Commercial Leases Overview

Commercial Property Value and Leases

Introduction

• The value of a commercial property is determined by the relationship between landlord and tenant, governed by a lease.
• Understanding leases is crucial in real estate.
• Sheila Potts is an experienced real estate developer and professor teaching about leases.

Learning Outcomes

1. Property Classes
2. Building Area Definitions
3. Essential Lease Contract Terms
4. Financial Terms in a Lease
5. Lease Options

Property Classes

• Properties are divided into classes based on location, age, and quality.
• Class A:
  • Highest rents due to prestigious locations and desirability.
  • Newer structures.
  • Owned by institutional investors (life insurance funds, private equity).
• Class B:
  • Rent less than Class A due to less desirable locations, fewer amenities, and being less impressive.
• Class C:
  • Favored by entry-level companies due to lower costs.

Lease Types

• Triple Net Lease (NNN): Tenant pays rent plus taxes, insurance, and maintenance.
  • Most favorable for landlords.
• Double Net Lease (NN): Tenant pays rent, taxes, and insurance.
  • Still favorable for landlords.
• Net Lease: Tenant pays rent plus some or all of taxes, insurance, or maintenance (but only one of these).
  • Less favorable for landlords.
• Fully Serviced Lease (Gross Lease): Landlord pays all expenses, but expenses are typically passed to tenants through higher rental rates or expense recovery amounts.
• Percent Rent Lease: Tenant pays rent plus a percentage of monthly sales over a certain threshold.
  • Common in retail settings for smaller tenants in malls.
  • Mall owners recoup investments for driving sales to those tenants.
• These definitions are approximate.
• Leases are heavily negotiated, and no two leases are exactly the same.

Building Area Definitions

• Total Gross Building Area: Total space within a building.
• Rental Area: All space in the building less any vertical penetrations. Vertical penetrations are ventilation shafts, stairwells, and elevator shafts.
• Usable Area: Area physically occupied by a tenant.

Graphical Representation

• Gross area includes both usable and common areas.
• Tenants pay rent on their usable area plus their pro rata share of the common area.
• Pro rata share of common area is the load factor, representing the tenant's contribution to the building's overall expenses.

Load Factor Example

• Tenant A has 4,000 sq ft of usable area.
• Building has 16,000 sq ft of total usable area and 2,000 sq ft of common area.
• Calculate Tenant A's load factor:
  • $Load Factor = (Tenant\ Usable\ Area / Building\ Usable\ Area) * Common\ Area$
  • $Load Factor = (4,000\ sq\ ft / 16,000\ sq\ ft) * 2,000\ sq\ ft = 500\ sq\ ft$
• Total rental area:
  • $Rental\ Area = Usable\ Area + Load\ Factor$
  • $Rental\ Area = 4,000\ sq\ ft + 500\ sq\ ft = 4,500\ sq\ ft$
• Tenant A pays rent on 4,500 sq ft.

Essential Lease Contract Terms

• Lease is a private contract between two parties, following contract law.
• Requires named parties and consideration (each party doing something for the other).
• Landlord provides space; tenant provides rent.

Seven Essential Elements of a Lease

1. Identify the Parties: Clearly identify the landlord (lessor) and the tenant (lessee).
2. Describe the Property: Provide a clear and accurate description, including address and unit numbers.
3. Term of the Lease: Specify the length of the agreement (fixed term or month-to-month), including start and end dates.
4. Rent: Clearly state the amount of rent, when it is due, and acceptable payment methods.
5. Rights: Transfer the right to possess, control, enjoy, and exclude, and may include the right to sublet or assign the property.
6. Signatures: Must be signed by both parties, with specific information about each party.

Financial Clauses in Leases

• Six typical clauses, but may vary.

1. Rent Payment.
2. Rent-Free Periods.
3. Rental Increases.
4. Tenant Improvements.
5. Security Deposit.
6. Common Area Expense Treatments.

Rent Payment (Section 2.1)

• Example: 22 per square foot.
• Payable in 12 equal monthly payments on the first day of each month during the first year of the lease term.
• Base rent amount.

Rental Increases (Section 2.2)

• Example: Base rent increases by 3% each year based on the previous year's base rent.
• Can be based on an index, step-up amount, or no increase at all.

Rent-Free Period

• Seven months of free rent following the base rent commencement date.
• Varies widely from no free months to years of free rent.

Tenant Improvements (Section 2.5)

• Landlord provides a specific dollar amount per square foot to help with the build-out of the space.
  • Example: 50 per square foot.
• Allows tenants to get into a space with lower upfront costs.
• Negotiations can involve higher tenant improvement amounts for higher rental rates.

Security Deposit (Section 4.1)

• Example: $$6,000 held by the landlord as security for the tenant's performance of the lease.
• Common in both commercial and residential leases.

Common Area Expense Treatment (Section 3.1)

• Heavily negotiated.
• Specifies who pays what.
• Example: Tenant pays their proportional share of operating expenses based on their rental area.
• Operating expenses may include real estate taxes, pest control, garbage/trash removal, and property management fees.

Bundle of Rights

• Landlord has the right to transfer rights in part or in whole:
  • Right of possession: Right to occupy and possess the property exclusively within the boundaries of law.
  • Right of control: Right to determine how the property is used subject to applicable zoning, environmental, and other regulations.
  • Right of exclusion: Right to prevent others from entering or using the property without the owner's permission.
  • Right of enjoyment: Right to use the property in a manner that does not infringe on the rights of others or violate laws and regulations.
  • Right of disposition: Right to sell, lease, or transfer the property or any of its rights to another person or entity.
• Rights transferred to the lessee:
  • Right of possession and control (Section 5.1): Tenant has the right to use and occupy the premises for office use, following stipulated rules and regulations.
  • Right of enjoyment (Section 19.1): Quiet enjoyment, meaning the tenant can operate their business without interference as long as they pay rent.
• Sections 12.1 and 12.2: Tenant does not have the right to dispose of the property.
  • Landlord retains the right to sell the property.
  • Tenant does not have the right to assign the lease or sublet the premises.

Options

• Options are codified rights in a lease for one party to change key terms without the agreement of the other party.
• Change is prearranged, requiring only notification to exercise the option.

Types of Options

• Landlord Options
• Tenant Options

Common Tenant Options

• Right to extend the lease.
• Right to end the lease early (break clause).
• Right of first refusal to take more space in the surrounding property.
• Lease options are bespoke.

Example Lease Option (Section 1.3)

• Tenant has the right to renew the lease for two possible five-year terms beyond the original lease.
• Requires written notice to the landlord within four months prior to the end of the lease.
• Rent increase continues at 3% per year.
• Can be negotiated to reset rent to current market rates.

Common Landlord Options

• Right to end a lease early (break clause).
• Right to move a tenant to an equivalent property or space in the same building.
• Landlord options in the example lease allow termination in the event of a breach by the tenant.

Obligations

Tenant Obligations (Section 8.1)

• Requires payment of utilities and keeping the place in good order.

Landlord Obligations (Section 8.2)

• Requiring to take care of the premises in general.

Ending the Lease (Section 9.1)

• Tenant must return the property in the same condition as they received it, subject to wear and tear.
• Anything affixed to the property becomes the landlord's property.

Wear and Tear

• Usual deterioration caused by reasonable use (e.g., scuff marks).
• Does not include damage from misuse or abuse.

Conclusion

• Property derives its value from leases.
• Minor changes in wording can significantly impact property value.
• Become familiar with lease clauses.