Commercial real estate leases are very complicated agreements. It’s important to have a general understanding of how leases work and what items can be negotiated to help get the best terms possible. After helping hundreds of clients through the leasing process at Lester & Lester, we know how challenging it can be to decipher business point negotiations included throughout the process. 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 an overview of common lease terms and definitions 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 hope you will contact us to get your best lease terms when you’re ready to enter into negotiations with your current landlord or when seeking 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, and a formal lease document is drafted only when both parties agree on the terms.
To keep it simple, I’m not going to go into full detail about when each business point is negotiated, but generally, 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 as it drives many of the other factors included in the lease. In today’s market, most tenants do not get to choose their lease term, and landlords are pushing for longer leases.
Lets look at the term of your lease, which fortunately, is relatively easy to understand. Commercial leases are for a specific number of years where you agree and are obligated to pay for the space during the entire period your lease is active. 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, and of course, may have a chance of being charged a higher rental rate. Usually, short leases will not offer as many concessions because the landlord will have less time to recover the expense.
Then, there’s the long-term lease that allows you to lock in your rental rate for a longer period. In Texas, longer leases also offer more concession options as landlords usually benefit more from securing a long-term tenant. However, the tenant will not have as much flexibility since they are committing to a space for a longer period of time. Thus, the lease term really depends on your company’s specific situation.
For example, a fast-moving startup with an unpredictable future and a short financial history would likely benefit the most from a short-term lease ranging from three to five years. On the other hand, if a company has an established history and a good idea of what revenues will be in the future, they may prefer a longer lease of five years or more.
Lease term is not only important to the tenant, but landlords as well, so it’s imperative to determine early on if you and the landlord will be able to agree on a term that works for both parties.
Another available negotiation item is the base rent, which is the predetermined amount of rent the tenant must pay. This rate is often quoted on a square foot per year basis, meaning that a 10,000-sf tenant paying a base rate of $20/sf will be paying $200,000 a year in base rent. 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, and 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, including offices, shared work areas, kitchens and restrooms located within the space itself. 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 are designed to calculate how much of the common areas should be included in a tenant’s rentable square feet. As you can see, a lot goes into the base rate formulation. I’m happy to provide these calculations any time.
Escalations are used as a way for 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; thus, many landlords require base rent escalations in their leases.
Tenants can benefit from escalations because it allows them to pay a lower base rent in the beginning years of the lease. Without escalations, landlords would likely charge a higher rate for the entire lease. The types of escalations include: the Amount Escalation where a predetermined increase in base rent per year is negotiated and agreed upon; the Percent Escalation is similar but where a predetermined percentage increase in base rent is added each year; and the 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 a lower rent if the index used sees a decrease. The Indexed Escalation is typically used in large, complicated leases where brokers are crucial in the negotiation process.
Concessions or Operating Expenses
Landlords often pass some (gross lease) or all (net lease) 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 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 the 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.
Sublease, Expansion and Termination Options
A possibility that you might want or even need to evacuate the space prior to your lease expiration exists, no matter the length of your lease.
Landlords have a lot of control in what the tenant can do, so it is very important to think about these provisions before you sign your lease. I recommend requesting these provisions in the initial stages. An early request for this information lets the landlord know these clauses/options are important.
Turning over your lease either entirely or partially to another tenant, or subleasing, is a great option for a tenant who is unable or unwilling to remain in their lease. A sublease allows the original tenant to move elsewhere without having to pay full price for a space they are not using, and the new tenant gets to move into the space without a wait and often at a reduced rate.
However, subleasing is not simply handing over your lease and walking away. For starters, the landlord has the decision power on whether subleasing is even allowed. They generally do not like subleasing, and may be hesitant to agree to it. You need to negotiate a favorable sublease clause in your original lease, or your sublease rights may be limited.
Even if you can sublease, it does not mean you will be completely free from your obligation. You are still responsible for the rent payments until your original lease expires, meaning if the new tenant stops paying, then you must continue to fulfill your lease obligation. Also, most tenants looking to sublease usually want a decreased rate, so you likely will still be paying a portion of the rent even after moving out.
Another option worth considering when negotiating commercial leases is the termination clause. If a landlord is set on leasing a space for 10 years, but you are only willing to commit to 5, then you could ask for a termination option in your lease to allow you to cancel the lease in 5 years. Landlords are typically reluctant to grant these, but it is an option worth considering.
Termination options are great rights to have in a lease, but some drawbacks need to be considered. Because some fees such as tenant improvements, free rent, and commissions are paid at the beginning of the lease, but intended for the entire lease; the tenant must pay a termination penalty to cover the unamortized amounts that result from the time lost when the lease terminated. This cost can be a big expense for the tenant depending on the size of the space and the length of the lease.
Tenants want the first say in whether they would like to renew their lease for another term, which is known as renewal rights. Rather than running the risk of losing the space to another tenant, this clause gives the current tenant security that they will have the option to stay in the same space when their lease expires.
You might think this clause is a given, but it is up for negotiation and interpretation. For example, if an adjacent tenant is interested in expanding into your space, the landlord may be inclined to offer your space to them rather than letting you renew your lease, especially if that tenant occupies more square footage than you or has a higher rental rate per square foot. With a renewal option, the landlord must offer the space to you first, regardless of any other interested parties.
It is a good idea to always use a tenant representation broker when working on any renewal as the length of the new term and rental rate is once again negotiable.
For growing companies, an expansion option is one you should consider; it gives the tenant the first say as to whether they would like to lease more space.
Two forms of expansion options are Right of First Refusal (ROFR) and Right of First Offer (ROFO). These essentially prevent other tenants from signing a lease on expansion space in the building before you are presented the option. The main difference between the two is the ROFR is typically triggered by an event while a ROFO can take place anytime within a certain period.
Some landlords insert a relocation clause in leases that allows them to move a tenant to a different suite if it is “comparable” to the company’s current space. You may want to consider having any relocation clauses removed from your lease during the negotiation process, mainly because your definition of comparable may not be the same as the landlord’s. If your location is important, like being on the first or top floor, then this is especially true for your lease. However, if the landlord is unwilling to completely remove the clause, we can help you negotiate by adding some contingencies if a move is enforced, such as: requiring the landlord to cover any moving or renovation expenses and ensuring your lease specifies you will receive the same rent, amenities and comparable square footage.
What you negotiate into your lease at the beginning can have a major impact on what happens while the lease is in effect. A good tenant representation broker will advise you on what clauses could cause problems down the road and how to minimize any risks associated with those clauses.
Parking for employees is a big deal in Texas’ large cities, especially in high-density, downtown areas; thus, parking can be one of the more important details when negotiating a lease. Since autonomous vehicle (AV) technology is not yet commonplace, we still need to plan this item since parking can be costly for employees, clients or visitors.
Be sure to leverage the parking point of the lease as landlords can offer a higher ratio of parking spaces per 1,000 sf or lower initial parking costs to make a commercial space more appealing.
In addition to ensuring the right amount of parking is available, you should consider whether the parking is covered or uncovered; if your spots are reserved or unreserved; and if your monthly cost is set or can the landlord increase it.
Each city has its own parking issues, and we know how to negotiate and find creative parking solutions for the tenants we represent.
Other Points of Negotiation
Even after covering these points of negotiation over our last two blog articles, you need to keep in mind countless other concessions when deciding what you want to be included in your lease. A fewof these items include: building hours, weekend access, signage, density restrictions, security deposit or credit letters.
Having the experience and knowledge to successfully navigate and leverage these negotiation points and concessions is just one of the many benefits of hiring a tenant representation broker to assist you throughout the entire leasing process. Contact us when you’re looking to renew, renovate or find something new.