Legal Considerations for Commercial Leases
Great news: your company is expanding! Bad news: you are outgrowing your current space. If this is your first time searching for commercial real estate, you will notice that there are some differences from residential real estate. This post discusses the importance of a Letter of Intent (LOI) and provides overview of some of the common legal issues in commercial leases.
Letter of Intent (LOI)
A letter of intent (LOI) is the precursor to the commercial lease. A letter of intent outlines the potential agreement between the landlord and the tenant and explains the key terms. There are two main reasons why parties should seek a LOI: it provides insight into the parties’ relationship and helps clarify terms. If you attempt to negotiate a LOI with a potential tenant and they are slow to respond or have unrealistic expectations, the tenant may be slow to pay rent and expect more from the landlord than anticipated. Similarly, if a landlord tries to pinch every penny from you or is unwilling to alter the space, the landlord might not be agreeable to accept rent late if you have a bad month.
Binding v. Non-Binding LOIs
A lot of parties focus on the main terms (e.g. rent amount, square footage, etc.), however, there are some other key features to a LOI. One specific feature is whether the LOI is binding or non-binding. Whether a LOI is binding or non-binding is based on the parties’ intent. Generally, the language of the LOI is the best way to exhibit the parties’ intent. For example, if the parties to not want to be bound, they should state in their letter that the parties will not be bound by the terms of the LOI.
Ten Important Terms to Include in Your LOI
Listing the parties may seem obvious, but it is important to know exactly which parties are going to be entering into the lease. This is especially true if you are going to enter into a lease with a company as opposed to an individual.
Use of Premises
Both the tenant and landlord will want to clarify the use (or any restrictions on use) of the premises.
The LOI should specifically address any rights to renew.
It is not uncommon for things to take longer when dealing with commercial leases especially if there is a build out. Both parties will want to ensure that they are clear on the possession date.
Determining whether there is a security deposit upfront will let you know how much capital you will have to put up if you are a tenant.
Landlord Build Outs
Are the parties expecting the landlord to build the space to fit a specific need? If so, who is expected to pay? When will the build out be completed? Does the tenant get a say? These should all be discussed upfront between the tenant and the landlord.
Leased Premise Description
Identifying the leased premise is especially important when there are common areas such as a conference room, reception area, or parking space. Are these items included in the lease? Does the tenant get exclusive use? Discussing these issues should occur upfront.
What is included in “operating expenses” may vary from landlord to landlord. This will become an important issue especially if you are dealing with a net lease. Each party should be clear about what is included in operating expenses to adequately determine how much rent will be and who will be bearing various costs.
What if the tenant wants the landlord to remove the property from the market while they are negotiating? What if the tenant wants to keep it confidential that they are looking at the space? In a non-binding LOI, the landlord is not obligated to do any of this. In a non-binding LOI, the parties should include clear “carve outs” about what is binding on the parties (if anything).
Outlining what happens if a party defaults on a potential lease obligation is crucial. This allows a tenant to know exactly what they need to do if they cannot make rent and lets the landlord plan if they do not have rent coming in.
Types of Commercial Leases – Gross v. Net
There are two main types of commercial leases: gross and net. There is also a hybrid of the two generally referred to as a modified gross (or net) lease. A modified gross (or net) lease blends the gross and net lease together.
A gross commercial lease is most similar to a residential lease where the tenant is charged a specific amount each month and that rent includes all operating expenses such as property taxes, maintenance fees, and property insurance.
This type of lease is helpful for business tenants because it allows them to forecast since they know the exact amount of the monthly rent. From a landlord’s perspective, this is easy for book keeping purposes and to know how much money is coming in each month.
A net lease is where the landlord charges the tenant a base amount of rent and then charges the tenant separately for common operational expenses. Operation expenses can include real estate taxes, property insurance, management fees, repairs and maintenance, utilities and other various items. There are various types of net leases as follows:
Single Net Lease
A single net lease means the tenant is charged a base rent and a portion of the property taxes. The tenant is generally responsible for utilities as well. The landlord covers all other costs.
Double Net Lease
A double net lease requires the tenant to pay a base rent, property taxes, and property insurance.
Triple Net Lease
A triple net lease is the most popular type of commercial net lease and requires the tenant to pay a bas rent, property taxes, property insurance and common area utilities (CAM). Generally, the CAM is prorated based on the amount of square footage a tenant leases and is generally determined on a year-to-year basis.
If you are a tenant in a triple net lease, it is important to review the terms carefully to determine what you will be responsible for as a tenant. Also, tenants should ensure that there are caps on the amount the CAM can increase from year-to-year.
Overall, there are a lot of considerations for a tenant or a landlord when entering into a commercial lease. It is important to keep these considerations and discuss your options with competent professions.