Introduction to Commercial Leases - Part 2

In our last article we discussed: lease objectives, the common types of leases, what makes a lease enforceable, cash flow, expense stops, common area maintenance as well as the tax benefits of improvements.

As we move on in this article, we’ll discuss additional lease types and become familiar with lease additional clause, strategies and identify common terms used in commercial leases.

Ground Lease

A ground lease is as lease for land alone, and is typically a long-term net lease. Ground leases are where land ownership is retained by the owner of the land and improvements are owned by the tenant.

These leases can typically be found in areas with a shortage in highly desirable land, and may be traditional in other areas. Following the end of the lease term of a ground lease, title to the land and improvements reverts to the lessor/property owner.

Step Leases

Step Leases allow contracted rents on long-term leases to change by preset amounts or percentages which will occur on predetermined dates. These preset amounts or percentages are called escalations.

While the lease payments vary over time and the term of the lease, the actual payments are calculated and disclosed prior to the signing of the lease agreement.

The most common types of costs involving escalations may relate to real estate taxes, insurance, utilities, operations, and maintenance.

Real estate professionals representing the tenant can provide historical trend information regarding these types of escalation so that increases can be predicted and informed decisions can be made prior to a lease signing

Indexed Leases

Indexed leases are those where the contracted rent is tied to movements of a pre-specified financial index; such as the consumer price index (CPI). Here’s an example: If the current year’s consumer price index increases by 3 percent, then the next years lease payment will increase by 3 percent.

Additional lease clauses

Several other options and clauses are designed to protect the needs and concerns of the owner and tenants and should be negotiated carefully and with diligence.

Lease Renewal Options

Commercial leases often grant a tenant the ability to renew a lease for a pre-specified period of time following the initial lease expiration. However, the rate at which the lease may be renewed is specified in the initial lease contract. A renewal option is often of value as it eliminates the need for a tenant a new location for the business prior to the expiration of the current lease. Even though the tenant is not obligated to renew the lease, hence the term ‘option’, the tenant is not bound by the lease to remain and may decide to find another location for the business if either the business requires it or the tenant so desires.

Expansion and Relocation Options

As businesses grow, it is essential to that growth commercial leases provide a tenant the right to occupy additional space in the commercial structure.

The rental rate and specified period of this space should be negotiated prior to the initial lease signing. Often, the owner will agree to give a tenant the right of first refusal as space becomes available in the building. If additional contiguous space cannot be provided in a reasonable time frame for the tenant, an owner may agree to relocate the tenant within the building or shopping center within a specified time period. These additional lease clauses should be negotiated and worded carefully.

Financial impact of lease clauses

After a decision has been made to lease commercial space a commercial real estate specialist may be enlisted to prepare a financial report which quantifies the potential tenant’s lease costs and which compares and contrasts alternative leases.

As outlined previously, the final lease terms will be dependent on current local market conditions and the negotiation skills of all parties involved.

Before analyzing the financial implications that a lease imposes on a tenant we need to upgrade our vocabulary to include commonly used terms. These terms and definitions may vary from market to market.

Base (contract) rent: This is the specified, pre-defined contract dollar amount for periodic rent (monthly payments). Escalations are based on this amount.

Total effective rent: This is the base rent once it has been adjusted to include concessions, allowances and costs that will become the responsibility of the tenant (such as operating expense pass-through).

Total effective rate: This is simply the total effective rent divided by the square footage.

Average annual effective rent: This is the total effective rent divided by the total years of the lease term.

Average annual effective rate: This is the average annual effective rent divided by the square footage.

Cost analysis

Now that we have defined some common terms we are able to understand how to analyze the financial impact and actual cost of a lease:

From the tenants perspective

In many commercial leases, the base rent does not necessarily equal the effective rent. An in-depth analysis of this will include all costs to the tenant such as concessions, allowances and other additional costs.

Here then is a basic formula for calculating a tenant’s effective rent:

The base (contract) rent + (Additional Costs - Concessions and/or allowances) = The Total effective rent paid which will be paid by the tenant.

From the owner’s perspective

This same analysis is covered from the owner’s perspective and will also include all costs to the owner:

Here then is a basic formula for calculating effective rent from the owner’s perspective:

Base (contract) rent - (Net additional costs - Concessions and/or allowances) = The owner’s Total effective rent as income.

Alternative Strategies

We’ve seen how the negotiation of a commercial lease can not only affect a prospective tenants’ and owner’s cash flow but also how complicated the process may be. When a prospective site located and analyzed correctly, the site may or may not satisfy the financial requirements of a prospective tenant.

With that in mind, let’s look at some alternative strategies for commercial leasing:

Sublease

A sublease is a separate lease in which the tenant may lease all or part of the leasehold interest to another tenant while retaining liability for the property and primary lease to the owner.

There are however risks to subleasing which an owner may not be willing to accept. These risks include:

Re-lease risk: The length of time it will take to find a sublease is unknown. Rental rate risk: It may be necessary to sublease at below-contract rent. Tenant quality risk: It may not be possible to find a high-quality tenant. Lease-term risk: A sub-lessee may want a shorter or longer lease than that of the primary lease. Lease agreement risk: A sub-lessee may want concessions, allowances, and other features that are not provided in the primary lease. Tenant improvement risk: The sub-lessor may have to pay build out costs for the sub-lessee.

Assignment

An assignment of lease is where all of a tenant’s leasehold interests in a property are transferred to a third party. In general this will release the original tenant from any and all responsibility of the remaining terms of the lease at the time of assignment.

Build to Suit

Build-to-suit development as those in which an owner agrees to develop or finish a property built to the specifications of the prospective tenant.

The costs for the improvements may in part be assumed by the prospective tenant and may be in the form of an increased effective rent.

A build-to-suit strategy will most likely involve a prospective tenant with significant financial capacity and strong creditworthiness.

Sale-Leaseback

A sale-leaseback is a strategy in which an owner purchases land, builds a structure on the land for their own use and in turn sells the entire property to an investor, and retains a long-term net lease.

Many companies use this strategy to convert their equity in real estate to working capital where it hopefully can generate a higher return from the operation and cash flow of the business.

Summary

While this article, appropriate title Introduction to Commercial leases does not encompass every aspect of all commercial leasing implications, it hopefully has provided those with a less then working understanding of commercial leases the knowledge and information needed when dealing with a commercial lease entity.

There are many different ways to structure lease transactions, clauses and financial implications in commercial real estate leasing.

An important item to remember is that many lease clauses will be applied to a cost to either the prospective tenant or the owner.

Commercial leases should be reviewed carefully by trained professionals or others fully qualified to negotiate and analyze both the short and long term implications of the lease and the financial responsibilities of all parties concerned.

Careful and diligent lease negotiations and analysis will provide both a prospective tenant as well as an owner the ability to profit and be successful in their individual endeavors.

© Copyright 2008 Jennifer MacKay. All Rights Reserved.



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