Commercial leases are complicated. These tips will help you sort through the legal jargon.
- Research is the key to signing the right business lease. Specifically, look at the building owner, landlord, zoning laws, environmental expectations and nuisance laws.
- Know how much you have to pay, what exactly you're covering and how much your rent will increase each year. Some leases include extra payments (e.g., utilities, insurance or maintenance), while others fold all of your expenses into one monthly lump sum.
- Establish details on how your lease will be transferred if your business closes or you move. Two examples are assignment of the lease, which allows another business owner to fully take it over, and subletting.
- This article is for business owners who are looking to lease a commercial space and want to ensure they understand the contract.
Signing a lease is an important step for any new business owner. Whether you're opening a store, moving into an office space or renting out facilities for production, at some point, you're probably going to have to reserve a space for your business. The world of commercial real estate can be complicated, and it can sometimes take years to find the space you're looking for.
Once you've found that space, signing the contract could feel like an annoying final step before you can get moved in and focused on running your business. But like most legal agreements, a business lease is an important document that requires some research.
"You have to do a lot of planning when you're moving from one space to another," said Walter Gumersell, partner with Rivkin Radler. "Confirm the terms that you're going to be taking." For example, include clauses about rent, the security deposit, the term of the lease and the use of the space. "You want that to be as broad as possible," he said.
It should be no surprise that the fine print in a commercial lease is very important. There are two basic steps to take before signing a lease: Do extensive research, and be aware of typical statutes included in business leases.
Steps for research include vetting the landlord, determining the building owner, researching zoning laws and getting a general feel for the area. Before you sign a lease, make sure you get an idea of the payment structure, your own personal risk exposure, the transfer structure, the landlord's desired holdover rate and any nuisance clauses in your lease. These are some important things to look out for, but keep in mind that typical commercial lease practices vary by state.
Commercial lease vs. residential lease
A commercial lease is required any time a business rents a commercial property for the purpose of conducting business from that location. Nishank Khanna, chief marketing officer at Clarify Capital, said a commercial lease agreement is a legally binding contract between a landlord and a business tenant.
"The landlord agrees to rent out the business property, which is typically an office space, in exchange for money," Khanna told Business News Daily. "Commercial leases typically last from three to five years, creating a long-term relationship between the lessor and lessee."
Although this may sound very similar to a residential lease, there are some important distinctions between a residential lease and a business lease. For one, while both involve a landlord renting space to a tenant in exchange for money, a residential lease cannot be used for business purposes.
In addition, "commercial leases are less regulated and offer less protection than residential leases," Khanna said. "They are typically longer in duration and offer greater flexibility when it comes to negotiating conditions than residential lease agreements."
Another difference is that renters in a residential lease agreement are usually not responsible for paying property taxes, whereas with commercial lease agreements, it's very common for the tenant to pay at least a portion of the property taxes.
Key Takeaway: Commercial and residential leases are similar, but there are some important differences, including how long the lease is and who pays the property taxes.
Elements of a commercial lease agreement
A commercial lease agreement is a contract, so it must include certain elements and key information for it to be valid and enforceable. At a minimum, information regarding the rent, security deposit, lease duration and any additional costs the tenant may be subject to should be clearly defined within the lease, according to Khanna.
"The 'other costs' category is an especially important one that should be carefully reviewed" before you sign the contract, Khanna said. "Building insurance, property taxes and maintenance costs fall under the 'other costs' umbrella. These additional expenses can quickly tally up to large overhead costs."
Khanna also noted that small business owners should be aware of the difference between exclusive and permitted use. For small business owners in competitive industries, an exclusive-use contract can be especially beneficial.
"An emerging brewery, for example, would be wise to request exclusive permission to rent out space within a community market, in order to decrease opportunity for competing sales," Khanna said. "Without exclusive permission, another brewery could rent space within the market and try to win business from the same pool of customers, thus reducing the first brewery's profit significantly."
Did You Know: There are several core elements of a commercial lease, such as the cost of rent, additional fees, the security deposit and the length of the lease.
Researching the area, landlord and lease details
Before you sign a commercial lease agreement, you'll have to do some research. Make sure to take the following steps while investigating.
1. Understand the area.
While looking for a new property, if you're selling a product or service to the public, analyze the area and get a good idea of your potential clientele. Location means everything for a small business to thrive, so when you're shopping around for the right properties, take the time to find the right new home for your business. Gumersell said this process can take two years or even longer, so make sure you plan accordingly if your current lease's end is in sight.
2. Find out more about the landlord and building owner.
Gumersell also said that one of the most important aspects of research that is often overlooked is learning more about the landlord and building owner. Sometimes, your direct landlord may not be the true building owner. Either way, find out as much about the landlord and building owner as possible. You're entering a business partnership together, so make sure you have an idea of who they are, what their financial situation is and whether they're making good on their payments.
In some states, for example, if a landlord fails to make his or her payments to the building owner, or fails to make mortgage payments to a bank, the business or tenant can end up getting evicted in the event of foreclosure – even if the business has been on time with every payment. That's just one example of how the relationship among a landlord, tenant and building owner can go awry. Gumersell said businesses can conduct a public records search to find out more about the landlord. You can also request documents related to the landlord's limited liability company or business entity to learn more about whether it's an ideal partner for your business.
3. Research zoning laws.
Another component to look into is the zoning laws. While your landlord may designate your space for, say, running a restaurant, you have to make sure the landlord's aims are consistent with the laws of your municipality. There are scenarios in which a landlord or building owner may think they can lease their space to a certain type of business, but it doesn't match standard zoning laws in the area. By aligning these two details, you can ensure that your business can operate without any major legal headaches from the town or city in which you're operating.
4. Learn about nuisance laws and the environment.
One of the most important aspects of signing a lease is being able to operate your business to its fullest capacity once you open your doors. Many leases have extensive points on noise, smells and equipment. Ann Brookes, a tax attorney, said that when she signed a lease for a restaurant, she had to negotiate an "offensive odors stipulation."
"The building rules said no offensive odors," she said. "Whether a smell is offensive is subjective, so I made sure there was an exception for smells ordinary to a restaurant."
It's also important to research basic environmental laws regarding the property before you sign anything, Gumersell said. Landlords often miss these laws, and they could be used against your business.
Tip: Before signing a lease agreement, do your due diligence on the property. Make sure to research the local area, the landlord, the zoning laws for the area, and any other nuisance and environmental laws the property is subject to.
Important commercial lease statutes to keep in mind
There are some key points to keep in mind when you are reviewing your lease. Rent structure is probably the most basic and most important aspect of any lease. By determining how much you pay per month, as well as how much your rent will increase each year, you can better determine budgets and get a full understanding of whether you can stay in business in this new space.
The lease terms are also very important. Consider short-term versus long-term leases. Long-term leases can be a great investment if you're opening a business in an emerging or growing area, whereas short-term leases provide you with the flexibility to move locations or shutter your business if it doesn't pan out in the way you hoped.
Both with payment structure and term, make sure you understand exactly what you're on the hook for each month. Ask your potential landlord about how the following expenses are paid:
- Property taxes
- Maintenance (both interior and exterior)
- Local nuisance laws (noise or scent)
- Utilities (water, gas, electric)
- Modifications (whether you can adjust the interior or exterior of your space)
Once you've established some basic pricing and term structures, it's time to dive into some of the less-obvious details. While your lease will likely vary by state, here are some good examples of statutes to be aware of before signing a lease:
Transfer structure. Iron out how your lease will be transferred if you want to leave the space or your business closes. According to Gumersell, there are generally two structures for transferring a lease: assignment of the lease and subletting. Assignment of the lease means the entire lease is transferred to a new tenant. Subletting is when a current tenant keeps his or her name on the lease but receives payment from a new tenant and transfers that money to the landlord. In both instances, you usually have to establish prior written consent before the lease transfer. This is a very important aspect of your lease to work out.
Personal exposure. In some cases, you may be required to sign personal guarantees when you sign a commercial lease. These agreements mean you're personally on the hook for aspects of the lease even if your business defaults. Work with legal counsel to negotiate this aspect of your contract. If possible, you only want your entity or legal business to take on the risk when signing a business lease.
Holdover rent. Holdover rent is a rent increase when a tenant stays after the lease has expired. It's hard to find a lease, and sometimes when businesses are moving spaces, they end up staying longer than their current lease allows while the new one is being set up. In many contracts, landlords include a clause stating that, in these instances, businesses are responsible for up to 250% of their normal rent payment per month. So, if you stay beyond your allotted time, it could cost you tens of thousands of dollars. Gumersell recommended negotiating this aspect down to around 125%.
- Nondisturbance agreement. In many cases, if the landlord fails to pay his or her mortgage on the property, your business will still be evicted, even if you're making all of your payments. With a nondisturbance agreement, if this occurs, you'll be permitted to stay and continue paying whatever entity has taken over the building from your landlord, Gumersell said.
Everything can be negotiated
While these are some good examples of things to be aware of, there are likely many aspects of your lease that can be negotiated. Work with your potential landlord – and, if necessary, an attorney – to make sure you get the best deal for you and your business.
"Where a residential lease has a fixed term, a commercial lease is often negotiable and can have a longer or shorter term depending on the conditions set," said Allan Borch, founder of Dotcom Dollar. "Commercial leases also have fewer legal protections because the consumer laws that apply to residential lease agreements do not cover commercial leases."
Tip: Don't hesitate to negotiate the terms of the lease. Many aspects of the contract, especially the length of the term, are negotiable.
Commercial lease agreement terms to know
Borch and Dan Bailey, president of WikiLawn, listed some key terms that small business owners should know regarding commercial lease agreements. The list does not include every possible term you may encounter on a commercial lease agreement, but it's an overview of the ones you are most likely to see.
Rent amount/base rent. This amount is calculated based on the square footage of the space. Make sure the number the landlord is using actually represents usable space. This rent is not dependent on revenue.
Usable square feet. This refers to the amount of space actually reserved for the business as a tenant, in cases of shared spaces.
Rent increases. Rent increases are usually based on a percentage of the total rent, and that can change from year to year. You can negotiate with the landlord to put a cap on rent increases.
Security deposit. This is the amount to hold the space until the paperwork is finalized. The amount should be specified both ahead of time and in the lease agreement.
Length of the lease. The length of a commercial lease is usually somewhere between three and five years, as commercial landlords prefer longer lease terms. The lease agreement also often specifies the start and end dates of the lease.
Improvements. This part of the commercial lease agreement lays out the types of improvements and upgrades that can be made to the space and who is responsible for the costs. Many aspects of this section can be negotiated.
Bottom line. Make sure you understand all of the terms in a commercial lease contract and are comfortable with them before signing on the dotted line.
Grant of lease. This is the clause that states that the landlord will turn the property over to the tenant once all of the conditions (e.g., paying the security deposit) have been met and the tenant accepts the property from the landlord.
Commencement date. This is the date on which the tenant takes over the property, more commonly stated as the first day the tenant becomes responsible for paying rent and maintaining the rental property.
Extension. Both parties can agree to an extension of the agreement in writing, and it must be signed by both parties.
Late fee. If the tenant is late in paying rent, they will incur a late fee that is outlined by the commercial lease agreement. This can be a flat fee or a percentage of the monthly rent.
Taxes. This section outlines all of the taxes associated with the property (property taxes, real estate taxes) and who is responsible for paying them. Within this section, there could be subtopics, like Contest of Taxes (the tenant can contest the amount of personal or real property tax they are responsible for paying), Payment of Ordinance Assessments (the tenant usually pays for all ordinary assessments, which are obligatory, and extraordinary, which are by choice) and Change in Method of Taxation.
Obligation for repair. This section states what types of repairs the landlord is obligated to make – like defects, deficiencies, failures or deviations in materials – that are vital to the operation of the property. It also outlines the repairs that tenants are responsible for.
Permits. Both parties are to acquire all necessary permits and licenses for making improvements or repairs at the location being rented.
Covenants. These terms are different for the tenant and the landlord; each has a separate set of covenants. For example, a covenant may state that the tenant is required to pay rent even if the landlord fails to uphold some of their responsibilities as stated in the lease.
Indemnity by tenant. This clause essentially removes all liability from the landlord in the event of injury, loss, claims, or damage, unless those things are a direct result of willful acts or omissions or gross negligence on the landlord's part.
Rent abatement/adjustment. This section states if the rent will be adjusted or eliminated in the event of property damage from a fire or other natural disaster.
Condemnation. This clause is often overlooked, but it's important. It determines what happens if the rental property is taken from the landlord by a government agency for public use, either by condemnation or eminent domain.
Option to purchase. This clause states that, at any time during the lease, the tenant has the right to buy the property at an agreed-upon price. This clause isn't mandatory, but it doesn't hurt to include it. The clause can also state that the tenant does not have the right to purchase the property during the term of the lease. Either way, it's good to have it in writing.
Key Takeaway: There are a number of lease terms you should be familiar with, including usable square feet, commencement date, grant of lease, covenants and rent abatement.
Commercial lease FAQs
Commercial leases can be complex. Below are four of the most frequently asked relating to commercial leases and their answers.
What is a typical commercial lease deposit?
It is normal for the lease deposit to include a security deposit and two months of rent. The average cost is around $4,000, according to research done by a property management group in Houston.
Are utilities included in commercial leases?
The answer to this question depends on the type of lease. The utility needs of a skyrise office suite are quite different from a textile semiconductor manufacturing plant. To simplify the sheer range of leases that exist, most commercial leases are split into three categories. A gross lease covers all operating expenses, and that includes utilities. A net lease is less inclusive and usually does not cover utilities. A modified lease can be either a gross or net lease, with custom changes negotiated by both parties.
When should you buy or lease commercial property?
In the long term, owning commercial property is typically more economical than leasing. Leases are still popular because many businesses can't devote a significant portion of their capital to commercial real estate. If a business can afford to tie up assets in commercial real estate, purchasing is the better option. If not, leasing is the way to go.
How long is a typical commercial lease?
Commercial leases are typically three to five years. That guarantees enough rental income for the landlords to recoup their investment. Leases are often negotiable, but for a commercial lease, landlords frequently allow customization of the space for the sake of the renting business. This means that landlords invest a lot more money into commercial real estate than they might for residential properties.