How to Spot Unfair Commercial Lease Terms, The Red Flags to Look For
Every single person had this idea, however fleeting, at least once in their life: “I want to be my own boss”.
Every success story starts with some or other inspired, self-employed individual who started his or her multi-million -dollar business right there in their garage.
We hear the stories, we devour the inspirational movies, and we think that we can do it, too.
Then we ground ourselves a little, and compromise that we do not need to be the next Steve Jobs, we just need something to live off of decently.
We have that business idea, so why does it happen that many of us never go through with it?
The thing is, it is more difficult then they tell you, and it is okay.
The movies are there for inspiration; your success depends on many other things: the nature of your idea, the finances, how hard you work, your motivation, and most importantly- the choices you make.
Did you know that about 70% of small businesses eventually file for bankruptcy?
The main reason for such a number is the fact that people are uneducated in what it means to have a business of your own.
In fact, a lot of small business owners have to have a real strategy before they make their business any bigger.
It is not just about being able to take vacations whenever and wherever, or deciding to stay in when you are just not feeling like going to work today. In fact, it is not about that at all.
You will probably work more than in your nine-to-five, and taking days of will be impossible as you are responsible for everything.
Now, let us assume that your idea is great, and that you figured out the financing, and that you are the dedicated, hard-working entrepreneur and you are ready to get out of your garage and into the business world.
WHAT IS YOUR NEXT STEP?
It is to find a place for your business to grow. You want that perfect office (or workshop, exhibition, or whatever your business is) space that will encourage customers to use your services.
It is time that you get that space for yourself.
Now, let us imagine that you do not have enough money to purchase the premises, but you do not have any issues with getting a lease.
Is it just as easy as “I like this space, let’s take it!”? Nope.
There is something called Commercial Real Estate Lease Agreement that both you and the landlord need to sign, after that, the premises are yours to use.
But before you jump to sign the document, you need to understand the importance of negotiating the agreement and some possible traps that may not benefit you in the future.
After you sign it, the document is legally binding, and there are very few ways to painlessly break it.
So, you are finally signing your office lease and it feels good because you are now free, this is your space of operation and you can do what you want to do with your business.
To do that, you have to be educated about what it means to sign a lease for you as a prospective tenant.
You need to figure out the motivation behind both your broker (if you have one) and your landlord, and your motivation as well, so that, when you go into it eventually, you do not get ripped off.
The main cause is to get the best deal for you.
If you are planning to venture into small business and want to educate yourself about signing commercial leases; if you are about to sign your first commercial lease and you do not know anything about it (most of us do not), or if you already have your office lease and you want to know whether you have made a good deal and/or want to avoid making mistakes in the future – this text is for you!
Before you even start looking for and thinking about putting your name on a document, you need to be sure what your needs are in terms of
- Space – i.e. how much space do you need? When you think about that, you need to look a little in the future, so you do not think about how much space you need now but how much you will need in 18 to 24 months. Your business will hopefully grow, so it would be inconvenient to break the lease before the legal end date because you have not planned well. You need a little room to grow, but your office space should not be way too big either.
- Term – i.e. what is your term? How much time do you think you would stay at that location? It is the duration of the agreement, and the usual terms are 12, 24, or 36 months.
- Location – i.e. where do you want it to be? Think about the area. Do you need foot traffic, do you need parking, would a shopping mall be a good fit, and how about a location near a freeway? It all depends on the type of business (e.g. a hairdresser’s salon would not make much sense on the side of the freeway).
- Affordability – i.e. what can you afford right now? To calculate this you need to take into consideration your monthly expenses plus personal expenses. Do have the amount of money saved up for the next six to twelve months? If you do, you are all set.
- Legal – even if your commercial real estate agent (broker) claims that a lawyer will look over the deal, you should hire a real estate lawyer who is not financially or emotionally attached to your broker. They will be able to give you more objective advice on how to negotiate, especially when it comes to those tricky, red flag clauses.
If you know your exact needs, you will be able to recognize what does not work for you in the agreement and negotiate better conditions for yourself.
As opposed to residential leases that are almost set in stone with very little ‘wiggle room’; the commercial leases can be negotiated to benefit each tenant uniquely.
No commercial lease is ever the same and this is why you, as the prospective tenant, have the power over the negotiation process.
TYPES OF COMMERCIAL LEASES
There are quite a few different commercial leases, but these are the three most common ones met in practice.
1. Percentage Lease
Percentage lease is when a tenant pays monthly rent as well as a certain agreed-upon percentage of their monthly sales in the business.
For example, if you are leasing a store in a shopping mall, you may agree to pay a percentage of what you earned through sales.
The percentage rate can and should be negotiated between the owner of the store and the landlord of that property.
2. Gross Lease
Upon signing the gross lease the tenant is only responsible for paying their monthly rent, and that rent includes everything – property taxes, CAM (Common Area Maintenance) fees, utilities, and other expenses that the landlord is responsible for.
This type of lease is very popular and preferred by the tenants since they do not have to make more than one payment. Ideally, the rent is specifically agreed-upon in the agreement.
3. Net Lease
In the Net lease, the tenant is responsible for paying the rent plus some or all of the other expenses. Those other expenses are all those CAM fees, taxes, and the rest that falls into the expense category and that was included in the gross lease.
Net leases come in three different shapes:
- Single Net – the tenant is paying only the base rent and the landlord covers all the other expenses (very uncommon).
- Double Net – in addition to monthly rent the tenant is paying taxes and insurance.
- Triple Net – in addition to monthly rent, the tenant is paying taxes, insurance, and maintenance.
The final financial difference between Gross lease and Triple Net lease should not exist as the expenses add up. Typically, however, in commercial real estate Double Net and Triple Net leases are the most common among all the types.
RED FLAGS TO LOOK FOR
Sometimes, the relationship between the landlord and the tenants does not go as well as desired or planned.
This is why you should always be aware of both of your legal rights before you sign the document.
If you are not versed in commercial real estate law, here are some red flags to look for in an agreement. They can prove helpful, but do not base your decision entirely on it.
If you find yourself on the brink of signing a lease, your safest bet is to contact an attorney who will help you navigate through the process of negotiation and signing.
1. Unfavorable Relocation Clause
The relocation clause means that your landlord can move your business to different office space if it fits his needs. It usually happens if a bigger or higher-paying tenant comes into the picture.
Should you agree to that? If you think that it might benefit you along the way, or at least that it would not be much of an inconvenience, you can sign the clause, but make sure that you negotiate the terms of that clause and ask for other benefits if the relocation happens (soft costs, restriction, rent decrease, and more).
The relocation clause might not be such a big deal if you are leasing the space for a workshop – no customers ever go there anyway.
On the other hand, if your business depends on foot traffic, relocating you may influence you negatively – e.g. your customers will not know where to find your office anymore, even if it is just a floor higher or lower.
2. Verbal Agreement
When you are investing your time, energy and money into a business, you want it to be safe and secure. The only way to legally ensure that for your business is to have it all written down.
Do not fall for friendly assurances that you will figure everything out as you go.
Remember, your landlord is also a businessman and their motivation is to earn more money as well.
This does not mean that you should not have trust in your landlord, only make sure that everything you have agreed upon is carefully and clearly written down, as to ensure that your business relationship will be smooth in the long run.
On the other hand, if the landlord insists on not signing anything it may be a clue for you to look elsewhere.
Can you have a valid lease without signing a document?
Yes. There is a presumption at law called “Month to month lease” which means that when a tenant is paying rent they can use the premises even without the written agreement.
That type of verbal lease can be broken by either party with a 30-day’s notice. In this case, a verbal agreement is valid, however, you have no guarantee that you will be able to stay on those premises if you decide that they are good for your business.
You will have no legal rights to fight the eviction if it happens.
However, it never hurts to be prepared for it if the time comes.
a) Lease Too Long
The lease you sign should not be 12, 24, or 36 months. Leases that are longer (5-10 years) benefit your landlord because they have a guaranteed and steady income for years to come, and understandably, they would try to push those terms in the lease.
You should negotiate for shorter terms because you want to keep your options open in case you see that you are outgrowing the current space, or that you do not need as much after all.
Another thing that you should pay attention to is the Renewal Clause.
The terms of renewal should be strictly specified in the agreement so that there are no unpleasant surprises in the future.
So what is your best option? A short lease with a great Renewal clause.
b) Vague Fees and Escalation
Triple Net lease is often considered unfavorable for the tenant, but it is the case only if you do not check all the facts right and fix them before you sign.
The NNN lease could prove problematic if the fees for the taxes, insurance, and maintenance are not determined by the lease.
Sometimes it happens that a landlord will raise the fees without any particular reason or documentation.
Maybe they had some unplanned expenses elsewhere and they are now trying to get you to pay for that indirectly.
If you make sure that the fee rates are precisely determined you are safe from that.
You also need to make sure that the escalation (annual raise in rent) is determined by the lease and that it follows the market state. Nothing in the lease should be provisionary.
c) Maintenance Clauses
Maintenance clauses are the trickiest to deal with as there are so many possible ways in which you can look at them.
They usually come up as a problem for the tenant in Triple Net leases if they are not distinctively and determined by the terms.
The maintenance clauses entail CAM fees, utilities, and repairs done on the premises during the leasing period.
Understandably, you as a tenant will be responsible for replacing light bulbs, AC filters and the like, and all the other adjustments you want to make to your new workplace (paint the walls, add new fixtures, change the carpets, and so on).
But what happens with damage caused by building’s natural decaying process e.g. a roof collapses, or the plumbing system is too old and needs to be changed?
The big repairs on the building are usually the landlord’s responsibility.
There is one clause that can come up in a lease that seems rather innocent but can cause problems when the lease is up and it goes “The tenant is responsible for keeping the building in good and tenantable repair.”
E.g. you signed a lease to a building that is in a less than favorable condition, and to accommodate it to your business, you did some repair and improved upon it.
That is reasonable, and if you signed the lease it is your responsibility.
The problem with this clause appears when you decide to leave the said premises and your landlord can legally demand (based on that clause) that the building is ‘put back’ to the original state.
Nobody wants to demolish what has obviously been improved so what the landlord essentially gets from you is the renovation of the space according to their needs.
The fix to this problem is to add this to the clause: “The tenant is responsible for keeping the building in good and tenantable repair but this clause does not require the tenant to put the property into any better condition than on the date of the lease”.
This addition to the clause and a list of inventory can save you (tens of) thousands of dollars.
The assignability clause is one of those that is missing from many agreements because it mostly benefits the tenant.
It means that your lease may be assigned to the other person while the lease is still in power.
E.g. Six years into your 10-year lease you decide that you want to sell your business for whatever reason.
The agreement is linked to your business and you, so without the assignability clause; you will not be able to sell your business before the lease is up.
The consequences can be various – from limiting your professional growth to bankruptcy.
e) Agreement Breaking Clauses
Agreement breaking clauses benefit both you and the landlord. If there aren’t any or if the terms of breaking the agreement are vague, you may not know what your rights are and what the rights of your landlord are.
For example, do you know if you have the legal right to break your agreement if a fire has destroyed your office? What about other reasons outside the human power?
Can your landlord evict you if you were late for last month’s rent? Maybe you can negotiate a seven-day’s notice before the eviction notice can take place.
Consult a lawyer about what the reasonable requests are and make sure that the reasons for breaking the agreement are unambiguously stated.
Is there a clause in your lease that allows you to sublease the office space if you need to? If not, make sure that you negotiate it.
Let us say that you have signed a 5-year lease on the office space. After the third year, you either need to move to a bigger office, or you need to downsize.
Staying in the smaller space can damage your growth, and paying for a bigger space than you need reflects badly on your finances.
The solution? Sublease!
Subleasing will guarantee that you will be able to pay the rent for that month or that you are free to look for another office space without having to break your agreement before the lease is up.
Many of the commercial agreements do not have that clause because you breaking the agreement before its expiration date will largely benefit the landlord.
g) Lease Start Date
So, let us say that you have agreed upon everything and that all that remains is to sign that lease.
Stop for a moment and think about this – will you need time to make necessary adjustments to the premises, or did you just want to make sure that the perfect space does not get taken away before you are even ready to move in?
If you need some more time to get the business up and running before actually starting to use the premises, then you might want to consider the lease start date. In this case, the signing date and the start date may differ.
If you do not pay attention to this you may end up not negotiating the rent for that period before the start date. Why do we consider this a contractual red flag?
Do you like to pay more than you actually need to? Probably not.
Ask your landlord to decrease the rent for the months you will use up to set up the business.
It goes with common sense to say that you should never, ever sign a binding document without carefully reading, negotiating, and revising it.
In commercial real estate there are large amounts of money going around, so a small oversight can cause your business to fail.
We hope that this text will help you catch those potentially harmful clauses in your lease and prevent you from making a mistake.
Look for those subtle and tricky points, call them out and fix them to help your business grow. If the situation is still way over your head, do not hesitate to hire professional help.
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