A Commercial Tenant's Guide to Lease Terms | leases, lease document, Net leases

You're facing a major lease agreement. The lease document is lengthy and written in mysterious "legalese." How do you know what the terms really mean and what the implications are for your business? A misunderstanding or overlooked issue today can become an expensive problem in the future. So it's useful to be able to interpret the terms of today's industrial lease documents.

The conventional wisdom is that leases are written to benefit landlords more than tenants. It's no surprise that landlords need to protect their interests just as much as tenants do, and no secret that brokers are typically paid by the landlords. However, with an understanding of your lease document - and representation by an ethical, skilled broker working on your behalf - you can secure a lease agreement that is a win-win for both parties in the transaction.

Types of Leases
One confusing aspect of leasing is that even industry insiders can be inconsistent in their descriptions of the various kinds of leases. Most industrial facility leases are a variation of "gross" or "net." Net leases are commonly used for single-tenant industrial properties, while modified gross leases are typical in multi-tenant facilities. These terms refer to how roles and responsibilities are divided between the landlord and the tenant, how various property expenses are paid, and who pays them.

With a full-service gross lease, the tenant pays a lump-sum monthly rent to the landlord, and the landlord in turn pays for taxes, maintenance, insurance, and utilities. The tenant also must pay for any additional property insurance, taxes or utility expenses incurred by their occupancy, and for their share of any future "pass-through" increases in property operating expenses.

A modified gross lease is common in industrial facilities. It is similar to a full-service gross lease, but certain operating expenses - e.g., real estate taxes, electricity, maintenance, or janitorial services - are paid directly by the tenant. This lease structure is useful if each tenant has a different business and has different needs, and/or if some utilities are directly controlled by individual tenants.

Like gross leases, net leases come in several varieties. A net lease requires the tenant to pay some or all of the property expenses directly to the source - whether a service provider, tax authority, or insurance company, for example. Since there are no set standards as to what costs may be excluded or included in a net lease, the lease is usually customized according to need.

With a single-net lease, the tenant pays a monthly lump-sum base rent as well as the property taxes. The landlord is responsible for all other operating expenses of the property and the tenant's premises.

With a double-net lease, the tenant pays a monthly lump-sum base rent as well as the property taxes and the property insurance. The landlord is responsible for all other operating expenses.

A triple-net lease, often used with single-user industrial facilities, means that the tenant pays "TMI" - taxes, maintenance, and property insurance. Tenants also are responsible for all costs associated with their occupancy, including personal property taxes, janitorial services, and all utility costs. The landlord is responsible for the roof and the structure, and sometimes the parking lot. If you are considering a triple-net lease, it's important to clarify the parking aspect up front or risk disputes down the road. A triple-net lease gives the tenant near-total control over the property, as long as they comply with the use limitations and other clauses specified within the lease. The disadvantage is that triple-net leases often cannot be cancelled except under extreme situations, such as an eminent domain ruling.

An absolute triple-net lease or bond lease is triple-net lease with one key difference: under no circumstances can a tenant cancel the lease. Property investors and lenders like bond leases, for obvious reasons, but the arrangement works only if the tenant company is reasonably expected to have a long lifespan.

Length, Holdovers, and Options
Landlords like long-term leases and will offer a lower rent rate and more concessions for a lease of 10 years or more. Companies, however, prefer flexibility, especially given the fast-changing pace of today's global economy. Many tenants aim for the best of both worlds by assuming a long-term lease with a cancellation option if at all possible. Some landlords will require a certain amount of notice or other compensation to minimize potential loss of income from vacancy.

On the other hand, industrial leases today often have shorter life spans than in the past. You will likely pay a relatively high rent for a lease of five years or less, but for some companies under certain conditions, the higher cost makes good business sense.

You also can request an option or options to extend the lease at a rental rate structure that you should negotiate up front. Typical arrangements include continuing per lease terms, continuing at a rate adjusted by a certain percentage, or continuing under prevailing market conditions.

Another lease length issue to consider is a possible holdover - staying in your space an extra one or two months beyond the lease expiration date. Landlords typically require holdover rent that is 200 percent of the last month's rent, but you may be able to negotiate a somewhat lower rate.

Other Terms
Premises: The term "premises" seems simple enough, but it should be clearly defined in your lease document. If you are leasing an entire building, for instance, does the lease include the parking facility? Are you responsible for parking maintenance? If you are leasing part of a multi-tenant facility, look closely at the landlord's definitions of common areas and your leased space. Since rent is charged per square foot, your landlord will, naturally, seek to maximize the measurement of the space you are leasing. Measurement, of course, is subject to interpretation - one can measure from the outside walls or the interior walls, for example, or include obstructed unusable space in the square footage.

Operating Expenses: Your lease document should include a complete description of the expenses for which you will be charged. Operating expenses are recurring expenses that are essential to the continuous operation and maintenance of a property, and the term does not include real estate taxes, insurance, mortgage payments, capital expenditures, and depreciation. Operating expenses can include repairs, trash removal, salaries of the landlord's employees, building improvements or operations of common areas (see below), among other items. Some of these expenses represent a potentially significant future increase in cost of occupancy, so it is best to read the list closely. Also, unscrupulous landlords will add expenses that you should not have to pay, such as the cost of marketing the property to other tenants or for square footage of the landlord's office space within the property.

Common Area Maintenance (CAM): In a multi-tenant facility, the landlord typically assumes responsibility for the structural elements of the property, while the CAM charges are divided among the tenants of the building and are included in your rent payment or paid separately, depending on your lease. Your CAM charges will be based on the square footage you lease as a percentage of the overall facility, and typically are summarized in the lease document as a percentage of the common areas. Again, it's important to know exactly what square footage will be used as the basis of the CAM charges and, again, examine the list of operating expenses closely to determine exactly what you are paying for.

Escalation: The escalation clause allows the landlord to increase the rent at a future time to stay abreast of inflation. The escalation may be defined as a fixed increase over a defined time period or as a cost-of-living increase linked to a government index - e.g., Consumer Price Index - or an increase directly tied to increases in operating the property.

Base Year: Base year refers to the first 12 months of a tenant's occupancy or the calendar year, depending on the timing of the lease. Base cost is the operating expenses of this first year and is used as the basis of future increases in operating expenses that are passed through to tenants. Therefore, you should note how the landlord defines the base year, because the beginning of the second year is when you begin paying pass-through expenses, if applicable in your lease.

Tenant Improvement Allowance: Landlords often will grant a tenant improvement allowance so that a space can be customized for your needs. The allowance is typically offered in terms of dollars per square foot, with the tenant responsible for any charges above the landlord allowance. Landlords and tenants alike usually prefer to control the construction process, and larger tenants have more leverage in obtaining a "tenant work letter" that gives them control over the project.

Subordination and Nondisturbance: Unless your landlord is a public company, it can be difficult or even impossible to know whether the company is financially stable and reliably paying the mortgage. To assure your business continuity, you can add clauses to your lease that will preserve the lease with its current terms should your landlord default on the mortgage and the lender assume ownership. Without this assurance in writing, the lender is not legally required to recognize your lease and you could face eviction or a steep rent increase. The subordination clause will state that the mortgage is subordinate to your lease, and the nondisturbance clause will state that the lender and future owners of the property cannot terminate your lease as long as you continue to fulfill your obligations. This clause is especially useful if area rents have risen considerably while you have operated under your current lease, as one of the first things the lender or a new owner would want to do is increase rent to market rates.

Americans with Disabilities Act (ADA) Compliance: Although the ADA has been on the books for many years, many buildings are not ADA-compliant. If your landlord is going to build out your space, make sure your lease includes a clause requiring the buildout to be ADA-compliant. Once you take occupancy, your business could be at risk for compliance, and the legal fees and the cost of retrofitting can add up quickly.

While this list obviously doesn't cover every possible lease term that you might see, these are some of the terms that can cause the most trouble if overlooked. What's important is that your lease terms point to the potential hazards for your business. The good news is that mysterious leasing terms are easy to understand at all once you're approaching them from a place of knowledge.