What to Know Before Signing a Commercial Lease in 2022 & 2023
There are a lot of things changing economically right now. Businesses are downsizing and landlords are gonna face-- at least on the office space side-- a lot of challenges in the coming months and years. I've heard of large corporations dropping their space by half, or sometimes two-thirds, in order to move employees out to satellite locations. They can then use different space sharing and coworking services, using different spaces on different days and so forth. We’ll soon see small business owners going out of business, and there will be a lot of space (retail, office space, restaurants and other commercial space) opening up and remaining vacant.
Typically, when one business falls, another one almost immediately appears. Therefore, there will be opportunities for business owners that do have the cash, or do want to start a new business, or are looking to rent a space as rent prices drop, and so forth. So I want to spend some time today talking about the kind of things that you should remember when dealing with a landlord and a commercial lease.
As a business attorney, I see a lot of situations where people go to rent space in which a realtor or broker shows them, they get the lease from the landlord, they sign it, send a check, and they're off and running. You should never sign a commercial lease without having an attorney review the lease agreement. Just because the landlord is presenting the lease to you does not mean that you can't negotiate or make changes. There may be parts of the lease that you're not aware of, that will come back to haunt you later on. These include things like price escalations, things that you're responsible for that maybe you shouldn't be responsible for, and more.
Remember that when it comes to commercial leases, or any contracts for that matter, everything is open to negotiation. It's all about leverage, right?
If the commercial space you’re considering is in high demand or is in a high-traffic area, you may not have a lot of leverage. The landlord may have choices and the ability to refuse to change the terms of the lease. Or, it may be an office space where they're going to have trouble renting out the space, so they're willing to make deals with potential renters. In those situations where the tenant has some leverage, there are plenty of landlords that can be very reasonable. Sometimes they're comfortable changing things to accommodate you, and are seeking happy tenants to move into their space. They want to start off on the right foot.
Don't assume that because you're given a lease agreement, it encompasses everything you need and represents your interests. Unlike residential tenants, who have a lot of protection under the law, if landlords don't include certain clauses and design the lease properly, the laws will not protect you. Residential landlords need to follow a lot of rules that are not true in the commercial space. It's an arms-length business negotiation. If a landlord seeks to evict a commercial tenant, he won't even go to landlord-tenant court. He goes to Chancery court, because it's not a landlord-tenant matter. It’s a matter of contracts.
Next, let's talk about leases. Obviously, every lease will have a term. It may have an option to extend the term, and I always recommend asking for options to accommodate future needs.
If you are a new business, it’s probably safe to accept a shorter term with maybe one or two options. If you've been in business for a longer period of time, you may want a longer lease, like a two- or three-year term with three-year options. This will add to the value of your business. For example, if you try to sell your business one day, the business owner or the purchaser might ask what term of a lease you have. If the purchaser thinks that in six months, a year, or two years you're going to get thrown out of the space, it reduces the business value and adds risk to the buyer's situation. So, it’s always a good idea to weigh the options about what your commitments are. Consider the value of a long-term lease versus a short-term lease, and what options the lease should include. Depending on the situation, this might include an option to buy the premises. Maybe you’re moving into a much larger space that you’d like to grow into and you might like an opportunity to buy the building in the future. Maybe the landlord is nearing retirement and is considering getting out of managing the building. It might be in the best interest of the business to ask whether they’re willing to consider an option to buy. Some landlords are open to these suggestions. So don't overlook it.
If you do negotiate an option to buy, you can also ask for some rent credits to go towards the purchase price over time. If you execute an option to purchase, you’ll have paid toward the property balance. There are situations in which people have options to purchase a business or a building at a certain price, then the market turns around and they keep their option to buy it at a much lower price. The parties to the agreement must execute the option in accordance with the provisions in the lease. Usually, you have to execute the option by writing to a certain address, within a certain timeframe.
If you don't do that, the building that you may have been ready to buy at a million dollars is now valued at 5 million and you didn’t “lock in” the option. Negotiating purchase options and meeting the requirements ensure the landlord can’t later sell to you at current market value. Not following the option requirements can cost you your option, which you may have even paid money for with the signing of the lease. To negotiate buying options into a new lease, you can request to pay the landlord a certain set fee in order to have this option.
You should also pay attention to leases that may have hidden escalation clauses for the rent rate over a period of time. In some situations, rent begins at a certain level, and includes escalations at the three- or four-year mark. Review lease renewal terms periodically, especially if you intend to buy, or are considering it for the future. You should also consider when it renews whether it will renew at an escalated percentage or just at fair market value.
When you lease a commercial space, if there are multiple tenants, and in some other situations, there's often a charge by the landlord for common area maintenance. Whether it’s a lobby, or an outdoor space, or something else, this is what that charge covers. It also covers the landlord's recurring expenses like plowing, lawn mowing, landscaping, and cleaning on a regular basis. He or she charges a portion to each tenant to cover these costs. So, if there are four or five tenants in the building and assuming all the rented spaces are equal, you'll probably pay one-fifth of the cost of the common area charges. What is often overlooked is the provision that allows you to question those charges and negotiate true cost liability for those charges. In that situation, you’d first want the right to see the bills that are being attributed to the increase of certain costs.
Usually, this lease charge starts with a common area, with the maintenance charge being the base cost per square foot. After that, the cost would increase each year based on real estate tax increases and other costs. Maybe some years there’s an extra plowing bill because it was a particularly bad winter, for example. The building then incurs more costs, which they may pass onto their tenants. You should have, in your lease, the right to review all of those increases to confirm that what the landlord is passing onto you is correct.
You also want to include provisions in the lease that require the landlord to notify you of price increases. Three to six months at the end of the lease is a good window to ask to be notified of these increases. If they fail to do so, they lose the right to pass that increase onto you for that particular year. I have represented clients who received surprise letters from the landlord that said something along the lines of, “Oops, we forgot to send you these increases for the last 10 years, can you write us a check for $50,000?”. Most small business owners who work on cash flow do not have that amount of cash on hand to meet a demand like that. It’s common for landlords to overlook rent increases and request large amounts of money to renew or continue a commercial lease. So don't overlook rent and expensive increase notifications when you’re negotiating your lease.
A lot of business owners do not have huge savings accounts; they work on cash flow. So that's a very important part of the lease and should be addressed early, because it can lead to lawsuits. These situations almost always lead to misunderstandings and problems with your landlord, at a minimum. Very often, the landlord has more legal leverage than you do.
Be aware of other costs that might be passed onto you, like capital improvements, the replacement of a roof, or new windows for the building that improve the property. When I'm representing a tenant, I don't want that to be passed on to my client. The landlord gets to continue benefiting from a new roof or new windows when the tenant is long gone.
Improvements are much different than the cost of maintenance, so be sure that the lease differentiates between the two. If the parking lot, for example, needs to be repaved because the tenants are using it and breaking it up, maybe that can be considered a regular maintenance cost. But roofs wear out just from time and it's gonna wear out whether you're there or not. Negotiate those things up front so the landlord doesn’t try to distribute the cost of his new roof among you and other tenants. You are not responsible for capital improvements, and can make that clear in your lease agreement. Tenants are responsible for increases in maintenance costs, because they are the result of the tenants’ regular use of the space. The difference between those things is very important: one is a capital improvement and one is a maintenance cost. In a lease agreement, these terms should be clearly defined.
There are plenty of situations in the larger professional marketplace when the landlord doesn’t necessarily ask you for a personal guarantee. But with smaller businesses, landlords often request a personal guarantee so your company cannot just close up and walk away from the lease. You might considering ask for something called a “good guy” clause to minimize your personal exposure. If your small business takes a turn for the worst, you act in good faith to help the landlord secure a new tenant. For example, by allowing prospective tenants to walk through the space and its features while you’re still operating and can help showcase the functionality of the space. If you help your landlord and are cooperative with them, it won’t trigger the personal guarantee. If you move out in the middle of the night and leave the landlord with an empty (or trashed) space and no notice, a lot of landlords would be angry. They would consider not renting to someone who is unwilling to give a guarantee against that behavior. If you’re struggling as a business, the last thing you need to do is deal with a lawsuit from the landlord who's probably suing you for money you don't have.
So, if you're cooperating and shutting down your business, immediately relinquishing the keys and not making it difficult to get into the space, the “good guy” clause applies. You may also have other stipulations associated with that clause. For example, if you left the space, maybe a stipulation is that you can't open the same business within a certain distance of the property. This ensures that you're not competing with the landlord for space, moving your business around the corner. So, this good guy clause can be designed to do different things. Be sure that when you get a lease from a landlord, you read it carefully and have your attorney read it as well. Ensure that not only have you read it, you understand it too.
If there are escalations written into the lease, be sure to map out when those escalations will happen. This way you know that they'll be coming. Escalations can be a very good way to get into a commercial space. Sometimes, they’re helpful when you can't afford the space. Maybe you can only afford to pay $18 a square foot and the going rate is $22 a square foot. The landlord may be willing to work with you. If you offer to pay $18 for two years, $22 for two years, and $26 for two years, the landlord may agree to let you begin your lease at a lower rate. As your business grows, you should be able to absorb those increases. You obviously have to make that determination based on your business goals and what makes sense for you, but in this scenario, the landlord is getting their $22 on average over time. He may be willing to adjust for time and rate, so you should be willing to suggest it if this is your case.
Sometimes landlords will give you space in what they call a “plain vanilla box”. The “plain vanilla box” gives you the walls, sheet rocked, with basic flooring, plugs and electrical switches, and basic functionality that brings the space to code. If you want an upgrade that may be at your cost. If you don't have the money to do that, you might ask your landlord if you can contribute a flat rate per square foot to the build out, in exchange for additional features for the space when you move in. You can negotiate to pay that added rate over time.
Some landlords give an allowance for the buildout. They'll allow a set dollar amount per square foot in good faith, and anything over that they’ll require a note for, which will add to the rent price. So, there are a lot of creative ways to get into some of these commercial spaces. If a landlord's willing to work with you, it's not all “plain vanilla”. Some landlords are not willing to do that. Some landlords are, because they recognize that getting a happy, productive tenant into the space is better for them than having vacant space.
You also may ask to stipulate upgrades for certain things. If the landlord's putting in basic carpeting or flooring, you may want to upgrade that. So that could be a stipulated upcharge that you would add to the square footage rate in the lease. You could also get a business loan and just pay the landlord for upgrades you want (which you'd also stipulate in your lease). In these cases, pay attention to what you can take and what you can't take when you move out of the space. More often than not, a lot of build-out upgrades that you’re paying for, you have to leave when you move out.
You can't take the carpeting, that's attached to the floor. If you put up glass walls in a building, those tend to be considered fixtures, depending on how they're installed. By the way, the landlord can accelerate depreciation of those fixtures, so that's something that you can bring to his or her attention. But generally, you can't take those with you when you leave the space; so those things are gonna have to stay. Sometimes it benefits the landlord to have the space built out as well. So you want to negotiate for situations like that.
If you need a basic lease, you can go to my website to buy and download one. If you need something reviewed, I charge a flat fee to review most leases, depending on the length of the lease. If you need a simple lease, please contact me via email and I’ll be happy to provide you with a standard lease with basic provisions for a discounted fee.
Be sure to listen to “The Accidental Entrepreneur,” available on all podcast directories. Or, visit our website to learn more about our products and services.
And if you have any questions or concerns, feel free to email us at info@beinhakerlaw.com.