The Lease Equation

The Lease Equation

By Stephen A. Cross, CCIM

Those knowledgeable about commercial leases (landlords, attorneys, property managers, agents/brokers) know they are complex legal contracts that have many variables – all of which are subject to negotiation. The following is a discussion of what I call the lease equation, which takes into consideration factors that can either directly or indirectly affect the tenant’s overall costs of occupancy as well as their rights.

Costs of Occupancy

Rental Rate. There are three distinct rental rates associated with almost every lease: the asking rate, the contract rate, and the effective rate. The asking rate is the advertised rate. The contract rate is the negotiated rate shown in the lease, while the effective rate reflects the economic incentives the tenant was able to negotiate. In my experience, contract rates are typically 5 to 15 percent lower than the asking rate. The value of leasing incentives (free rent, tenant improvements and the like) can effectively reduce the contract rate by another 10 to 15 percent, or more.

Escalations. Escalations of the rental rate do not have to be annual and can occur every two or five years, or never. When required, strive for nominal, infrequent increases and be mindful of your business’ ability to increase prices to customers, patients or clients.

Free Rent Period. In new leases and renewals, and regardless of market conditions, I suggest requesting one month of free rent for every year of the lease term. Free rent should consist of the base rent as well as any operating expenses (i.e., NNN expenses) passed through to you. Many landlords prefer to “burn off” free rent at the beginning of the term, although it could be spread throughout the term.

Security Deposits. If an amount greater than the last month’s rental is required, request the excess portion be applied toward future rents in the event you are not in monetary default at those times. Note that the reference to “monetary” default is significant, as there are several types of default.

Base Year Operating Expenses. The base year is a baseline used to determine the amount, if any, of operating expenses that are to be passed through to a tenant. I suggest the following: 1) Set the base year as the year following the commencement date; 2) Place a cap on annual increases attributable to controllable expenses (such as property management) at no more than 5 percent per annum; and 3) Stipulate that the base year shall be automatically reset upon the exercise of any option to the next calendar year. On newly constructed buildings, make certain the base year is named as the year the building is fully assessed for property taxes.

Tenant Improvements. On second-generation space (i.e., previously occupied), it is common to request the landlord provide new flooring, paint the entire suite (tenant to select colors), and provide minor wall relocation or removal, all at no cost. If substantial remodeling is needed and providing the permanent improvements will have value to a future tenant, it is common to negotiate a tenant improvement allowance of $25 to $100 per rentable square foot, with all or a sizable portion being amortized into the rental schedule as additional rent.

Renewal Options. Stipulate the number and length of renewal options as part of the original lease. I suggest capping the amount of any increase in the rental rate and subsequent escalations. In the event excess tenant improvements were fully amortized during the original lease term, be certain they are not also assessed during the option period(s).

Warranties. Stipulate that the landlord shall warrant the HVAC, water heater(s), electrical, plumbing and roof, among other things, for the entire occupancy period including any exercised option periods. A fallback position is to cap your out-of-pocket costs attributable to the repair, maintenance, or replacement of these things at a nominal amount per year (not per occurrence).

Lessee/Tenant Rights

Expiration Date. While most leases expire on a certain date, some automatically extend for a period and at a new rental rate. This is known as an evergreen provision. Make certain you have a clear understanding of the expiration date and, if applicable, the period during which you must give formal notice of your intent to terminate a lease or exercise a renewal option.

Holding Over. Most leases assess a penalty in the event the tenant stays in the space after the expiration date. These penalties can range from 125 percent to 200 percent or more of the last amount due. Be careful to read this section of the lease carefully, as some spell out the percentage rather than use a number (i.e., “two hundred percent” rather than “200 percent”). The percentage of any holdover penalty is negotiable and can be zero.

Guarantees. If your business or professional practice is an established going concern, a corporate guarantee should be sufficient. In the event a personal guarantee is required, stipulate that it be extinguished after a period of on-time rental payments (say, 12 months) or applied to future rents due. Guarantees are a contingent liability and can affect the businesses’ ability to obtain credit.

Transferability. Be certain the lease and all options can be assigned or transferred to a subtenant or buyer of the business/practice.

Be mindful that the above terms and conditions address only some of the variables that should be negotiated in even the simplest of leases. In that regard, always negotiate in writing… and request written responses. 

Stephen A. Cross, CCIM, owns CROSS Commercial Realty Advisors (crossrealty.com) and is a licensed real estate Broker. Mr. Cross advocates exclusively for tenants and buyers and, since 1984, has advised over 2,700 business owners, attorneys, physicians, facility executives, investors and corporate decision-makers on ways to lease and purchase property at the lowest cost and most favorable terms. Mr. Cross is also a consulting expert on matters involving the conduct of agents and property owners, the fair market value of leasehold and fee simple property, pre- and post-closing due diligence, and the analysis of commercial leases and purchase agreements. Contact: 480-998-7998 or steve@crossrealty.com.