For many entrepreneurs signing a lease seems like renting an apartment – a Tennant/Lessee agrees to pay a certain fee to Lessor/Agent per month. Right? Nothing could be further from the truth.
The first lease many entrepreneurs sign is usually short-term because who knows if the business is even going to work. But say it does and now it’s starting to grow -- you need a new spot either for better location, better facility or larger space. The second lease you sign is often pivotal in the survival of your business. The terms of your lease can act like a slow leak in your tires or can leave the door open to incur huge expenses when the unexpected happens. Leases are legal contracts and should be examined closely and, more importantly, understood completely before you even consider signing one.
There are different types of commercial leases and a number of abbreviations that differ in meaning and usage depending on who’s using them. When it comes to commercial leases, there are several basic structures that equate to what the tenant is responsible for paying besides rent each month:
- Single Net Lease, Net Lease: tenant only pays utilities and property tax; landlord pays maintenance, repairs and insurance.
- Net-Net, or Double Net Leases: tenant is responsible for only utilities, property taxes and insurance premiums for the building; landlord pays maintenance & repairs.
- Triple Net Leases: tenant responsible for all costs of the building, except the landlord is generally responsible for structural repairs.
- Full Service Gross, or Modified Gross Lease (also called modified net lease): split structural repairs and operating expenses (property taxes, property insurance, common area maintenance (CAM), and utilities) between the tenant and landlord called ‘base rent.’
Full Service or Modified Gross are the most common type of lease for multi-tenant buildings. With these, the rent does not increase if operating expenses do, but on the flip side, the rent does not decrease if the operating expenses drop in a year. The difference in these comes down to what “gross” means in the lease – different leases can include or exclude certain operating expenses (it’s common to see all janitorial and electric utility costs for the rented space paid for by the tenant separately). This additional rent, or “base rent,” derives from a formula that determines the amount of and types of operating expenses paid by the tenant that can increase over the term of the lease.
There are many different commercial leases and terms, but you’ll find that the devil’s in the details. Entrepreneurs probably sign more Modified Gross Leases than any other. Here are some examples to watch out for to help you avoid becoming another one of the countless businesses lost to unforeseen issues related to commercial real estate. There is probably no better place to look for these real estate lease examples tripping up entrepreneurs than New York City. CPA and award-winning author Mike Bivona has owned numerous commercial rental properties throughout New York City and Long Island over decades. He told me about a particular building he owned in which one of the tenants had a bathroom in their office. Not totally uncommon, but after the owner had left for the day , someone flushed a clogged toilet causing water damage down two floor levels. Guess who got stuck with the cleanup and repair bills? The tenant whose toilet overflowed.
Bivona gave me another example. A doctor’s office tenant had a patient come in for his checkup, parking his oil truck in the parking lot. The oil tank leaked oil into the drains, which led to the Suffolk County sewage system in New York. The whole building had to be shut down by the county, while they cleaned the parking lot, drains, and the entire drainage system. Businesses lost revenue and the whole cost of cleanup hit the medical office tenant. Bivona says, “As soon as there is any dispute, claim or cost involved, the first thing the landlord or management company is going to do is pull out the lease agreement. If you don’t know who’s responsible for the damages in a lease, chances are it’s you.”
I know you’re probably thinking these things won’t happen to you; they’re extreme examples. But not so fast. Real estate leases are a vital piece of any business’ costs, and there are many risks. Leases are generally quoted in a price per square foot. Often lease agreements can be recycled by landlords and may not be up to date with the actual space due to remodeling, repairs or simple measurement errors. Incorrect measurements by landlords due to error or intent are common enough that there’s a term for it—“rubber rulers." The most common mistake entrepreneurs make is not verifying the space they are renting. You could be vastly overpaying. The actual space you’re planning to use for your business is referred to as the useable area, yet the rent in an agreement is based on the rentable areas, which includes the useable area plus a percentage of common areas like lobby, hallways, elevators, and loading docks. These other areas are generally expressed in the calculation of your rent as a “multiplying factor” in addition to your useable space. Bivona advises, “Don’t just automatically agree to a multiplying factor in a lease. If your business is a one- to two-person operation with little traffic you may be able to get a lower multiplying factor saving money to your bottom line. Depending on the terms and length of the lease, this could add up to real money for an entrepreneur.”
Michael Siteman with M-Theory Group in Los Angeles told me that another common mistake made when signing a lease involves operating expenses. No, not your company’s operating expenses, but the operating expenses contained within the lease under a separate provision. These are often made up of variables such as taxes, utilities, maintenance, landscaping, and repairs. While this may seem common sense to you, you should not breeze over it. Siteman advises to review this section thoroughly and he should know – he has spent more than 28 consecutive years in commercial real estate in the southwestern quadrant of the U.S. working for companies such as The Staubach Company and Jones Lang LaSalle. Besides making sure to find out exactly what is included in these operating expenses and negotiating out items that are not pertinent to your space, he warns that “landlords use the term ‘base year’ for the operating expenses, and many times the operating expenses or ‘base year’ is factored off of the year before you occupy the space, so you shouldn’t pay operating expenses until the second year.”
Another nasty issue in commercial leases is the “escalation clause.” This is what increases the base rent and unless your lease is short-term, it probably includes one. Escallation clauses are both valid and very common and are used by landlords to pay for increases in the costs of the building. But while they may be valid and common they are also one of the biggest possible money traps for a tenant. When an aggressive landlord is paired with a naive tenant, an escalation clause can increase rent exponentially over years. The Internet is full of stories of this. As they say, a fool and his money are quickly parted. Michael Bivona also warns, “Tenants have to be very careful with escalation clauses as they can be a very costly add on. You know how crazy escalation clauses can be? What about increases in inflation indices? There is no end to what landlords will do to increase their profits. Tenants should be sure to negotiate a cap on this.”
Lease agreements can be as varied as rental spaces. In fact, there is really no standard format for commercial leases other than retail and industrial, according to Siteman. You can get copies of standard retail and industrial leases from The Association of Industrial Realtors or AIR Commercial Real Estate Association.
These points are really just the tip of the iceberg when analyzing threats from and within real estate leases. It may seem overwhelming even at this point, but remember, a commercial lease is a legal contract between you and a landlordwho is interested in getting as much risk off of themselves and onto to the renter - you. So do not simply rush through a lease agreement like you did with your first apartment lease; it is a binding legal agreement. I recommend involving a real estate attorney that specializes in property leases to help you with this. Depending on how well you construct the terms of the lease, when something goes wrong, such as an unforeseen accident or unexpected cost inflation, your commercial lease can ultimately be a friend or an enemy to your business.
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