For companies seeking office, retail or other commercial spaces, leasing costs are commonly one of their top long-term fixed capital expenses. Commercial tenants need to understand how to negotiate favorable lease terms to position themselves for success before signing. Here is a sampling of such issues and some tips for tenants approaching lease negotiations.
1. Term Length
Tenants must have a long-term lease plan before negotiations begin to be sure the term length matches their company’s business goals.
Start-ups or high-growth companies, for whom flexibility is paramount, may seek shorter term leases with options to renew or expansion rights. But if renewal options are part of the deal, rent and other costs payable during the renewal period must be clearly defined. For example, “fair market rent” should be defined by a formula that both landlord and tenant can agree on, or even simpler, a set fixed percentage increase over the prior year’s rate.
More established organizations and traditional industries may prefer a longer term in order to establish stable and predictable cost metrics and negotiate savings, given they are guaranteeing a longer stream of revenue to the landlord.
Term length can also impact marketability of a business, because a buyer seeks long-term stability at an established location. These “key money” deals are particularly popular in brick and mortar retail shops and restaurants, where location is crucial.
2. Exit Strategy (Right to Leave)
Exit strategy is key to protect a tenant’s business in the event of financial challenges, acquisition activity or outgrowth of a space. This can be particularly crucial for newly launching or young businesses.
But expectations should be in line with market norms. In competitive real estate leasing markets in this current up-cycle where tenants are aplenty, the right to cancel may be hard to come by.
Tenants operating highly-regulated businesses, like restaurants, bars and healthcare or life sciences companies, may need a contingency clause that delays commencement until they can secure all licensing and permitting requirements and provides a cancellation right if they are unable to open for business.
3. Notice and Cure Periods
A commercial landlord has broad legal rights and remedies available to enforce against defaulting tenants that are potentially destructive to their business. These often include lease termination, rent acceleration and enforcement costs (including court costs and attorneys’ fees), any of which the landlord may exercise the moment an event of default occurs.
Tenants should push for grace periods, the right to receive written notices of defaults and a reasonable opportunity to cure before a default is declared under the lease. A typical notice and cure period will condition a tenant default upon failure to pay rent for 3-5 days following receipt of written notice of such failure from landlord. Usually, cure periods for performance obligations (such as for repairs) are longer (often 10 days or more) than that of payment obligations.
4. Assignment and Subleasing
Assignment and subleasing rights are essential to guarantee tenants have adequate flexibility as their businesses undergo growth and change. If the lease is silent with respect to transfer rights, a tenant may assign or sublet its interests.
However, most commercial leases expressly restrict a tenant’s transfer rights without landlord’s prior consent. While it is reasonable for a landlord to have a say in the party occupying their property, tenants should push to be sure the language provides that their landlord cannot “unreasonably withhold, condition or delay” its consent in order to avoid delays and disputes later on.
Tenants should also understand that only a termination, not an assignment or sublease, will accomplish getting a lease off their books. Most subleasing and assignment clauses provide that tenants remains liable for all lease obligations following such a transfer. A full release must be negotiated separately to ensure a clean exit strategy.
5. Net or Gross: Rental Structures
Rental structures can vary widely in commercial leases, so negotiating rental rates must account for what “additional rent” tenant will be liable for during the term.
Triple Net (or “NNN”) lease structures provide that the landlord will pass through all costs for taxes, insurance and common area maintenance to the tenant. Tenants should do thorough due diligence to understand what such costs are comprised of, negotiate for appropriate exclusions and push for caps on increases to avoid large, unexpected cost spikes that can throw off their metrics mid-term. NNN leases are commonplace in retail and industrial sectors.
An “industrial gross” lease, common in office leasing, means the tenant is responsible for the monthly rent, as well as utilities, premises maintenance and their pro-rata share of the increase in the taxes and operating expenses over a base year amount. Again, due diligence is key to fully understand what costs are being included and to gauge what the average annual out of pocket will be.
Also, tenants should be aware of outside factors such as change in ownership of a building, which in some states like California, triggers reassessment of the building at the purchase price. In such a case, if a landlord has owned the building for a long period, the tenant could be facing a very high tax bill, even if the tenant only leases a small percentage of the space.
Percentage rent structures require a tenant to pay the landlord a percentage of the tenant’s revenue once it reaches a certain “breakpoint” level. This structure, popular in restaurant and retail spaces, typically does not benefit the tenant, unless the base rent is extremely low.
The obligation on the tenant to report its performance to the landlord on a regular basis can hurt future negotiations. If the landlord knows the financial performance of the location, it can materially and negatively impact future flexibility and negotiating leverage. But nonetheless, percentage rent is a fairly common concept, so if it is necessary, tenants should make sure to understand and negotiate such points to ensure lease compliance.
6. Tenant Improvements
Even in a landlord’s market, tenants can often negotiate tenant improvements, since they increase the long-term value of the landlord’s asset. In negotiating for build-outs, understand that landlords seek to recoup their contributions through other lease terms, such as increases in expenses passed through to the tenant or in determining rental rates.
Be clear on all costs and requirements, such as vendor selection, bid process, contribution caps, materials and insurance standards. Strike a landlord’s right to require removal and restoration of improvements to their original condition upon lease expiration – instead, require the landlord to confirm any restoration requirements at the time he or she grants approval.