Negotiating commercial leases can be either a pleasant experience or a miserable disaster. Whether you are planning to negotiate the lease directly with your landlord or seek the assistance of a professional (i.e. Legal Counsel, Commercial Real Estate Broker, or a professional lease negotiator) being aware of how key areas of your lease affect your business for the next 10-20 years will help you sleep better at night and ensure you’re not caught off guard when your delinquent or violate a condition of your lease unexpectedly. Do not simply leave the negotiations in the hands of whomever you hire unless you plan to pay them every time something arises concerning your lease! At the end of the day the parties named in the lease are fully responsible for adhering to the terms and conditions of the lease! Anyone you hired to do the negotiations was just hired help and will have no legal obligations to the lease. Therefore, having familiarity with the below 10 key items when negotiating a commercial lease will help you to know where to focus your time prior to and during the lease negotiations.
Although the types and complexity of leases vary, they all generally contain these 10 key focal items. As a licensed real estate broker and having just negotiated our start-up restaurant lease, I wanted to share this knowledge in hopes it will help others seeking information for negotiating commercial leases & renewals. In addition to the 10 key items when negotiating commercial leases, you can leverage other expert resources to gain a general understanding of the leasing process and how to prepare for negotiations. Watch the below video for additional free tips to consider when negotiating your lease!
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1) Locations, Locations, Locations
The age old statement to select your business location based on “Location!”, “Location!”, “Location!” is still just as critical today as it was when the statement was first created. However, to apply the best leverage in your lease negotiations it should read “Locations”, “Locations”, “Locations”! Having multiple site locations picked out that you can commence working with each sites brokering agent will double or even triple your lease negotiation effectiveness. Particularly if you’re deemed by the landlord as a valued long term “lessee” (i.e. Tenant/Client). Strongly consider using a commercial real-estate broker who can take the lead partnering with you and helping you through the process if your not familiar with the local area, contacting and engaging people you don't know or simply don't have the time. Keep in mind you need to stay guarded (i.e. on your toes) once you pick your agent because the agent will typically receive their payment from the Lessor (i.e. landlord) you decide to contract with. Once you have narrowed your search down to two or three possible locations it’s time to gain a better understanding if those locations will financially work for your business model. Oh! Be aware that if a real-estate agent/broker is not used and you negotiate the lease directly, the lessor, as a matter of practice, always includes funding in their budget for a sizable commission to the lessee’s broker. The commission is usually around 3% of the full term of the lease base rent. If the lease is negotiated directly without a broker for the lessee, that funding is now available for use in your negotiations in the below areas. Be creative! Almost everything is negotiable!
2) Rent & Letter Of Intent (LOI)
Before you spend a lot of time traveling around looking for those perfect locations you must have a very comprehensive understanding of your business financial performance model. Regardless of the type of business you’re planning to perform, if the proforma (ie Profit & Loss) model is not understood in detail you will waste everyone’s time attempting to seek locations that you and your team will have no clue as to whether the location is affordable or will contractually work! Depending on the size and complexity of your business you may need to involve other expert members from your team to ensure everything is correctly addressed.
Once you understand your P&L model you and your team will have the necessary insight to successfully engage in detailed discussions concerning the applicable properties. Since rent costs will drive 5-12% of businesses expenses it's best to address the rental rates first with the lessor. Ideally you want your rent rate to be 8% or less of your expense budget. Commercial rental rates can be comprised in many different ways. For this discussion we will assume the total rental cost is comprised of 3 components similar to a triple net lease; the base rent, the Common Area Maintenance (CAM) inclusive of insurance, and Property Taxes. Depending on the location and properties demand these values can vary widely. Therefore call around to other surrounding available property brokers to ensure your being quoted a fair rate. You will want to understand each of these values as monthly and annual rates when plugging the information into your “P&L” model. For example, a $22 base rate per square foot, a $4.50 CAM rate per sqft, a $1.50 property tax rate per sqft are all annual rates. The monthly total rate would be $28/sqft per year. So for a 1,000 sqft space your annual rent would be $28,000 exclusive of local sales tax for where your business will reside. On a monthly basis the rent would be $2.33/sqft multiplied by 1,000 sqft or $2,333.33/month.
Literally everything in a lease is negotiable until it is formally signed. Negotiating the rental costs for the above items are typically done very early early in the process and captured in a document typically issued by the landlord that is referred to as the “Letter Of Intent” (LOI). An LOI is the top level document that starts to take shape based on discussions between the lessee and lessor parties. LOI’s are typically non-binding contractually but do start to establish precedence for the rent, the focal items noted below and most importantly work to be completed by the lessor & lessee as part of any construction activities performed. Do not skimp on writing down the details of the discussions and capturing them as formal meeting minutes. Keeping detailed notes will aid in the development of an LOI that resonates with both parties and thus minimizes wasting time to make major corrections. As the LOI takes shape it should adequately cover details regarding the 10 key items when negotiating commercial leases and renewals.
3) Tenant Improvements
This area of the lease is typically straight forward and remains highly negotiable. It’s customary for the lessor to offer a certain amount of money per square feet to the lessee. This helps the lessee perform and pay start-up and move-in activities known as “Tenant Improvements” (TI). A good negotiated lease will obligate the lessor to provide the equivalent of 1 years’ worth of TI funding or other equivalent compensation (i.e. free or discounted rent). When negotiating your TI funding keep in mind there may be other activities the lessor has committed to perform in addition to the direct pool of TI funding. For example, if the lessor states they will provide $20/sqft of TI for the same 1,000 sqft space we noted above, that would result in $20,000 of TI funding the lessee will receive from the lessor to use however the lessee (i.e. your business) wants to. In addition, lets say the lessor agrees to install a new air conditioning and heating system, perform roof repairs and other misc. items explicitly stated in your LOI. Let’s say those items total $10,500. The lessor effectively will contribute $30,500 ($20,000+$10,500) to the overall TI funding. Typically TI funds are used to pay for activities and equipment that will become the lessor’s assets at the end of the lease because it's typically too costly to remove those items from the property. To help with cash flow issues upfront in the start-up/move-in process, attempt to negotiate to have the lessor release TI funding in increments as work is completed by the lessee. The lessee will need to provide proof to the lessor that no subcontractor leans exist on the property. Remember to be creative and don’t be afraid to ask the lessor to consider a great idea you might have!!! You can't receive what you don't ask for!
4) Commencement Date
The commencement date stated in a lease is hugely important since it establishes the targeted date your business will commence official operations and your first rent payment will become due. The other important thing to remember about the commencement date is that it is NOT usually the date you signed the lease nor when your lease went into effect. Typically at the signing of the lease the overall lease will go into effect. However, there is usually a specified amount of time from the signing of the lease to the date of commencement known as the “Build Out” or “Start-up” or other similar term that allows the lessor and the lessee to perform critical activities to get the property ready for opening day! Usually the lessor has a smaller amount of time required to get the property ready for the lessee in the overall Build Out/Start-up time span. All the lessor’s work will be specified in detail initially in the LOI and then in the formal lease paperwork. It’s the Lessee’s responsibility to ensure there are no gray areas which gives the Lessor an opportunity to take short cuts!
When specifying the Build Out/Start-up time frame ensure the time frame is sufficient for both parties to adequately perform their work, inclusive of any local/gov. inspections that can become quite lengthy to complete. The lease should clearly delineate how much time the lessor and lessor have to complete their work during the overall Build Out/Start-up time span. For example, if the lease states that the Commencement date will occur 180 days from the date the lessor is able to start performing Build Out onsite construction activities it should be further clarified that the lessor has 30 days to perform their portion of the Build Out/Start-up work and the Lessee has the remaining 150 days to complete it’s contracted work.
5) MaintenanceCredit: pixabay
Not paying attention to the maintenance section of the lease can literally ruin your business due to all the hidden costs required to repair and/or replace items on the property you may have originally thought the lessor will repair. However, it is the lessee’s responsibility to cover a portion of the repair bill. For example, your office is on the first floor of a multi-story office complex and the elevator goes out one day. The lessor has the elevator repaired. Two months later your business receives a pro-rated bill for your share of the repair costs which were not in your operating expense budgets! Another costly unexpected cost comes when the HVAC system has to be replaced sooner than expected. You call the lessor requesting to have it replaced because the lessor installed the original system as part of their work scope during the Build Out/Start-up activities. The lessor politely informs you that it’s your responsibility to cover the replacement of the system as stated in the lease. You review the lease and confirm you’re responsible for a large HVAC replacement cost that must be performed immediately because it’s affecting your business! OUCH!!! What about plumbing or electrical issues that trace back to somewhere outside the building? Who's covering those type of expenses?
More importantly have operating budgets for these type of items been put into your P&L model to determine how much money needs to be set aside to cover these issues and how it will affect the businesses profit margins? It’s imperative to spend the time upfront when formulating the LOI to socialize these type of questions with the lessor and establish a clear understanding of whose responsible and document the agreement as part of the LOI process. A simple method is to have a Maintenance Checklist drafted up for all the items that would come into question. Particularly maintenance that borders on the inside or outside of the building and may be considered as part of the buildings infrastructure and thus assumed to be the lessor’s costs. If you’re not sure then definitely ask! And Remember, everything is negotiable!
Adequate available parking can be another critical item that can literally defeat your business if not planned out carefully. If your business is dependent upon a constant amount of high volume traffic (ie restaurants, stores, etc.) in order to meet your sales projections, having insufficient parking can limit your businesses growth potential no matter how good the product or service is! If you own a restaurant you may want the lessor to set aside dedicated parking for patrons to pickup to-go orders or for delivery staff to park in so they maintain a high rate of food deliveries and maximize their productivity vice driving around the parking lot looking for a place to temporarily park their vehicle.
The key is you don’t want to sign a long term lease and discover in your first month or two of operations the site has inadequate parking provisions. It’s very important to assess your businesses parking needs! Observe the traffic flow of your surrounding tenants and how that may impact your business during various times of the day. Finally consideration should be given to monthly expenses that may be required by the lessor. For example, if your business is dependent upon a parking garage facility the lessor could impose a monthly fee for use of the garage by your employees or pass along service and maintenance fees so the lessor avoids incurring the costs.
Take adequate time to scout each of the locations your targeting and visualize what the traffic patterns could be like at major peak hours of operation, as well as, how any special costs imposed by the lessor could drastically impact your bottom line. If the property passes your evaluation but you still have concerns write them down and communicate them to the Landlord. If any of your concerns are show stoppers then you’ll know to move on early in the process as opposed to getting stuck with a location that won’t work and constantly having regrets for going through with the lease!
7) Personal Guarantee
Personal Guarantees are essentially extra insurance for the lessor such that if your business is found in default of the lease and not able to properly cure the issues, the lessor has the right to come directly to the Personal Guarantor(s) (usually that’s you and any other partners who signed a Personal Guarantee) to financially settle the outstanding financial commitments outlined in the lease. For example, if your lease rent was $100,000/year for 10 years and your business defaults the first month of your second year of operation and declares bankruptcy the lessor has the right via the Personal Guarantee to seek financial settlement for the $900,000 in rent monies directly from any of the Personal Guarantors named in the lease!
Typically Personal Guarantees are requested by the lessor for start-up businesses that do not have 2 or more years of prior financials that the lessor can review to assess the strength of the business. Larger more complex deals may require personal guarantee’s by the lessor. However, given the financial obligations this puts most small business owners in, it is highly recommended you do not sign a personal guarantee with the lease! Personal guarantees are not required by law or other business regulations! It is more for the reasonable protection of risk for the lessor. If the lessor will not agree to a lease unless a personal guarantee is provided, negotiate for a limited term personal guarantee. Particularly if the business partners have strong credit records! The term should be directly proportional to the amount of capital the lessor had to invest into the building. If the lessor expended $180,000 in TI and other capital investments to get the property ready for your business, then with an annual rent of $100,000 the personal guarantee should not be longer than 2 years. After year 2 the lessor would have made back their initial $180,000 with $20,000 in income. Worse case a term of 4-5 years for the above example should be acceptable, especially if the business has been free of any defaults and met all the of the lessor's financial obligations. At the end of the day both parties will have to determine what’s acceptable relative to the risk of possible default on the lease. As mentioned earlier having multiple site locations increases your negotiating power on tough topics like personal guarantees!
8) Protection From Compeition
Everything presented thus far are items directly effecting your business that you can attempt to directly control. Losing business due to unexpected competition moving into the area, particularly directly into the lessor’s complex is something you likely will have little influence or say over once the lease is signed. The lessor's mission is to find the best long term tenants possible in order to meet their financial objectives. Often this means a direct or indirect competitor to your business is permitted to establish their business with the lessor. We’ve all seem this occur! At the same time though if you have been a solid tenant and the forecast looks like that behavior will continue the lessor is unlikely to bite the hand that feeds them. Especially if your business is of excellent standing and it looks like that behavior will continue.
With that said instituting a non-compete or selective use clause into the lease that will protect your business from the lessor leasing to “Like-Kind” businesses would be beneficial. If you have a large well performing business concept hold your ground in the negotiations to ensure your business is protected. Once you sign the lease and fail to protect your business it’s inevitable that Murphy’s Law will occur and something bad will happen. That anchor tenant that you thought was going to be there for the next 10-20 years just went out of business or decided to relocate and now your lessor is in discussions with a another business that has a similar offering to yours or may adversely impact your business? Does your lease protect you? If not it should have! Be diligent and persistent!
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Similar to an aircraft fighter jet that has an ejection seat to allow the pilot to safely escape from his plane quickly and easily, a well negotiated lease must have the ability to assign the lease over to someone else or some other graceful exit strategy. Assignment of the lease may be needed for a new partner who is taking over for you because you decided to retire early or personal family matters arose. The new owner will likely want to inherit the existing terms of the lease vice facing negotiating a new lease which could cause costs to rise and legal protections to disappear! Should you wish to terminate the lease for various unknown and valid reasons you nor your partners should be penalized for deciding to terminate the lease. When negotiating your lease ensure that you have an easy and simple to use ejection seat type method that allow you to assign or terminate your lease in a way that is favorable to you, your partners and the lessor!
Advertising your business is critical to ensuring a steady flow of traffic, leads and sales. Depending on the size and location of your business you might have a strong need to have your companies name displayed on the lessor’s Sign Pylons at the entry/exit points, on your buildings frontage above the main entrance etc. and other key locations. The lessor may have special provisions for erecting signage inside business parks such as directory listings near the elevator. The key point is you need to ensure your lease provides specific wording that will permit you to properly advertise your business on the lessor’s property preferably for free of charge or for a nominal fee. Also ensure you’re aware and concur to any expenses required to repair or remove any signage you erect.
Negotiating commercial real-estate leases can be very complex and involve a lot of areas requiring subject matter expertise such as zoning ordinances, regulations and other local code enforcement that will require you to hire specific expertise to ensure your properly represented and legally protected. Overall though a large portion of leases focus around everyday common sense activities that you will want to be directly involved with to ensure your business is adequately protected. I wish you the best of luck in your negotiating endeavors! Should have any questions feel free to share them below in the comment section or contact me directly if they are of a private nature.
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