If you’ve gotten this far, you’ve already found a qualified advisor, you’ve read your broker’s commission agreement and you’ve selected your team. At this stage you might be tempted to put your feet up and let your team take it from here. Much like with your brokerage commission agreement, it’s important that you read your lease, understand what it means and stay active in the negotiations.
While the prospect of reading, understanding and negotiating a commercial lease may seem daunting, the good news is that you can safely rely on the 80/20 rule to get you through. That is to say, learn the most important 20% of everything there is to know, and you’ll know 80% of what you need to know.
“THE FIRST 20%” – RULES TO LIVE BY IN COMMERCIAL REAL ESTATE LEASING
- RULE #1 EVERYONE’S INTERESTS ARE NOT ALIGNED. It’s nobody’s fault, it’s just the way it is. Brokers get paid on the gross value of the lease. So, a ten year deal pays double what a five year deal does for the same work. Longer leases are also more valuable to your landlord. No one is going to push for a seven-year versus a ten year-lease except you. Embrace this.
- RULE #2 LEASE ONLY WHAT YOU NEED. No company ever went bankrupt because they didn’t have enough space… the same cannot be said about the reverse. Err on the side of caution when it comes to sizing your new space. Subleasing (and becoming a landlord) is a terrible and expensive option to fall back on.
- RULE #3 NEGOTIATE (AND PAY) FOR OPTIONALITY. Make sure your lease has termination and contraction options that suit your business needs. A termination or contraction option is always worth a small increase in your rent.
- RULE #4 FIXED IS BETTER THAN MARKET. Make sure you have fixed renewal terms and coterminous leases. Don’t put yourself at the mercy of a rising market. Remember, you can always negotiate if the market rate goes down! You’ll strengthen your hand even further if you have coterminous leases that you can consolidate and take to the market for a better deal.
- RULE #5 NOTHING IS FREE IN LEASING. Like commissions, treat tenant improvement dollars like they are your own money. So get value for it! Challenge your team to bring your budget in below your landlord’s TI allowance and take that money in free rent or moving expense.
- RULE #6 START EARLY. Whether you’re looking to sign your company’s first lease or you want to renew, you need to start looking for space early. Unless your lease is less than 2,000 square feet, nine months is the least amount of time you’ll need, and 12 months is more realistic. For renewals, you need to allow enough time for your broker to create a credible auction, which means you have to have enough time to theoretically lease space in a new building.
Them’s the rules. The remainder of this guide walks through the key terms of your lease and tells you what you need to know and the stuff no one else will.
Need to know: This is the length of your commitment. The obvious natural tension here is that tenants typically prefer shorter leases (ideally with renewals) to preserve flexibility and optionality, and landlords like longer leases as they reduce re-tenanting risk and costs, which is good for financing and sale values. The longer the term, the better deal you are likely to get from the landlord. FYI, brokers always like longer terms as they increase commissions.
What no one tells you: The seven-year term is the “sweet spot” for most office tenants and (probably) for most landlords. For landlords, it covers them on their typical five-year financing and they can usually be very aggressive on terms. You will like the seven-year term because your termination option fees and contraction option fees (more on these later) are based on the remaining term of your lease at the time you exercise.
For example, if the term is seven years and then after seven years you exercise a fifth-year termination option, you will have burned off 5/7ths (71%) of the lease cost. This is compared to 50% (5/10) on a ten-year deal. When you see the termination payment numbers from your broker (make sure to ask for them!), you will realize that on new space built out from shell condition, the fifth-year termination fee on a ten-year deal is so large that the option is almost useless. The same fee on a seven-year deal could be as much as 40% less. And, if you don’t like your existing space or landlord anymore, or you just need to move, your new landlord can usually pick up your seven-year deal termination fee as part of the new deal. This is probably NOT happening with a ten-year lease.
Need to know: There are two components to your rent: i) base rent, or net rent, which is the money your landlord actually receives, and ii) operating expenses, or opex, which are your share of the building’s operating costs (taxes, utilities, landscaping, janitorial, repairs and maintenance, etc).
Depending on your property type and/or market, your lease could structure these components any number of ways. The most common are as follows:
• Full Service Gross: Tenant pays stated gross rent every month, say $25psf, and the landlord will be responsible for base year operating expenses (more on base year opex below). So, of that $25, the landlord might keep $15 in net rent and have opex of $10, but the tenant needn’t know the breakout until after the base year (see below).
• Full Service Gross + Tenant Electric: same as gross lease, except Tenant pays stated rent plus their own electric (which is usually separately metered or sub-metered).
• Net Lease: Tenant pays base rent plus their proportionate share of operating expenses. In practice, the tenant will pay an estimated monthly operating expense to the landlord, and then reconcile any difference from actuals at the end of the year.
What no one tells you: From your landlord’s perspective, all dollars are not created equal. Most landlords try to keep rent as high as possible to increase sale value and/or leverage. As such, landlords are more willing to give larger TI allowances or free rent, but will fight to the death over the rental rate.
Need to know: In a Full Service Gross lease, tenants are typically charged for operating expenses above their “base year” operating expenses. The “base year” is typically the first year of the lease term or the first full calendar year of the lease term (using a calendar year helps the landlord do all tenant base years off the same time period). By way of example, if operating expenses in the first year of a lease are $10, that will be the maximum amount of expenses the landlord will pay each year for the remainder of the lease. So, if in the second year of the lease, opex is $11, the tenant will be responsible for their $25 face rent PLUS $1 for expenses above the base year. You should make sure that your lease provides for these expenses to be competitively bid in good faith by the landlord where possible (taxes are not possible, janitorial service is).
What no one tells you: Landlords will play games in your first year to push your base year expenses as low as possible so they can maximize the rent they get (the net rent) and push through more expenses later in your lease. For example, instead of the $10 noted above, they could delay making some payments to vendors until the following year. Thus, opex could go down to $9 for the base year instead of $10, and the second year when it goes up to $11, your rent goes up $2 instead of $1. So, be sure to ask for the right to audit your base year for the first three years of your lease. Make sure expenses in the first year of lease are not “low balled”. The property management division of your brokerage firm can help with this. Ask your broker to include this service as part of their commission. All the Fortune 500 companies know this.
ESCALATIONS (OR STEP-UPS)
Need to know: Escalations refer to periodic, typically annual, fixed increases to your rent. Conventions vary by market, but escalations are generally quote in terms percentage increases to gross rent, usually 2–3%, or per square foot increases to gross rent, usually $.35 to $.50.
What no one tells you: Landlords are more concerned with year-one rent than escalations because that’s what their lenders base their loan on. You should focus on the average rent during the term and be willing to trade a higher starting rent for lower escalations.
RENT ABATEMENT (OR FREE RENT)
Need to know: At the commencement of most leases, depending on market conditions, landlords will generally give the tenant a few months of free rent as a concession, or incentive to move in.
What no one tells you: As discussed earlier, all dollars are not created equal. Given the impact on sale value and financing, it is usually preferable for a landlord to give free rent than lower your year one rent. Also, try to convert the unused tenant improvement allowance discussed above into more free rent. If your Landlord balks, ask them if you can have the money as a credit in year five of your lease (including as a credit against your termination fee). No one ever asks for this. Remember, building in flexibility up front is key.
Need to know: Tenant Improvement allowances, or (“TIs”), are the dollars your landlord will give you to help build out your new space. Depending on your market, landlords will typically give a certain allowance for every year of term on a new lease, and roughly half that figure for every year of a renewal lease. E.g. $50psf on a new 10-year lease ($5psf/year) and $25psf on a 10-year renewal ($2.50psf/year).
What no one tells you: The same improvements don’t all cost the same. Getting good general contractor quality at fair pricing is key. Ask your broker to provide you with a construction manager (“CM”) as part of their commission. The CM will make sure the landlord bids out your tenant improvements and that you approve of their selected general contractor and subcontractors, as well as all their pricing. During construction, the CM should visit the site weekly to make sure the work is on time and being done in a quality manner. Lastly, when the work is complete, they will coordinate your furniture and IT installation.
In short, without a construction manager you are operating in the dark with regards to the entire construction process and potentially leaving a lot on the table. Why? Because you do this once every five years and do not have a staff member available to do this, nor the expertise to do it well. The CM does it every day.
Need to know: Rent is quoted per square foot ($/sf), so the nominal amount of rent a tenant pays every month is a function of square footage. Square footage, however, can be quoted several different ways:
• Gross: Measured from the “dominant outside surface” of the building, this is typically 2 to 3% higher than “rentable.”
• Rentable: Measured from interior wall to interior wall, or “wall to wall.” This is the typical measure for most leases.
• Usable: This is the amount of space you can actually use (i.e. excluding bathrooms, lobbies, corridors, conference rooms, etc).
The difference between what you pay for (rentable) and what you can actually use (usable) is known as the core factor. For example, if you have a 10,000 square foot lease and 8,500 square feet of usable space, your core factor would be 15%, or 1 – 8,500/10,000. A core factor for an office building is low if it is less than 15% (unusually efficient), and high if it is more than 20% (unless the building has a lot of amenities like a fitness center and restaurant). Make sure you understand whether and how the landlord is charging you for these amenities. The core factor is a common way to charge you, and probably the fairest.
What no one tells you: Some landlords play around with the core factor to “create” square footage and “grow” the building. First, you should know the core factor for all your potential buildings because this lets you compare the usable (actual) square footage you are getting and your true cost per sf. Second, the lease should allow for your architect to measure your space according to BOMA (Building Owners Management Association) standards after you move in. Your architect can help with this, but you have to push for it. They typically do not want to rock the boat with a landlord the might want to work with in the future on building a building. If the rentable sf is off by more than 2% from that in your lease, the sf is adjusted (and so is the rent). Good landlords won’t mind this. If a landlord does mind, run. They are cheating you.
LEASE COMMENCEMENT DATE
Need to know: This is the date a lease is supposed to begin. Given the long process of designing, permitting, and building out tenant space (see Chapter 2), there are often delays. Some leases have timeframes for each party to meet certain obligations, otherwise penalties can be assessed to either the tenant or the landlord, depending on who is at fault. In some cases, those penalties can include a tenant’s right to terminate a lease. This VERY bad for a landlord, so negotiate hard for stiff financial penalties in lieu of a termination option, in order to provide the landlord with strong incentives to deliver your space on time.
What no one tells you: First, don’t sign a lease that doesn’t have a firm move-in date. Second, have your construction manager check and make sure the local permitting times are consistent with those the landlord has represented, especially in light of the status of your build out plans.
Need to know: Much like with rental apartments, landlords ask for security deposits to make sure you can actually afford your lease and to incent you to leave the space “broom clean” when you leave. If things go wrong, e.g. a tenant files for bankruptcy, the deposit is used by the landlord to offset their losses.
What no one tells you: The security deposit is a pittance compared to what the landlord actually stands to lose if you go bankrupt (just compare your termination fee – which they are unlikely to receive in a bankruptcy – to your security deposit). So, if you want to minimize your security deposit, educate your landlord about your business as if they were your bank (because they kind of are) . Unless you have shaky credit, the security deposit should only be a month or two. Importantly, if you put up a multi-month deposit, it should be reduced yearly as long as you do not default. For a seven-year lease, ask for a “burn-off” of 20% per year for five years. Also, do not hesitate to tie the return of the deposit to your financial performance. For example, say to the landlord, “we are not there yet, but if we hit $10 million in sales and $1 million in cash flow, we get the deposit back”. It’s a win-win, the landlord just wants to know you can pay your rent.
Need to know: Make sure your attorney verifies that you have correct zoning for your use and the correct local government certificate for your occupancy. Landlords will very rarely do this for you, in which case you could be in default of your lease before you even move in.
What no one tells you: Some uses may be allowed under zoning but you wouldn’t want them in the building. Add such exclusions to your lease.
Need to know: A building’s signage is often limited by code. However, monument signage almost always easier for a landlord to give than building signage. If the landlord is willing and interested, it is smart to trade building signage (that you’ll likely pay for) for prominent signage in front of the building (that the landlord is more likely to pay for).
What no one tells you: In your lease, limit signage that is allowable by other tenants. You don’t want your building to look like a retail strip center.
Need to know: Make sure you don’t have asbestos issues or infiltration of radon or other gases.
What no one tells you: Your real estate lawyer isn’t a haz-mat specialist. If there is or has been haz-mat in your building, get a specialized attorney to take a quick look.
RESTRICTIONS ON OTHER TENANT USE
Need to know: Tenants include these provisions to prevent landlords from leasing space in their building to their competition.
What no one tells you: This can be difficult for landlords their ability to lease available space is the lifeblood of their business. If your landlord pushes back, offer to only restrict them from leasing on your floor. If this still isn’t sufficient for you, offer to provide a list of the three to seven companies you absolutely cannot have in your building. This is generally workable.