By Doug Bend
This article was originally published in American Express Open Forum.
If you’re looking for space for your new business, taking the time to educate yourself about the key terms of a commercial office lease before you sign can pay enormous dividends.
Unlike residential leases, commercial leases typically carry long terms, require significant monthly payments and include extensive clauses that can increase your financial obligations, such as having to pay for building maintenance and common area expenses. In addition, most leases are drafted by the building’s landlord, which means they reflect the landlord’s interests, not yours. As a result, having basic knowledge of a few key commercial leasing concepts can greatly improve the terms of your lease.
First, you should take a practical approach to gauge your relative bargaining power. During poor economic times, property owners are less likely to expand or take risks, which makes more commercial spaces available. To avoid having vacant space, they’re tend to be more flexible and offer perks to attract potential tenants.
But when the commercial real estate market is hot (as it is now), the inverse occurs. This makes it even more important for you to do your homework so you don’t sign a lease you might later find unpalatable.
The following four provisions can help you determine whether the lease you’re about to sign is a great business opportunity—or one you should walk away from.
1. Security Deposit
As a business owner, it’s never advantageous to have a big chunk of your money tied up. Unfortunately, many landlords often require large security deposits because it helps them manage the risk of default on long-term leases. If your potential landlord insists on a significant deposit, try to get them to compromise by offering to pay the first three months of rent in advance in exchange for a lower security deposit. This way your money isn’t simply being held for security purposes.
If you have little to no credit, however, the landlord may be concerned your startup funds will dry up before the end of the lease term and won’t want to compromise on the amount of the deposit. (This is often the thinking behind commercial space for tech startups in the Bay Area.) Under these circumstances, a landlord is unlikely to accept advance rent in exchange for a lower deposit. However, they might consider a schedule that involves releasing some of the deposit back to you yearly after you’ve proved that you’re not at risk of default.
2. Additional Rent (Triple Net Expenses)
If a landlord hands you a lease that doesn’t require building expenses reimbursement from you, go out and buy yourself a lottery ticket because it’s your lucky day. Nearly all leases include additional rent charges, often in the form of “triple net expenses,” which means you’re required to pay your pro-rata share of all insurance, taxes and operating expenses for the entire building.
The key to managing your share of expenses is to get the landlord to narrow their definition of covered “operating expenses.” This also limits the potential for a landlord to disguise a rent increase as a necessary operating expense.
To limit your potential exposure, you should ensure that the expenses passed on to you are industry standard, which will even vary according to where the space is located within the building. For instance, renting space on the first floor may require you to pay additional operating expenses, something that’s not nearly as reasonable to pass on to someone with space on the top floor.
Additionally, if you and your landlord agree to share the cost of capital improvements, you should require that those costs be amortized over the anticipated life of the improvement rather than over the term of the lease. Otherwise, you might have to pay more than your fair share, particularly if the improvement comes toward the end of the lease.
You should also consider the possibility of your landlord selling the building to another party, which could result in increased property taxes. It’s a good idea to investigate when the last reassessment occurred and seek to limit a payment increase if there’s a reassessment after the property sells.
3. Company Use Restrictions
Many commercial leases limit the permitted uses of the leased space. And while restricting the use of the premises to certain business activities, such as a day spa or marketing firm, might seem reasonable at the time of signing, if you later want to sublease your space, a restricted-use provision could limit your pool of potential subletters.
Ensuring that the premises may be used for “any business office purpose” will help preserve your ability to find a wide variety of subletters in case your business circumstances change.
4. Subordinate Lease
If the lease you’re about to sign is made “subordinate to an encumbrance,” such as a mortgage, the lease may be automatically terminated if the encumbrance is foreclosed. This could be particularly difficult to swallow if you’ve put in a significant amount of work to find the perfect space or if you’re renting at a below-market rate.
If there’s already an encumbrance in place at the time of signing, you should negotiate a nondisturbance agreement with the beneficiary of the encumbrance, such as the bank, that says you can remain in the leased space as long as you comply with the terms of the lease.
Signing a lease without understanding all the different clauses can be a mistake that can eventually kill your business. Even a precursory knowledge of these key provisions—and some due diligence on your part—can help you secure a lease that’s beneficial to both you and the landlord.
For questions about a lease, or to seek legal guidance and tips surrounding a lease transaction contact Alex King at firstname.lastname@example.org or 415 322 0762.
Disclaimer: This article discusses general legal issues, but it does not constitute legal advice. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.