Investor: A private individual who owns a building or shopping center as an investment and/or tax write-off. This owner will probably be eager to find and keep a long-term tenant to insure the steady rental income necessary to meet mortgage payments and insure a positive cash flow. Depending on the wealth, goals and personality of this owner, he or she may be very easy to work with or very difficult. If you can communicate directly with an individual owner, you may be able to obtain concessions that would be rejected by a leasing agent. An individual tends to place more importance on the perceived personality and integrity of the tenant. Generally, the lease should be simpler and easier to negotiate with an individual owner.
Individual Owner/Co-tenant: A private individual who owns a building or shopping center in which he is also a tenant. In addition to sharing the characteristics of the owner/investor, this owner may also be motivated to find a tenant that complements and enhances the success of his or her business at the premises. Such an owner may reject a tenant that does not generate adequate (or year-round) traffic or attract the “right” type of customers.
Limited Partnership or Corporation: The characteristics of a small group of investors will be similar to those of the individual owner/investor. However, the entity will be more sophisticated, professional and objective than an individual. The degree of sophistication depends, in part, on the size of the organization. Some are huge with holdings in several states or even nationwide, often comprised of multiple smaller limited partnerships, each investing in one or more properties. The ease with you can negotiate a favorable lease will depend on the person or people who are handling leasing for the organization and the size of the group. The limited partnership may make special concessions for a desirable long-term tenant. If the organization is trying to obtain refinancing it may be anxious to get a lease signed, even if it is less favorable than desired. Their standard lease may be relatively simple or very complex. Some leases may contain uncommon clauses due to experiences and concerns of individual partners.
Property Development Company: These landlords are in the business of constructing buildings and shopping centers and making them profitable and more valuable. Often their objective is to get a property fully leased and sell it at a big profit; then invest the proceeds in the development of other properties. However, many development companies hold properties indefinitely if they are very profitable or if they cannot be sold for a satisfactory profit. This may especially be true for the property where the development company is housed. Development companies may be more flexible than other landlords in the interest of achieving a greater occupancy rate to appeal to financiers and prospective buyers. Leases will be similar to those of limited partnerships.
Types & Characteristics of Landlords (continued)
Investment Trust Company: Investment trusts tend to be among the largest and most sophisticated of landlords. They are usually managed by a team of sophisticated professionals including specialists in leasing and property management and property acquisitions. Many are very large and bureaucratic and have in-house legal departments. Because of their high level of sophistication and extensive experience, expertise and risk-aversion, a typical investment trust lease is very long (often more than 50 pages) and complex. An investment trust is usually concerned about the long-term prosperity of the property and, therefore, tends to take a long time–perhaps 60-90 days to negotiate a lease.
Negotiating Through a Leasing Agent
Most shopping center and office building landlords employ a leasing agent to find tenants and negotiate leases and the leasing agent is who you will probably be dealing with. Keep in mind that the leasing agent’s objectives may not be in complete accord with the goals of the landlord. The agent’s goal is to find a long term tenant and earn a commission (usually a percentage of the annual rent). When considering a short-term lease with the possibility of a long-term renewal, the agent might not be interested in the small commission and, therefore, might not present your proposal to the landlord. If you are turned down by the agent, you might find out who the landlord isand approach him or her yourself.
Most commercial leasing agents are very sophisticated and can, in fact, help you obtain concessions from the landlord in the interest of closing a deal. Remember, though, the agent is working for the landlord, not you, and will not volunteer to make concessions or make you aware of negatives about the property or pitfalls in the lease. Many entrepreneurs are intimidated by leasing agents who are skilled in getting tenants to conform to landlords’ “lease requirements”. Keep in mind the old adage, “everything is negotiable”. But also remember that your ability to obtain concessions on issues of importance to the landlord will be greatly dependent on the demand for the premises and your desirability as a tenant.
A common tactic of leasing agents is to have an initial meeting with a prospective tenant to discuss general provisions such as the lease term and rent and reach an agreement in principle. Then the agent will prepare multiple copies of a lease reflecting the points agreed upon and send them to you with a cover letter requesting that you sign and return all copies to be presented for the landlord’s signature. Naive tenants frequently succumb to this intimidating inference that the lease is now in final form as agreed upon and cannot be changed. Actually, the detailed lease terms are not agreed upon by you until you read the landlord’s proposed lease and sign it. And the lease is not final until it is signed byyou, the landlord and any other party to the lease. Never sign a lease until you have read, understand and are willing to accept all of the lease provisions. Agents are accustomed to negotiating the fine points of leases with tenants and making changes in
the initial drafts.
Negotiating Directly With the Landlord
The landlord may be less sophisticated and easier to deal with than a professional agent. Direct negotiations, however, can also result in an impasse which might have been resolved by an agent serving as intermediary. Dealing directly with the landlord could save time, but could also take longer if the landlord is not readily accessible. As mentioned previously in the discussion of characteristics of landlords, the individual owner may make decisions based on less objective criteria and be more influenced by personal impressions. The landlord may also be more receptive to making concessions or signing a short-term lease than an agent. Also, if there is no agent to pay a commission to, a lower rental rate may be possible. Given the choice, I would generally prefer to negotiate directly with the landlord.
Using a Lawyer
If you are a poor negotiator or do not have the time or aptitude to analyze and interpret the lease, and you can afford it, you might be wise to hire an attorney. However, you should find a lawyer who has special expertise in leases and who comes with good re ferences from sources you can trust. Hiring a lawyer does not insure that you will get the advice you need. I have seen leases that were “blessed” by attorneys which contained provisions that I would never have agreed to. Lawyers have also been known, on occasion, to kill good deals because they are overly anxious to change provisions that do not really pose serious concerns or carry relatively low risk for you. A good lawyer isn’t always a good business person. Therefore, you must read the lease yourself to determine the deal you are willing to make. However, asking for changes in a professional and non-demanding manner usually won’t hurt your negotiations. You’ll never get what you don’t ask for. You should rely on your attorney to explain legal language and provisions that you don’t understand, to point out potential problems and to advise you. All final decisions should be made by you since you are the one who is making the deal and must live with the terms and conditions agreed upon.
Standard Lease Forms:
Most landlords have adopted standard lease forms which include all of the terms and conditions they would like to have. More sophisticated landlords have developed their own standard leases, usually under advisement by their attorneys and leasing agents. Major real estate development companies and investment trusts tend to have very complex leases (usually 40-50 pages or longer) including provisions to protect the landlord under almost every potential situation that the landlords or their lawyers have ever experienced, heard of, or read about. While such standard lease forms also reflect terms and conditions that are fair to the tenant (often dictated by tenant’s rights laws), they are almost always heavily weighted in favor of the landlord.
Negotiating such a lease can be very time consuming, confusing and frustrating. Many tenants give in and sign the standard lease without changing the provisions they don’t fully understand because they have relied solely on the landlord or the agent for explanation. This is a mistake! You will be legally bound by all terms and conditions of the lease and you should make sure you know the exact meaning of every provision and how it could affect you. If necessary, seek advice from an experienced entrepreneur or an attorney.
TIP: National firms such as H & R Block present landlords with their own standard lease forms which are favorable to the tenant. Consider developing your own “tenant friendly” standard lease like the sample lease we’ve included at the end of this chapter.
Key Leasing Considerations
The following discussion of common lease provisions is general and not exhaustive. Your particular circumstances might involve factors not discussed here or situations not addressed in this discussion of key leasing considerations. For this reason you are advised to seek qualified legal advice in making any important leasing decision about which you may be uncertain.
1. Premises Description: The lease should include the correct legal description of the premises that you are leasing. Ideally, the shopping center or office building will be identified by its designation as legally recorded in the jurisdiction in which it is located. The space you are leasing should also be identified by its U.S. Post Office address and, in the case of subdivided space, a detailed description including its square footage, dimensions and location within the building. Often drawings are attached as lease exhibits and referenced in this provision. These exhibits should show the location of the leased premises within the site and include a floor plan of the leased premises drawn to scale.
TIP: Measure the dimensions of the premises and calculate the exact square footage of the space you are leasing. It is not unusual for the square footage to be overstated in the lease, resulting in a significant overcharge of rent. Note that some landlords add to the square footage of subdivided space a proportionate share of common area space such as halls and rest rooms.
2. Lease Term: Complex leases may define the “Term” as beginning on the “Commencement Date” and ending on the “Termination Date”, and these terms are defined elsewhere in the lease. If you encounter these terms, stop and locate all references in the lease to the Commencement Date and Termination Date and scrutinize these provisions carefully for potential pitfalls. For example, the Commencement Date might be defined elsewhere in the lease as the later of the date you want the lease to begin and the date the landlord completes construction or landlord required build outs. In fact, you might have to find another location, resulting in the obligation to pay rent for two offices! The best solution is to insist on exact calendar dates for commencement and termination and provide for the right to cancel the lease in the event that the premises is not delivered on the date you need possession. (Note: the Termination Date will usually be specified as the earlier of the date you have agreed the lease will end or the date the landlord has the option to terminate the lease under a default provision.)
TIP: Always start a new lease on January 1st and obtain early possession–rent free–to set-up the office for occupancy, and have the lease end on April 30th.
3. Rent Charges: Base rent for commercial retail or office space is usually determined and quoted as an annual rate per square foot. For example, a rental rate of $12 per square foot for a 1,000 square foot space would total $12,000 per year or $1,000 per month. Keep in mind that the base rent charge is only one component of your rent cost. When comparison shopping for office space (and budgeting), you must consider all occupancy costs, including “pass-through” charges (see item 4 below), build-outs (see Glossary definition), utilities, repairs & maintenance, sign fabrication and installation and anything else you must pay for at each location.
Rent escalation provisions are often built into long-term leases. Some landlords may provide for annual rent increases, others might allow the rent to stay constant for two or more years or throughout the entire term of the lease. Usually a renewal option will include a rent increase. Many landlords tie the rent increase to the annual rate of inflation determined by the “Consumer Price Index” of the U. S. Bureau of Labor Statistics or some other such index. Other landlords will specify a percentage or dollar increase. Recent rates of inflation have been 4% or lower. The landlord might use a 6% factor to hedge for increased inflation. Or might use an even dollar amount that equals or exceeds the anticipated rate of inflation. For a $12 per square foot rate, a 50 cent increase represents 4.2% and a $1 increase equals 8.3%. Therefore, a 50 cent annual increase or a $1 semi-annual increase under today’s economic climate would be fair for a lease with base rent in the $11 to $13 range.
Quite often a big problem is finding a suitable space that is not too large. Your main office can probably be operated comfortably in a 1,000 square foot space. For a branch office, 600-800 square feet should be adequate. Professional office buildings often afford flexibility, but retail storefronts in most shopping centers tend to start at 1,000 to 1,600 square feet. Because it is to a landlord’s advantage to build and rent larger spaces, there is a shortage of small stores in prime retail shopping centers in most sizeable markets. If you rent a space that is 25-50% larger than necessary, not only will your rent be higher, but your lighting and air conditioning cost will be increased proportionately.
TIP: If a desirable space is too large for your needs suggest to the landlord that the space be subdivided. Usually the space will be too deep, in which case an adjacent existing or future tenant might be willing to expand into the rear of your space, leaving you with a smaller store.
TIP: If you are signing a long-term lease, ask for an abatement of rent for up to 6 months or longer, especially if the landlord is incurring little or no cost to make improvements to the premises. Depending on market demand for space, landlords have been known to allow up to year of rent-free occupancy to attract a good long-term tenant. It doesn’t hurt to ask!
“Percentage rent” is common for traditional retail tenants in malls and major “strip” shopping centers. A retail merchant typically pays a guaranteed minimum rent plus a percentage of all “gross sales” or any gross sales realized above a specified level. Service businesses, however, typically pay a flat rent amount that is not tied to revenue and all . Seasonal mall offices and leased departments are often leased under percentage rent arrangements (further explanation in Chapters 4 & 5).
4. “Pass-through” Charges: Many retail shopping center landlords offer only “triple net leases”, which means that all costs of operating and maintaining the shopping center are passed through to the tenants. Under a net lease, each tenant pays a percentage of these “pass-through” charges equal to the percentage of the total leasable space in the center occupied by the tenant. Thus, If the center is 100% leased, the landlord pays none of the costs. Pass-through charges include, but may not be limited to, the following costs: (1) property taxes, fees & assessments, (2) insurance, including property, liability and fire & other casualty, (3) common area maintenance, (5) landlord’s operating costs, (6) shopping center marketing costs, and (6) any other cost incurred by the landlord in connection with the property.
When negotiating a lease with pass-through charges, you should find out how much those charges are currently running per square foot of leased space in the shopping center and add that to the base rental rate for comparison to other options. Usually estimate amounts will be assessed monthly for pass-through charges, then adjusted to actual costs after the close of the year. As mentioned under “Rent Charges”, you should also consider all other occupancy costs which may vary among different properties.
5. Utilities: Again, utilities should be considered along with rent and pass-through charges as occupancy costs for comparison shopping and budgeting purposes. Professional office buildings typically include utilities in the rent (to save the cost of installing separate meters and to permit flexibility in restructuring space). Retail shopping centers usually install separate meters and require the tenants to put all utilities in their own names. Depending on the type of HVAC system and the insulation and size of the premises, utility costs can vary greatly from one office to another. Consider too that you may be required to post a utility deposit for a new location.
TIP: Ask the utility company (or the previous tenant) to provide you with the actual cost of utilities for the past year or two.
6. Security Deposits: Posting a security deposit is a losing proposition for the tenant and should be avoided if at all possible. Most small business owners cannot afford to have any working capital tied up. Try to convince the landlord that there is no risk that you will not honor all terms of the lease which will undoubtedly include a clause holding you responsible for any damage to the premises. Offer references instead of money.
TIP: If the landlord will not waive the security deposit, ask to put the money in escrow in a savings account in your name to be released upon satisfaction of the lease terms. As an alternative, ask the landlord to pay interest on the security deposit.
7. Rent Payment Schedule & Terms: Usually base rent and estimated pass-through charges are due and payable on the first day of every month. Sophisticated landlords will specify that any set-off or deduction is prohibited regardless of the reason. However, you might ask for a provision to permit a set-off if critical services necessary for you to operate are not provided by the landlord. Most leases provide for tenant’s failure to pay rent within 5-10 days after the due date to constitute a default (see discussion later in this chapter). Some leases–in addition to late payment constituting a default–provide for the assessment of stiff late charges (e.g.: $50 plus $20 per day from the due date).
TIP: Ask for a provision requiring at least 5 days written notice of non-payment of rent before it constitutes default. Explain that a bookkeeping oversight could occur or your check could be lost in the mail.
8. Upfiting Leased Space: It is common for landlords to spend substantial sums of money for “build-outs” needed by long-term tenants. Often rent rates reflect the cost of such build-outs which will be recovered by the landlord over the term of the lease. As an alternative to making build-outs, the landlord may agree to a lower rent, or an abatement of rent, or may even give the tenant a payment or allowance to make the desired improvements. Before negotiating, find out what the landlord has done for other tenants.
Whether improvements are made by the landlord or the tenant or both, the lease should stipulate the improvements that must be made by the landlord and may be made by the tenant. This will usually require an addendum with detailed descriptions, specifications and, if necessary, drawings, as well as required completion dates. Any work that you agree to perform as the tenant should be at your option, using a non-union contractor of your choice (or yourself). Again, cost that you must incur to upfit the space should be considered as occupancy expense.
The lease should stipulate that any removable improvements made by the tenant, such as fixtures and equipment, will remain the property of the tenant. The landlord should agree to this provided that any damage resulting from the removal of the improvements is repaired and the premises is restored to its original condition.
9. Use of the Premises: This is a critically important provision that is often skimmed over too hastily by tenants. Be sure this clause stipulates every type of business you are now engaged in or are contemplating for the future. Also consider that your business could change, requiring you to provide new services or products or to subrent the premises. Since you are paying rent for the space, you should be entitled to operate any legitimate business that is not detrimental to the shopping center or prohibited by other tenant leases. The sample lease at the end of this chapter contains an example of a tenant-favored use claus