How do commercial leases work?

When most folks are ready to start a business and lease commercial space, they’re rarely prepared for the differences that they find between residential and commercial leases. Most incorrectly believe that they can provide a credit check, first month’s rent and one month’s rent as deposit and they’re good to go. But since there is SO much more financial risk for commercial landlords, that’s simply not the case. Here’s a very high level overview of how commercial leases work.

Rent structures

When you’re dealing with retail or low rise office space, you’ll almost always be dealing with NNN (pronounced triple net) leases. What this means is that the landlord will charge two types of rent:

Base rent, which covers the landlords debt service (mortgage) and whatever profit margin they’re looking to earn from the property.

The other is NNN rents (also loosely referred to as CAM, OPEX, Additional Rents, Other Rents) which is the sum total of all of the property’s expenses, including taxes, insurance, maintenance, and property management.

NNN Rents are pass-through expenses, meaning the landlord passes those on the tenants on a pro-rata basis. If you’re leasing 1,000 SF in a 10,000 square foot building, 10% of the property’s expenses will be passed on to you. Because these expenses are set mostly by third parties, Landlords almost never negotiate these rents. However, because some Landlords are better at controlling and fighting increases in these expenses, it’s important that you and your agent verify that NNN expenses for one building are comparable to nearby like buildings.

When talking with agents, it’s vital that you make sure you understand what both base rents and NNN rents are for a property. Most brokers don’t advertise NNN rents, only base rents, and that can lead to big miscalculations when tenants aren’t aware of the total rents.

Commercial Buildouts

Another line item that you’ll need to budget for is the costs involved in building out or retrofitting a retail space for your use. Typically, landlords will offer a Tenant Improvement Allowance for new tenants to make modifications to their spaces. For first generation spaces (meaning the building is still in shell condition – foundation, ceiling, demising walls, and glass) you might expect to find TI allowances in the range of $18 – $40 per square foot. For second generation spaces (meaning it is largely already built out from a previous tenant), allowance will be much lower, often in the $5 – $15 per square foot range.

What is vital to understand is that these allowances are not fronted to the tenant. They’re reimbursed. Tenant’s have to incur the entire costs for their buildouts including architects, contractors, permitting, inspections, and the actual construction up front. Then, once construction is complete and you’re open for business, you’ll provide an invoice, a copy of your occupancy permit, and a signed lien waver from your contractor and subcontractors. The landlord will then reimburse you UP TO your agreed upon improvement allowance for actual expenses incurred. Any costs over and above that amount is not reimbursed. Lastly, the landlord does not reimburse for equipment purchased for the building such as computers, office furniture, fixtures and decorations. Think only items that are built permanently into the space.

Lease Terms

You’ll also want to understand how lease terms work. We all know that residential leases are typically either six months or a year in length. With commercial property, those terms more often than not are much longer. For first generation buildings, tenants should expect to be looking at a five year term. That’s because the landlord will have considerably higher expenses (tenant improvement allowance) that the most recoup over the term of the first lease. For second generation space, landlords may often consider a 2 – 3 year term if the original lease was completed in full.

Different property types may alter these terms though. For example, industrial buildings often have minimal buildouts so landlords may be more agreeable to shorter terms. Likewise, office condos are almost never subject to build-out and are leased as-is so landlords may be more agreeable to shorter terms. The key is having an experienced agent that can advise you on a case by case basis of what you can expect.

The Process

The general process for leasing commercial space goes like this:

Hire your agent (that’s me) → complete general application and financial statement → find and tour properties → make an offer via a non-binding letter of intent → negotiate terms → sign lease and deliver rents/deposits → take possession of the space → buildout → final inspections → open for business.

Hire an Agent

Just as with a residential lease or purchase, you’ll want an experienced, licensed commercial agent that represents your interests. That’s where we come in. And the best part is that our fees are typically paid by the landlord.

Complete Application / Financial Statement

We need to be able to vouch for your financial strength before ever touring properties. That’s why we’ll ask you to complete an application and a personal financial statement, which we’ll share with landlord’s only upon written authorization from you.

Find and Tour Properties

We’ll deliver a list of properties that closely matches the needs and wants that you’ve selected for your business. You can review properties online and narrow the list to only properties that closely match what you’re looking for. Then we get to go tour them!

Letter of Intent

Once we find a property that you want to pursue, we’ll draft a non-binding letter of intent that will summarize all the terms under which you’ll agree to a lease. This document typically will travel back and forth between Tenant and Landlord with various changes until the terms are agreed upon by both parties.

Lease

Once the Letter of Intent is finalized, the Landlord will draft a final lease. Since the Landlord’s attorney typically drafts these leases, they almost always favor the Landlord. As your agent, we limit our review of leases to ensure that the terms specified in the Letter of Intent are included. We will always then encourage you to hire an attorney for final lease review.

Deliver First Month’s Rent and Deposit

Once the lease terms are agreed upon, you as the tenant will wet sign (meaning with an actual blue pen) and deliver cashier’s checks – one for the first month’s rent, and one for your deposit. We will then deliver the lease and checks to the landlord’s broker for final execution.

Possession

Once the landlord executes the lease, their property manager will make arrangements to meet you at the property for delivery of the space. Typically, you’ll sign a document verifying delivery and the landlord will give you the keys.

Buildout

From here, you’ll engage your architect and contractor to begin the buildout process. Planning by both of those parties should have started as soon as you selected a space.

Final Inspections / Occupancy Permit

Once buildout is complete, you or your contractor will need to contact the local permitting department to arrange for final inspections. Once inspections have been passed, you’ll receive an occupancy permit and you can officially open for business!