Key Areas of a Commercial Lease

By Admin - May 13, 2022 - Commercial Real Estate

Commercial leases are often an essential part to the operation of a business. While some businesses own their own property, many rent a property, building, or portion of a building from a landlord. The capital outlay for purchasing property can be inhibiting for many businesses, particularly in the current economic climate, and this is especially true of small or startup businesses. This makes renting space the more realistic option for many companies, and, accordingly, commercial leases can be one of the more fundamental parts of business law.

While many people have signed a residential lease at some point in their lives and the overall idea is the same (i.e., renting a space from another person), commercial leases have many nuanced differences, are sometimes more customizable and negotiable, and carry their own sets of regulations (including zoning and nuisance laws regarding exact commercial uses of space). Those leasing commercial space generally have less protection and more responsibilities than those leasing residential space, and it is important to have a base knowledge of commercial leases and proper advising before entering into such an agreement. Leases are contracts that are binding on the parties, and with the average length of a commercial lease being 3-5 years, a bad decision can affect a business for a long time.

For purposes of this article, the key terms within a commercial lease will be examined, including which terms are more advantageous to a landlord or to a tenant. The key thing to remember is that most provisions are negotiable and therefore can vary between leases.

Rent

Rent might seem like a simple provision, but it can be nuanced. Perhaps the first type of rent to come to mind is a fixed rent, which is a flat amount. Often, but not always, utilities may be added to this. But there are other options. A “net lease” is one in which there is a fixed rent and the tenant pays some or all of the operating expenses for its portion of the property, including things like taxes, insurance, and structural and maintenance repairs on the building. A “percentage lease” may have a lower or no fixed rate but instead takes a percentage of the tenant’s profits from its business.

The landlord may reserve the right to increase rent after a certain time or rent increases might be built into the lease, either in the form of a fixed percentage or dollar amount increase or one that is tied to an index such as the Consumer Price Index (and therefore adjusts automatically for inflation).

Length/Term of Lease

While most residential leases are a year, many commercial leases are longer. As mentioned before, the average length is 3-5 years and some may go 10 years, with the rare 99-year lease or some other essentially lifetime lease (though the latter are typically special circumstances done as a type of gift).

Generally, a landlord will want a longer lease to guarantee income longer, but if the landlord knows there might be opportunity with future higher-paying tenants or to sell the property, the landlord may want a shorter lease.

Similarly, a tenant may want the security of a longer lease but may not want too long a lease because it is difficult to know what circumstances years down the road will be (e.g., whether they will still be in business, if it will have outgrown its space, if it would be better to move to a different area, etc.). Therefore, both parties need to examine their circumstances and future risks and opportunities to optimize the length of their commercial lease.

What happens at the end of a term can also vary. There may be an automatic renewal or notice may be required by one party to vacate or not renew. Occasionally, particularly with a single-occupant building, there may be a purchase option for the tenant.

Early Termination

A commercial lease will sometimes give the option for one party to terminate the lease early. This can be triggered by a certain event or be in the mutual agreement of the parties.

One common provision is that if rent is not locked in and can be raised year-to-year, the landlord will have to notify the tenant in advance of the increase in rent, and the tenant will have the ability to terminate the lease early if it will not agree to the increase in rent.

Other possibilities exist, however, including the ability of a party to terminate the lease (or even the termination happening automatically) if the tenant ceases to be a business, if the landlord sells the property, or if there are significant changes in the market or the needs of the business. However, such provisions can heavily favor one party and may be difficult to place in the agreement.

Sometimes early termination will require the terminating party to pay a fee to the other party, which could be in a dollar amount or a certain timeframe of rent. Generally, an early termination clause will also include a release of claims regarding the early termination if the clause is followed by the parties.

Often the landlord will have the right to inspect the premises to give (reasonable) approval to their condition and can require or charge the tenant to fix any issues the tenant has caused or left. There may also be a limit to how soon an early termination clause can be triggered.

Initial Build-Out, Alterations, and Repairs and Maintenance

Because the purpose of a business and therefore the use of the premises will vary from tenant to tenant, commercial tenants are often responsible for parts of the alterations and maintenance.

An initial build-out is done before the tenant takes possession of the premises to prepare the space for the tenant’s specific purpose and layout. Sometimes planning and overseeing these changes is the responsibility of the landlord (who will consult with the tenant on the changes) and sometimes this is the responsibility of the tenant. Costs are sometimes born by the tenant and sometimes by the landlord (sometimes in the form of an allowance from the landlord who will pay up to that amount).

Alterations will often be necessary later to make the premises usable for the tenant’s specific purpose. These alterations are usually the tenant’s responsibility and at the tenant’s expense. A lease may require the tenant to obtain approval from the landlord for certain types of alterations beyond cosmetic ones or above a certain expense, especially if they will affect the structure of the building or the appearance of the exterior. There may also be a requirement for the tenant to restore the premises to the way it was before the tenant moved in.

Typically, a landlord will be responsible for maintaining the structure of the building, common areas, parking areas, etc., but a tenant will be responsible for repairs and maintenance inside of the space it controls, particularly for things that wear down after regular use. While a residential landlord might be responsible for replacing an appliance or lighting fixture if it wears out, items like that are usually the commercial tenant’s responsibility to replace.

Authorized Uses

Depending on the zoning, neighboring uses, or level of risk the landlord wants to take, the landlord may limit the uses of the property. Commonly this may include banning certain hazardous or industrial uses in some areas or uses that would create a nuisance for other tenants, but this also can include more stringent regulations. An area that is office spaces will probably allow only offices and not something like a restaurant, for example. On the other hand, a storefront property with a percentage rent may only allow a use that is held out to the public to be profitable.

Non-Disturbance Clause and Subordination Clause

A non-disturbance clause protects the tenant’s rights in case of a change of circumstances for the landlord. If a landlord declares bankruptcy or sells the property, a non-disturbance clause will protect the tenant from being evicted. This will generally require the owner to include in any agreement to transfer interest in the building that the tenant must be allowed to stay, and the landlord or tenant may be required to seek such an agreement with the landlord’s creditor. This protects the tenant’s investment and continuity in its space on the property. This is often paired with an attornment clause, where the tenant agrees to recognize a new property owner as landlord.

The non-disturbance clause can combat a subordination clause, which landlords typically want to include to have flexibility in using the building as collateral for financing. With a subordination clause, the tenant’s rights are placed behind the lender’s so that the lender has the right to terminate a lease to foreclose (thus, the importance of having a non-disturbance clause for the tenant). Without a subordination clause for tenants, many lenders will not accept a property as collateral.

Insurance

Often both parties will be required to maintain certain insurance policies. A tenant will generally have to maintain general liability insurance, including a personal injury allowance, fire and extended coverage insurance, and business-specific insurance. Often a landlord will have to approve a policy or insurer and will have minimum amounts of coverage. A landlord may also be required to maintain general liability and fire and extended coverage insurance. The reason is because, as discussed before, both parties are responsible for different aspects of the premises and therefore either could be liable depending where and how damage was caused.

Waiver of Rights

While it may not seem fair to allow a tenant to waive certain rights, courts generally give effect to the mutual intent of the parties to a contract. Since a commercial lease is a contract, if a tenant agrees to waive certain rights, a court will generally enforce the waiver. While there are a handful of rights that cannot be waived in residential leases, the list is shorter in commercial leases.

One common example of waivers of tenants’ rights is the waiver of the landlord’s statutory warranties, which essentially means the landlord is responsible for delivering the premises to the tenant in a usable condition but afterwards leaves the tenant to ensure it stays that way. Another is a restriction of the landlord’s responsibilities to ensure “quiet enjoyment,” where the tenant can use the premises without interference. The landlord may try to limit this to only actions of the landlord or those the landlord can control or conditioning it on the tenant not being in breach.

Perhaps one of the most subtly important waivers is the waiver of subrogation. Subrogation allows an insurance company to pursue a claim in place of the party it insures to attempt to collect what it paid out to the insured party. Subrogation could allow, for example, a tenant’s insurer could sue the landlord if the insurer has to pay a claim to the tenant for something that occurred at the property. A waiver of subrogation does not allow the insurer to bring a claim.

Other possible waivers include a waiver of the maximum amount, use of, or deadline to return a security deposit; waiver of the statutory rights to terminate a lease under certain conditions (such as loss of the premises or partial condemnation); and waiver of the right to assign a lease.

A tenant can attempt to negotiate at least some reasonable exceptions to the waivers or negotiate them out of the lease altogether, and the more rights left intact for the tenant, the better for the tenant. Likewise, the tenant can also negotiate restrictions on the landlord’s rights, such as requiring longer notice periods, having the right to self-help, or abating rent for interruption of services.

Assignment and Subleasing

By default for most agreements, parties can “assign” their interest to another person or the tenant can sublease to another tenant, but an agreement can forbid this for either or both parties. This gives flexibility to a party to relieve itself of some obligations of a contract without breaching it by terminating early. Usually, a lease will explicitly state whether this is allowed. Ideally a party wants the ability to assign, but bargaining power can determine whether the other party will allow it. In the middle of the extremes is the requirement to get approval from the other party before assigning or subleasing, and sometimes a party is not allowed to unreasonably withhold approval.

Security

Depending on the area and type of business, a commercial lease may contemplate security measures on a property. This may include basic requirements of the tenant to secure the property or place responsibility on the landlord, such as having a security system on the building or even providing manpower to monitor the property.

Remedies

In the event that a party breaches, there may be specific remedies which are outlined for each party. One such remedy can be liquidated damages, in which a set amount of money is required to be paid for a breach without the need to prove actual damages. Sometimes for a landlord this is the ability to keep the tenant’s security deposit. Other remedies may include early termination or the breaching party paying the other party’s attorneys’ fees.

There may be a timeframe in which a party has the right to cure a breach and a duty for the non-breaching party to mitigate damages (e.g., for the landlord to make reasonable attempts to find a new tenant if the tenant vacates early).

Miscellaneous

There are some provisions in commercial leases and contracts generally which do not require much explanation but are nevertheless important:

• Naming the parties

• Where and how notices are to be sent

• Description of the premises

• Important dates

With a number of highly-negotiable and legal-technical terms present in these contracts, it is worth considering legal assistance in drafting, negotiating, and reviewing a commercial lease before making such a major and long-term decision.