FEATURE ARTICLE, JUNE 2004

STARTING OFF ON THE RIGHT FOOT
The right lease can be a platform for success for commercial real estate tenants.
Judi Woodyard

Woodyard

Now more than ever, commercial tenants in the western United States must pay close attention to their real estate needs when leasing space for business. The terms of a commercial lease depend upon market conditions, location and the property. To negotiate leases that allow for company success, tenants must understand the basic economics of the lease agreement.

Once one or more sites have been selected for consideration, it is important to carefully compare — on an “apples-to-apples” basis — the actual lease terms because they will have a substantial monetary effect on the business over time. A well-negotiated lease should complement the overall business plan, allowing for measurable or predictable growth during a given period.

The type of lease that a tenant enters into will determine how the operating expenses of the property are handled. Lease types are classified as full service, modified gross or net. Each type impacts the tenant and landlord in a different way, although the end result is similar.

A full-service lease incorporates all operating expenses, taxes, insurance, utilities and maintenance into the lease rate. The tenant pays one rent amount that covers all necessary services. Full-service leases specify that expense coverage is guaranteed in a base year or comparison year, but tenants will be responsible for increases in expenses over the base year or the lease will set forth an amount of money, expressed as annual dollars per square foot, as an expense stop. In the instance of an expense stop, the tenant has no guarantee of expenses — for even the first year — and is responsible for any cost that exceeds the expense stop number.

A modified gross lease is similar to full service except that only operating expenses, taxes and insurance are covered in the tenant’s rent. Utilities — specifically, electricity — and interior janitorial service (within the tenant’s premises) are not included in the tenant’s rent payment. The covered expenses are controlled through either a base year or an expense stop, as mentioned above.

Net leasing means that no expenses of any kind are included in the base rental payment. A net lease can specify that the landlord pays the actual monthly operating expenses and then bills the tenant for said expenses in addition to monthly rent. These expenses do not include the tenant’s electricity or janitorial services, which remain the renter’s responsibility.

Most leases call for annual rent increases. However, a long-term lease should be an exception. Lease terms of 10 years or more should accept rental increases every 2 to 5 years. Increases can be set at a specific dollar amount, a percentage increase or by the Consumer Price Index.

Other than rent, the primary factors that affect the economics of a tenant’s occupancy are as follows: the type of lease, measurement of the space, terms of the lease, annual rental increases, amount of security required, additional rents in the form of base-year costs eclipsing expense stops, the definition of operating costs, parking charges, the terms of any renewal options, tenant improvement allowance, shell definition, sublease terms, lease termination clauses, expansion options and, in some cases, equity participation. Other indirect factors that may lead to increased costs are poor planning, rushed rental decisions, negative credit standing and a lack of specific market knowledge.

The handling of tenant improvements is also important to the long-term economics of the transaction. The tenant must be sure of who owns the improvements. Several components factor into this determination: a) who entered into the contract to build the improvements, b) who wrote the check(s) to the contractors, c) was the allowance actually paid to the tenant by the landlord, d) did the tenant complete the improvements and submit invoices to the landlord and e) does the lease differentiate between standard improvements, “over-standard” improvements and trade fixtures.

The ownership of the tenant improvements dictates the allocation of depreciation and the right or obligation to remove them at end of the lease term. If cash reimbursement is given for the improvements, the tenant must be wary of the IRS rule stipulating that the allowance be declared as income.

The best hedge against an unattractive lease obligation for any company is advance planning. Start early, hire a professional that knows your marketplace and carefully compare your operational requirements against a realistic business plan. It is also important to create a good credit standing for your firm, just as you would personally.

If you find that you need short-term space in order to stabilize growth issues, accommodate new contracts or compensate for uncertainty in your marketing strategy, commercial space requiring few modifications can be located. Such an approach will allow you an additional 1 to 2 years to make a decision on a permanent facility. If moving twice is not an option, many landlords will work with specific “stepped” occupancy on a must-take basis, an option basis or a right of first refusal.

Although very little difference exists between lease contracts in the western states, market conditions vary greatly, so contract negotiations differ for each item in the lease — particularly, the cost of tenant improvements, operating expense coverage, property tax issues and specific case law regarding things such as eminent domain, default and subleasing.

Judi Woodyard is president of Commercial Associates in Las Vegas.


©2004 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.