Chapter 4 | The Fundamentals of Commercial Leases

Overview

Chapter 4 details the fundamentals of commercial leases, and how they influence the value of a property. Both economic and non-economic lease terms are important. It is essential to understand different aspects of leases, the reasoning behind them, and the negotiating leverage of each party, all of which ultimately play into the contracted lease terms. To illustrate a commercial lease, this chapter walks the reader through the main terms addressed in a shopping mall lease.

Summary

Rents negotiated between a tenant and a landlord determine the scheduled future cash flow of a property. Rents consist of 3 components: base rent, base rent escalations, and percentage rent. Percentage rent, also known as overage, is unique to retail rents and specifies the percentage of the tenant’s gross revenue that a landlord receives in addition to the base rent and escalations.

Operating expenses are comprised of two components: common area maintenance (CAM) and specific tenant expenses, as well as property taxes, insurance, and utilities. A lease will specify the cost allocation of these items between the landlord and the tenant.  Generally, CAM expenses are divided between all tenants of a property, based on their respective pro-rata share of leased space, while each tenant pays directly for the costs incurred within their leased space. A retail lease will often specify requirements and cost allocations of other items such as marketing, HVAC, security, and property maintenance. These lease items will detail the level of service the landlord is obligated to maintain and who will pay for these services.

Tenant improvements (TIs) and free rent are concessions landlords make to attract and retain tenants.  TIs are changes made to the leased space to satisfy the tenant’s fit-out preferences. These can include changes to the layout of the space or the addition of fixtures or infrastructure.

Net rent is the rent received net of all operating costs. Some leases are negotiated as “triple net” — meaning that all costs (including insurance, utilities, and property taxes) are passed through to the tenant. Net effective rent is a somewhat ambiguous term, but in this chapter, it refers to the rent net of unrecovered maintenance and operating costs, the amortized value of free rent, the amortized value of leasing commissions, and the amortized value of TIs. Figure 4.1 summarizes an example of how to calculate net effective rent.

It is important to note that non-economic terms are just as important as economic items when contracting tenants for a property, particularly in the retail sector. The second part of this chapter reviews, in detail, some important items that need to be correctly contracted into leasing agreements with retail tenants to ensure the success of the entire property. A landlord needs to negotiate clauses such as restrictions on signage, going-dark provisions, and defining hours and days of operation. Tenants may want to negotiate expansion rights and limit usage restrictions by the landlord. It is important to remember that most items negotiated in a contract are non-monetary, yet affect the underlying value of a property.

Questions

These are the types of questions you’ll be able to answer after studying the full chapter.

1. What are the three basic components of rent in a retail leasing agreement?

2. What incentive does a retail tenant have in paying percentage rent?

3. What is an anchor tenant?

4. What are TIs?

5. What is “triple net rent”?

6. What is a “radius restriction”?

Excel Figure

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Key Terms

To view the definition, click or press on the term. Repeat to hide the definition.

The owner/landlord of a property.

The tenant of leased space at a property.

Property operating expenses that change in proportion with the level of building occupancy. Examples include:

– electricity
– telephone service
– sewer rents and charges
– water and oil/gas
– repairs and maintenance
– janitorial and cleaning supplies and service
– elevator maintenance contracts
– shuttle bus service and maintenance
– fitness center equipment maintenance and replacement
– accounting fees for reimbursements
– common area snow removal (variable due to unpredictability)
– common area landscaping and plants.

Property operating expenses that do not change based on the level of building occupancy. Examples include:

– management fees
– management office rental value
– common area electricity
– supplies, uniforms, dry cleaning
– insurance premiums
– security
– concierge
– painting of common areas
– building employee wages and benefits
– payroll taxes
– legal fees
– window cleaning
– maintenance contracts for boilers, HVAC and other mechanical, plumbing and electrical equipment
– emergency generator service and maintenance
– licenses and permits
– trash removal/recycling
– pest control.

Tenant repayment to the landlord for tenant suite-specific expenses initially borne by the landlord.

The initial year’s rent for leased space.

How the base rent changes during the life of a lease; may be based upon inflation measures; may grow at specified dollar or percentage increments over the lease; or there may be no rent escalations in the lease at all.

A form of additional rent that specifies the percentage of the tenant’s gross sales revenue that the landlord receives in addition to the base rent and escalations; helps to align retail tenant interests with those of the landlord.

Any rent obligation of the tenant to the landlord under the terms of a lease other than base rent and base rent escalations. Percentage rent is a form of additional rent.

Property spaces available for use by all tenants, such as the lobby, hallways, roof deck, parking and outdoor landscaped areas.

Upkeep of shared spaces such as the lobby, sidewalks, parking areas and outdoor landscaped areas.

A negotiated cap on one or more operating expense items that protects the tenant from unbridled operating expense increases during their lease term.

The year in which the lease is signed, at which base levels of operating expenses are set, and above which increases in expenses may be borne by the tenant.

Interior construction performed to make a tenant’s space fully operational.

The landlord’s cash contribution to the tenant’s approved scope of work; typically quoted in $ per square foot.

No rent is paid during the first weeks, months, or years of the lease. A negotiated concession used to induce a tenant to agree to other lease terms.

Rent after all operating costs are paid.

A lease structure, most common in retail properties, in which the tenant pays all operating (and frequently capital) costs, including insurance, utilities, and property taxes in addition to the contractual base rent and escalations.

Leases that make the tenant bear the cost of certain operating and capital items, shifting the risk of increases in such costs from the landlord to the tenant, altering the ownership risk of the property.

Annual rent, net of: unrecovered maintenance and operating costs (property taxes, insurance, utilities, etc.), the amortized value of free rent, the amortized value of leasing commissions, and the amortized value of TIs.

When a tenant vacates a space but still pays their rent. This prevents potential competitors from moving into the space.

The lease or purchase option of additional future space near or adjacent to the tenant’s current location in order to satisfy the tenant’s growth at the same location.

A lease term that prevents landlords from leasing to competitors of the lessee.

A clause that states a tenant will only lease if other named tenants remain in the center.

Restrictions imposed by the landlord that prohibits the tenant from opening other stores within a certain distance of the subject property.

Chapter Headings

  • Economic Terms
  • Rent
  • Marketing Budget
  • Utilities, Insurance, and Property Taxes
  • HVAC – Heating, Ventilation, and Air Conditioning
  • Security and Property Maintenance
  • Tenant Improvements
  • Free Rent
  • Capital Costs
  • Net Rent
  • Non-Economic Terms
  • Signage
  • Going Dark
  • Hours and Days of Operation
  • Length of Lease
  • Expansion Rights
  • Usage Restrictions
  • Sublet Rights
  • Location Assignment
  • Detailed Description of the Space
  • Tenant Mix
  • Parking
  • Recourse and Security Deposit

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