Commercial real estate leases are complicated agreements. It’s important to have a general understanding of how leases work. It’s also important to know what items can be negotiated to help get the best terms possible.
After helping hundreds of clients, we know how challenging it can be to decipher business point negotiations. We are here to help our clients receive the best lease structures and outcomes possible for their needs.
To help our clients better understand the commercial lease structures, we have a corporate real estate glossary here. Knowing the terminology will help you feel more comfortable with the leasing process. And no matter what stage of the leasing journey you are in, it is important to have an expert at your side so all lease agreement elements are in your best interest.
Because the topic of lease negotiations has such a large amount of information, I am breaking this blog post into two parts, emphasizing the term and concessions today. When both parts are complete, I’ll add the entire article to my website.
Contact us to get your best lease terms when you’re ready to enter into negotiations. We will be able to help with your current landlord or new space.
Points to Negotiate Within a Lease Agreement
Most terms of a lease agreement are negotiated well in advance of drafting the actual document. During the Letter of Intent (LOI), landlords and tenants discuss and negotiate each point of the lease through their brokers. A formal lease document is drafted only when both parties agree on the terms.
The LOI includes:
- the term, rate, and escalations,
- concessions, including tenant improvements and/or free rent,
- sublease, expansion and renewal options, (next week) and
- parking options (also next week).
The lease term may be one of the first points negotiated because it affects other factors in the lease. In today’s market, most tenants do not get to choose their lease term. Landlords are also pushing for longer leases.
Let us look at the term of your lease, which are fairly easy to understand. Commercial leases are for a specific number of years. You will be obligated to pay for space during the entire period of your lease. Tenants need to be confident when confirming how long they want to lease a space.
Short term vs. long term
As you would imagine, a short lease means the tenant has less certainty on future rental costs. Each time a tenant’s lease expires, they must renegotiate the terms. Therefore, there may be a chance for a higher rental rate. Usually, short leases will not offer as many concessions because the landlord will have less time to recover the expense.
Long-term leases allow you to lock in your rental rate for a longer period. In Texas, longer leases also offer more concession options. This is because landlords benefit more from securing a long-term tenant. However, the tenant will not have as much flexibility due to committing to space for a longer period of time. Therefore, the lease term depends on your company’s situation.
For example, a startup with an unpredictable future and a short financial history may benefit the most from a short-term lease. A company with history and a good idea of future revenues may prefer a longer lease of five years or more.
The lease term is important to the tenant and landlords. So it’s imperative to determine early on if both parties will be able to agree on a term.
Another available negotiation item is the base rent. Base rent is the amount of rent the tenant must pay. This rate is often quoted on a square foot per year basis. So a 10,000-SF tenant paying a base rate of $20/sf will be paying $200,000 a year. While this may seem simple at first, it does get more complicated when you dive into the details.
Rentable Square Feet vs. Usable Square Feet
In commercial buildings, there is a difference between rentable square feet and usable square feet. This difference has to be clear for you to truly understand the base rent.
Usable square feet is the actual amount of space the tenant will occupy to conduct business. If you think of an empty office, everywhere you can walk in that space falls under usable square feet. This includes office space, work areas, kitchens, and restrooms within the space. However, this square footage is not the number you should use to calculate your rent.
Rentable square feet (RSF) includes the total usable square feet, plus a pro-rata share of the building’s common areas. Specific formulas calculate how much of the common areas should be in a tenant’s rentable square feet. As you can see, a lot goes figuring out the base rate. I’m happy to help with the calculations at any time.
Escalations help the landlord to incrementally increase the base rent annually to keep up with inflating market rates. The longer the lease, the more a landlord is exposed to inflation and rising rental rates in the market. A landlord isn’t going to want to sign a lease with a tenant at $20/sf and 5 years later find the market averaging $30/SF. Therefore, many landlords require base rent escalations in their leases.
Tenants can benefit from escalations because it provides a lower base rent at the beginning of the lease. Without escalations, landlords would likely charge a higher rate for the entire lease.
The types of escalations include:
Amount Escalation where a predetermined increase in base rent per year is negotiated and agreed upon.
Percent Escalation is similar but where a predetermined percentage increase in base rent is added each year.
Indexed Escalation introduces more variability into a tenant’s rental rate because the escalation follows an index (usually the Consumer Price Index) and increases based on the amount of the index. This type of escalation can lead to lower rent if the index used sees a decrease. The Indexed Escalation is typically used in large, complicated leases. Brokers are crucial in the negotiation process with these type of leases.
Concessions or Operating Expenses
Landlords often pass some or all of the expense of owning and operating a building on to their tenants. Regardless of the lease structure, you always want to give some attention to this item. It’s important because it can be a significant portion of your overall cost.
As with base rent, operating expenses are calculated based on a tenant’s pro-rata share of the building’s rentable square feet. For example in a net lease, a 10,000-rentable square foot tenant would pay $90,000 per year if operating expenses were $9.00/sf. In a gross lease the tenant would additionally pay his proportionate share of increases in expenses. This is another negotiation point that you don’t want to overlook.
Things start to get complicated when expense stops, also known as base years, come into play. In a gross lease, since the landlord is responsible for the operating expenses of the building, they prefer some insurance to protect against rising taxes or a tenant using an abnormal amount of utilities. To do this, they implement a base year stop that will stay in effect for the life of the lease.
After the first year of the tenant’s lease, the landlord will record what operating expenses were and inform the tenant of the costs they incurred. Over the rest of the lease, the tenant becomes responsible for any operating expenses in excess of the level set in the base year.
Is anything really free? Well, maybe but not free rent. While it can be a benefit for both the tenant and landlord, the intricacies and reasons behind offering free rent need to be examined.
Free-rent is basically what it sounds like: the landlord offers the tenant a specified number of months to not pay rent. Also known as abated rent, these free months are normally given in the first few months of the lease, but can also be spread throughout the term.
Free-rent can be a little misleading, however, because it often does not mean the tenant is paying nothing for those months. In most cases, it is the base rent that does not have to be paid, while operating expenses and other costs not associated with the base rent are still paid by the tenant.
So why would a landlord offer a tenant free rent?
They would use the item to help entice a tenant into making the move into the new space. Relocating/moving costs can be a big expense for tenants, one which can potentially influence them to stay in their current space. To overcome this, especially if a building has a lot of vacant space, a landlord may choose to make the first few months of a lease less expensive for a tenant to encourage them to sign a lease and relocate.
However, there can be a downside to free rent from the tenant’s perspective: the landlord may ask for a higher rental rate than if no free rent was offered. While this is not always the case, it is up to the tenant to decide if the benefit of the months of free rent at the beginning of the lease outweighs the potentially higher rental rate throughout the remainder of the lease.
If you want to renovate the new office space to better suit your company’s culture, but may not want to pay for the entire cost out-of-pocket, then this is where negotiating a tenant’s improvement allowance can come into play.
Tenant improvements (TIs) are a predetermined construction allowance given by the landlord to the tenant, usually quoted on a per square foot basis. For the tenant, TI really can be a great way to make space perfectly fit their needs without having to completely pay for it out of their own pockets. However, TI is not as straightforward as it seems. It must be negotiated into a lease, which can sometimes be a challenge depending on the market. When demand is high and landlords are having no trouble filling vacant spaces, it may be harder to negotiate TI into your lease. And know that the landlord typically gets a say in what you can use your TI allowance on.
In a market with low demand, a landlord with a lot of vacant space may prefer to agree to a hefty TI allowance to incentivize tenants to lease space rather than leaving the space vacant.
In addition, some landlords offer large TI allowances even in markets with high demand in exchange for tenants signing longer-term leases. While it may be a large out-of-pocket initial expense, being able to sign a tenant into a long-term lease at favorable rates can end up being better for the landlord in the long run and allow the tenant to minimize their upfront costs.
We will advise you to get an estimate of what the improvements/changes are likely to cost before going too far in the negotiation process. Of course, we can help guide you every step of the way.
The Americans With Disabilities Act (ADA) holds both tenants and landlords responsible for ensuring the building is accessible to disabled persons. This includes not only the building’s exterior but also common areas and your own space as well. While most modern buildings are built with ADA in mind, older buildings may require these improvements to be made.
We first ask the landlord to guarantee the building is ADA compliant before you ever sign your lease to reduce the chances of you having to pay for major improvements. We also build in specific clauses in our lease negotiations to protect you from future costs for ADA improvements to your space and to the common areas too.
Join me next week when I’ll cover a few more items to negotiate, along with my favorite and ever-changing point of the parking allowance.
Choose the best tenant representation in the Dallas-Fort Worth area. Contact us today to discuss your commercial real estate needs. Make sure to connect with David Lester on LinkedIn and check out his recommendations.