Everyone will have his or her own individual and purely business issues when considering leasing new commercial space, how much space is needed, where should it be located, how much rent can be afforded and so on.
There also are a variety of other common non-legal and non-technical considerations and goals which any new tenant needs to think about and, when possible, include in the early lease discussions which discussions often result in a letter of intent which guides much of the rest of the lease negotiations. The goal of this article is to illustrate some of those topics. Not everyone will be concerned about every one of these issues nor will every landlord be willing to agree on all of these issues.
Landlord Expense Reimbursement. Commercial leases typically are written on either “triple net” or “full service” basis.
Originally the phrase “triple net” referred to the tenant reimbursing the landlord for the tenant’s pro rata share of (1) taxes, (2) insurance and (3) maintenance in addition to paying the monthly rent. Today many lease forms go further and include other charges, some times fairly and some times not. The mostly apocryphal theoretical unfair charge is the landlord including his unemployed brother-in-law on the building payroll at an excessive salary at the tenants’ expense. Thus the tenant’s challenge is to understand the extent of charges the tenant will incur, e.g. for property management, after hours heat and air conditioning, landlord improvements to the property, any cap or maximum on these charges. In defense of the triple net lease, it can actually hold down the tenant’s lease costs since the landlord does not need to pad the basic rent to cover potential increases in operating costs. There also is market pressure on landlords to keep their triple net charges to a reasonable level since sophisticated tenants will compare these charges between competing potential landlords.
Triple net charges also can be the source of future friction. Recently I was called by a tenant whose share of triple net expenses increased several fold from one year to the next, probably because the landlord had made remodeling or long term capital improvements to the building and the landlord apparently was passing these costs back to the tenants as “operating costs.”
The tenant’s pro rata share is most commonly determined based on a tenant’s percentage of the building’s total leasable square footage, but not always. The leases of some landlords, especially larger shopping centers, may provide that the area occupied by some larger tenants will be excluded from the computation thus increasing the other tenants’ percentage shares. Some landlords also try to calculate the pro rata share of tenants based on the tenant’s share percentage of just the “leased” portion of the building so that the tenant’s share of expenses changes depending on the landlord’s occupancy level. While there are some expenses which are at least partially occupancy-dependent e.g. some, but not all, utilities, most expenses are not.
“Full Service” lease in its most basic form means that the tenant is to receive everything, both use of space and landlord services, in exchange for the payment of the monthly rent without any obligation to reimburse the landlord for other expenses. A common variation on this theme though is that the absence of the additional charges applies only to the first or base year of the lease term so that any cost increases beyond the base year are passed through to the tenant as additional charges. While the amount of the charges may be less, this version of the full service lease raises most of the same questions as a triple net lease, namely which costs can be included and are there any caps or exclusions? Note with a new building, the expenses of operation of the building during the first year of the lease term likely will be substantially lower than in subsequent years because of new building warranties, because there is less need for maintenance with a new building and because the building may be only partially occupied thus reducing utility, janitorial costs. The tenant may try to negotiate for a base year later than the first calendar year such as the first full calendar year when the building is at least 85% occupied.
Rent. Rent is commonly quoted on a “rentable square footage” basis. If a tenant measures the interior of the premises, the measured size likely will be ten or fifteen percent smaller than the landlord’s calculation of the “rentable” square footage of the same premises. The reason is that rentable square footage include an allocation of building common areas so that the tenant’s square footage is more than the tenant’s “usable” square footage in the premises. Common areas can be common hallways, building foyer, restrooms and so on. Because of design considerations, one building may be more efficient with a lower percentage of common areas. The difference in cost to the tenant of a building with a 7.5% common area “load factor” and a 15% load factor can be several dollars per square foot per year, not insignificant. If a tenant is a full floor tenant, this can be a basis for asking for a reduction in this charge since that floor would have no or less common areas.
Commencement Date. With a new lease, months, perhaps even many months, will be required to complete design, obtain permits and construct the tenant’s premises. Will the tenant be required to pay rent or operating cost reimbursements during this time? There is no single answer but some rent-free time to build out the tenant’s needed improvements is a common issue for lease negotiations.
Landlord Contributions. Depending on the market and the economy at the time and on the landlord, there may be potentially negotiable landlord contributions to the tenant’s project:
- Commonly a commercial landlord will agree to contribute some amount per square foot to the tenant’s improvement costs. This can pay a substantial portion of the tenant’s cost to make the space useful. There can be issues of which costs may be paid by with the tenant improvement allowance, for example, only “permanent” improvements such as walls and floor coverings or can the allowance cover the cost of furniture, cubicles and equipment? In some leases, the landlord will allow the tenant to apply any unused tenant improvement allowance to reduce the tenant’s future rent payments.
- If the tenant is represented by a leasing agent, the landlord often will agree to pay the tenant’s lease commission obligation.
- “Free” rent is a common negotiating point. Some landlords want to keep the “face rate” for their leases higher assuming that will aid a future sale or financing. To offset the nominal rent amount, the landlord may agree to give the tenant credit for a number of months of no rent at all so the average rent level will be acceptable to the tenant. With a triple net lease, a related question then is whether the “free” applies only to fixed rent or also to operating expenses?
Renewal Terms. A tenant wants lots of renewal terms; a landlord does not want the tenant to have lots of renewal terms. The tenant’s option to renew is one-way; the tenant is not obligated to renew although the landlord is obligated to allow the tenant to renew. If a tenant has an option to renew the lease, the landlord cannot accept a new higher paying or bigger tenant in lieu of renewing the first tenant. Issues to consider with options to renew are:
- How many options to renew?
- How will the renewal rent be calculated? Sometimes the renewal rent is set at the time of the initial lease. More commonly, there is some potential adjustment to the rent, e.g. fixed percentage increase, a consumer price index increase or most commonly some version of arbitration to allow a presumably disinterested third party to determine the level of market rent at the future renewal time.
- With a renewing tenant, a fair argument can be made that the renewing tenant should receive a lower than market rent since the landlord will incur no cost or loss due to vacancy between old and new tenant, the landlord likely will not have to pay as much in tenant improvements costs with a renewing tenant than with a new tenant, and likely no leasing commission to be paid. A five or ten percent discount from true market rent can be justified for a renewing tenant.
- On renewal, will the landlord provide the tenant with an allowance to improve or freshen the premises as likely was done with the first term of the lease? Carpets do wear and paint may need to be touched up even in the best maintained office setting.
Option to Terminate. The opposite of a tenant’s option to renew is an option to terminate. Especially with a start up business, a tenant may want to include a right to terminate the lease early if the business is not as successful as expected. There termination options usually involve some form of termination payment ranging from reimbursing the landlord for the unamortized cost of tenant improvements and leasing commission to some higher payment for early termination of the lease.
Landlord Services. Does the landlord provide some basic janitorial service? On what schedule? Is heat and air conditioning available daily or only during the usual work week? Will the tenant have control over the temperature in the premises? A modern system should have multiple zones within the premises to meet different heat and cooling needs. Does the Landlord charge for unique services required by the tenant such as weekend hours or special air conditioning for a computer server room?
Are there other issues that will come up in a lease negotiation or review? Yes. Depending on the landlord’s lease form, there likely will be many more issues to be resolved before the lease is signed. The goal of this paper is only to highlight the main economic issues that should be addressed in the early discussions leading up to the letter of intent. No tenant should expect to receive the landlord’s agreement to every request (nor should any landlord expect a tenant to agree to every request by the landlord). The art of the lease is to reasonably balance the competing interests of the tenant and the landlord.