Commercial Real Estate Lease Terms & Definitions
– Cutting Thru the Mumbo Jumbo
This article will help you to understand the most widely used terms of commercial leases, but remember there is no substitute for years of experience. If you would like to schedule a lease review or speak to a live person, please contact Lease Smart here.
TYPES OF LEASES
Note: Many commercial real estate leases refer to the Tenant as the Lessee, and the Landlord as the Lessor, which is correct as the terms are synonymous. We will use the terms landlord and tenant to discuss these terms since those terms are less easily confused. The world of commercial real estate leases is complicated enough without confusing terms unnecessarily!
ALSO, different areas of the country use different terms and have different ways of doing things. For our purposes, we are using the most basic, typical examples.
There are three main types of commercial real estate leases: Full Service Lease, Gross Lease and Net Net Net Lease (also referred to as “triple net lease”.
FULL SERVICE LEASE: Used most commonly in high-rise, multi-tenant office buildings, a full service lease simply means all the services are included in the rent: operating expenses including maintenance, property taxes and insurance, security and janitorial services, as well as utilities such as water, electricity, heat and air. In addition to high-rise office buildings, this lease may also be found in older buildings where utilities may not be separately metered.
Note: When using a Full Service Lease in a typical multi-story office building (perhaps we should refer to this as an “Office Lease”), the Tenant will be introduced to the concept of Load Factors. A Load Factor becomes necessary when the Tenant uses a certain square footage inside their offices, but also shares in the hallways, bathrooms, elevators, lobby, etc. Because of the shared space, a calculation is done to determine how much of the building’s space is devoted to these common areas, and that “Load Factor” is added in to the Tenant’s square footage. In other words, if twenty percent of the building is devoted to common areas, then approx. twenty percent more footage is added to the Tenant’s “useable” area.
GROSS LEASE: This type of commercial real estate lease says the Tenant pays a gross amount for rent (plus sales tax where applicable), and the Landlord is responsible to pay the property’s operating expenses such as property taxes, insurance, management or maintenance costs. However, unlike a Full Service Lease, the Tenant is responsible for utilities like electric, janitorial services, and possibly water and sewer charges depending on the verbiage of the lease document. Also commonly labeled as Office Leases, in many of these Gross Leases, the Landlord may put an “expense stop” provision in the lease, meaning the Tenant pays the excess, or increase, of certain expenses which are over a specified ceiling. Most commonly these expenses would be taxes, insurance, electric, and even HVAC repair costs.
Gross leases may also commonly include a Load Factor as described above, and Full Service leases may include Expense Stops.
NET LEASE: Most common with today’s commercial properties, especially in the retail sector (perhaps we should call this the “shopping center lease”), the “Net Net Net” Lease directs the Tenant to pay the Landlord a “Base Rent” which is “net” of property expenses. Added to this is an additional amount for the Tenant’s share of the property’s expenses such as property taxes, insurance, common area maintenance (C.A.M.), property management, etc. Many times this is referred to as a “Triple Net” lease in reference to base rent being the net of 1) property taxes, 2) insurance and 3) common area maintenance. The terms used vary depending on region of the country, but this additional amount may be called “Operating Expenses”, “Common Area Maintenance (CAM)”, and others. In the “Triple Net Lease” world, the Tenant will become familiar with the term “reconciliation”, which is a yearly accounting the Tenant will receive indicating how close the Landlord came to hitting his estimates, and how much more the Tenant owes in cases where the amounts collected were underestimated. The Tenant may also receive a credit if the estimates were high, but that does not happen often!
RENTAL RATE: Based on the “Rentable” square footage (after the “Loss Factor” has been added in), or the “Useable” square footage. Many commercial leases describe the way the space is measured, and some just use a fixed size. Some leases don’t actually describe the size, since they don’t want a tenant doing a measurement and coming back after many years wanting a credit for rent paid on space that wasn’t there. In these cases, the lease will just state the space as “Unit X”, for which the rent is “Y”. Interestingly, especially in shopping center leases, the space may be measured as “from the inside of inside walls, and from the outside of the outside walls, so Tenant actually pays for space that is taken up by physical wall!
YEARLY RENT ADJUSTMENTS: Rent may be fixed over the term of the lease, or it may include yearly increases, or “adjustments”. Rent can either be adjusted by a specified dollar amount, a fixed percentage, or tied to a fixed index such as the Consumer Price Index (CPI). In shopping center leases (or any type of retail leases or restaurant leases), increases may also be tied to the tenant’s sales, and if the sales are not high enough and provide enough extra income to the Landlord, the Landlord can cancel the lease!
TERM: “Term” is the length of the Lease, plus options to renew. Typically a five-year lease with a five-year option is safer for the Tenant than a ten-year lease, since they are only committed to five years. Landlords would prefer the ten-year lease. Many times Tenants will go with the longer lease if the right incentives are negotiated with the Landlord.
TENANT BUILDOUT ALLOWANCE: Commonly referred to as “Tenant Improvement Allowance”, T.I. Allowance, or simply “TI”, this is the amount of funding the Landlord will give to the Tenant to reimburse the Tenant’s cost of finishing the interior improvements. This amount changes drastically depending on the market, economy and competition of other available space (overall vacancy rate in the building or market).
NOTE: Many times the Landlord will refer to providing the Tenant with a “Vanilla Shell”, “Vanilla Box”, “Warm Shell”, etc.. Since each landlord defines the terms differently, it is imperative to get the definition spelled out in writing. Generally speaking, the term “vanilla shell” means the Landlord is providing the space with four walls ready for paint, concrete floor, ceiling, lighting, bathroom, standard electrical and plumbing stubbed to the premises. “Warm Shell” means the electrical, plumbing and HVAC systems are brought to some level of completion. This would NOT include floor covering, wall covering or any interior partitions.
VERY IMPORTANT: Many times, the “TI” offered by the Landlord is NOT enough to bring the space to completion, and Tenant is expected to contribute more of its own money. All depends on the market, the creditworthiness of the Tenant, the rent being paid, and the skill of Tenant’s negotiations!
PERSONAL GUARANTEE: Landlords may require that an individual(s) personally guarantee the lease, since most commercial real estate leases are between two business entities (LLCs, Corporations, etc.). Usually it is the owner of the business who acts as personal guarantor, but the bigger the company, the less likely a personal guarantee is required. When guaranteeing the lease, the business owner can be sued personally by the Landlord upon default by the business-entity Tenant.
RENEWAL OPTIONS: Renewal options are a pre-negotiated agreement of the terms wherein a Tenant may extend his lease for an additional period. These are unilateral, meaning it is up to the tenant whether or not they are going to be exercised, and many Landlords allow Renewal Options only begrudgingly. Also, in most cases, the Tenant must give notice to Landlord months in advance of its intention to renew its lease. The Landlord doesn’t WANT the Tenant to leave after the lease term, but it does want to negotiate a new commercial lease based on the rental rates and terms of the market at that time.
NOTIFICATION: Usually there is a notification period prior to lease expiration in which the Tenant must notify the Landlord if it intends to exercise the option. Many times a notification period ranges from three to six months. The purpose is to give the Landlord time to search for a new Tenant if the current Tenant decides to vacate.
PERCENTAGE RENT: Also known as “overage rent”, percentage rent is used most often with retail tenants with shopping center leases, mall leases or single-tenant leases (like free-standing restaurants on out-parcels), where the Landlord actively promotes the property and thus benefits from his tenants’ sales. Especially common in large shopping centers and malls, percentage rent is paid on those sales that are over and above a certain dollar amount (the “breakpoint.”) The breakpoint is either a fixed number or it will adjust with increases in base rent. A “natural” breakpoint occurs when the Tenant pays its base rent or “x” percent of sales (whichever is more.)
NON-COMPETE: A landlord may require a non-compete clause that will insure the Tenant will not open a similar store within a certain distance or market area. This usually only happens with a percentage rent lease.
USE: This clause specifies to what purpose the premises may be used, because if the Tenant changes their scope of business or products they sell, both the image of the center and the business of other tenants might suffer. In many retail centers, landlords spend a significant amount of time and money attracting the right mix of tenants that in turn attract specific types of shoppers. To maintain the center’s value, the use must conform to the tenant mix that will most benefit the center. Another reason landlords insist of the inclusion of this clause is because another tenant’s lease may include the “right of exclusive use.” In that case, a specific product or service can only be provided by a certain tenant, thus obligating the landlord to prevent other tenants from selling those same goods or services (see following section.)
EXCLUSIVITY CLAUSE: Many tenants desire (and some require) an exclusivity clause to be made a part of their commercial lease, especially shopping center leases. This provides the Tenant with an exclusive right to sell its product or service on the property (ex: pizza, eye glasses, insurance, etc.)
ASSIGNMENT AND SUBLETTING: This becomes relevant when a Tenant wants to sell the business, merge, or bring in partners. Obviously the Landlord doesn’t want a financially strong Tenant to simply be able to transfer the Lease obligations to a financially weak tenant. Assignment refers to all of the Tenant’s rights, title, and interest in the lease being assigned to another party.
Subletting occurs when the Tenant leases the premises to another but still has the primary responsibility to the Landlord to see that the terms and conditions of the lease are carried out in accordance with the original lease. As with the assignment, the Landlord typically must approve the sublessee. In a sublease, if the sublessee does not pay the rent the original tenant is still responsible.
In both cases, the Tenant is still “on the hook” with the Landlord, unless the Tenant has received a release of obligation from the Landlord (called novation.) The primary difference is that with a sublease, the original tenant’s lease is still in place, and it can charge the sublessee different terms such as a higher or lower rent, etc.
Since the Landlord has to undergo some legal fees during this process, it is fairly normal for Landlord to charge a fee to complete a Lease assignment.
SIGNAGE: While most landlords and tenants agree on the importance of an attractive facility, some Business Owners feel that constructing the biggest, brightest sign possible is an even higher priority. If every tenant in the center constructed a sign with its own specifications, the result could be an eyesore leading to something easily thought of as “sign pollution.”
The Landlord wants a successful building consisting of successful tenants and consequently should work with tenants as much as possible regarding sign requirements. However, problems can arise when tenants compete for the largest, brightest sign with no thought given to the overall resulting look. Additionally, issues develop when the local zoning department develops sign restrictions or tenants use different size and style signs (some hand-painted plywood!) Detailed descriptions of the signage allowed or anticipated will be in any good commercial lease. Want signage on the outside of a large, multistory building? Tenants should expect to pay for the rights.
DESCRIPTION OF PREMISES: The Tenant should think about what is useable versus what is rentable. A good commercial real estate lease will describe the location in the center, the size of the space and the method used to measure the space so that disputes won’t arise at a later date. The space that the Tenant actually uses is termed “useable,” while the space that the Tenant rents is termed “rentable.” In many cases, usable and rentable square feet differ. This is because space can be measured from the inside of the inner (“demising”) walls and the outside of the outer walls, and remember the previously discussed “load factor” which includes the Tenant’s share of common areas such as hallways, bathrooms, etc.
RELOCATION: In some commercial leases, especially shopping center leases, the Landlord has the right to relocate the Tenant to another space if the Landlord wishes. Reasons for this include necessary remodeling or the expansion of a neighboring (usually anchor) tenant. Many times this clause will provide that the Landlord will furnish the Tenant with new space that has similar sign exposure, frontage, and overall attractiveness.
LEASE OPTION : Occurs when the Landlord provides the Tenant with an option to purchase the premises.
DEFAULT: There are various ways for a Tenant to be in default of its Commercial Lease, such as non-payment of rent, selling goods or services not included in the use provision or not operating during the agreed upon hours. The manners of default depend on the terms of the individual lease.
REMEDIES OF DEFAULT: The Landlord will typically want the freedom to use every possible remedy to cure a default and all possible power to remove the Tenant from the premises should that become necessary. When negotiating a lease it is possible to remove some of these, but Landlords get very nervous when tenants focus on this too hard!
ESTOPPEL: If the Landlord sells or mortgages the property, the Tenant agrees to sign a letter that will acknowledge the Tenant’s current lease situation. Typically this “Estoppel Letter” will note the remaining term on the existing lease, rental amount and any existing arrears or outstanding charges.
INSURANCE: The Tenant must obtain its own liability insurance and insurance for the contents of the space, including inventory and tenant improvements. The Landlord may specify the specific dollar amount of liability coverage required by the Tenant. The Landlord will also insure the building in respects to liability and property damage (and may pass that cost on to Tenant). While both parties liability coverage may overlap, the property insurance covered by the Landlord includes everything except the interior contents of the Tenant’s space. Most commercial leases require the Tenant to provide the Landlord with proof of insurance.
TAXES: Any good commercial real estate lease will be clear on which party is responsible for paying any taxes levied on the premises. In a net lease the Tenant pays. Even with a gross lease, any increases may be passed on to the Tenant. There also may be a provision for special assessments for sewer, road, street lighting, etc..
DAMAGE OR DESTRUCTION: A good commercial lease should note what happens if a natural disaster impacts the property (i.e. does the Tenant continue to pay rent and for how long.) This clause covers that situation and gives both Landlords and Tenant the options of how much time is allowed for the Landlord to repair the premises, and what are the Tenant’s obligations.
REPAIRS: Who makes repairs to the premises (electrical, plumbing, HVAC, etc.) ? Obviously, it would be ideal for the Landlord to make all exterior and interior repairs but this is usually not the case.
ALTERATIONS: It is important to include this lease clause in the event that the Tenant makes major changes to the premises and quickly vacates, leaving the Landlord with an expensive mess to fix. In the worst case scenario, such improvements might have been done without permits and no consideration to meeting code requirements. Typically, the Landlord reserves the right to approve all of the construction work done to the Tenant’s premises. The Tenant shows the Landlord plans and permits and the Landlord gives approval.
CONDEMNATION: This lease clause discusses in detail the possibility of the city, county, state or federal governments condemning all or part of the property for a road, right-of-way, or utility easement. Usually the Landlord’s responsibilities depend on the amount of the property condemned and the effect on the parking area and physical building. If the condemnation is severe enough, the Landlord will usually cancel the lease.
ATTORNMENT: If foreclosure proceedings are brought against the Landlord by the mortgage holder (or if a deed is given in lieu of foreclosure), the Tenant shall recognize the transfer and accept the new owner as the Landlord.
SUBORDINATION: When a buyer purchases the building the Leases remain in place and are not affected by the change in ownership, i.e. Tenant agrees that the Lease is subordinate to the mortgage. In the same way, the Lender’s position is not affected by changes in Tenant lease situations.
NON-DISTURBANCE: Unless the Lender has agreed to a Non-Disturbance clause, in the event of foreclosure, the lender has the option of keeping or terminating the lease. Many times this term is not in the lease, so when negotiating the lease, you may have to have the Landlord or your attorney add this clause.
HOLD OVER: This lease clause specifies the situation if the Tenant stays beyond the term of the lease. Usually it states what conditions and terms of the lease will apply, as well as any increase in rent during this hold over period. Usually, when negotiating the lease, this “holdover penalty” can be reduced.
INDEMNIFICATION: Very standard in any commercial real estate lease, Tenant agrees not to file suit against the Landlord for any mishaps that occur at the premises (i.e. bodily injuries sustained by Tenant or customer.) It usually also states that if the Landlord and the Tenant are named in a lawsuit together (perhaps a customer is filing a lawsuit) then the Tenant shall pay all the Landlord’s costs in connection with such litigation. This is an area where the Landlord’s attorney and the Tenant’s attorney will fight it out over terms like “negligence” and “gross negligence”.
APPOINTMENT OF A RECEIVER: Specifies what happens if either the Tenant or the Landlord declare bankruptcy, as well as any actions a receiver may take. If the Landlord declares bankruptcy, the receiver could cancel the lease, even a well written commercial real estate lease! Tenant should look carefully at the financial strength of the Landlord to judge the likelihood of bankruptcy or foreclosure.
ABANDONMENT: Discusses Landlord’s rights if Tenant abandons the premises during the lease term. When negotiating the lease remember that may also deal with issues which effect the remaining businesses: an anchor store vacating the shopping center before lease expiration could affect the profit of the smaller stores since they rely on the draw of the anchor tenant. Additionally, the insurance rate of the building could increase due to a sudden increased exposure to vandalism. Sometimes in retail operations, abandonment is defined by terms of the dollar amount of merchandise that must be available for sale or the amount of hours the store is open. If the store lacks merchandise or is closed most of the time, this will decrease any percentage rents and affect the income of other tenants.
RULES & REGULATIONS: Very common in most modern commercial shopping center leases, this covers items such as parking regulations, sign requirements, limitations on noise and smell, etc. Such rules govern how tenants must act and are in everyone’s best interest. Landlord usually has the right to modify the Rules and Regulations as changes become necessary – this is a part of all good commercial real estate leases.
NOTICES: This section covers how the Landlord and the Tenant deliver any notices and what constitutes a receipt of notice. Notices may be delivered personally, by mail with return receipt requested, or tacked on the door of the premises (the lease will state the method.)
RECORDING THE LEASE: In some regions the Landlord will record the entire lease or a short form of the lease in the county governmental offices. A recorded lease is considered to be an encumbrance on the property. In some states a lease for a period over 10 years must be recorded and, for state transfer tax reasons, is considered a sale and taxed as such.
We hope you have found these commercial lease terms and definitions useful. There is still no substitute to having an experienced commercial broker negotiate the financial terms, and a real estate attorney review the lease prior to signing. Together, they make a complete team!