This is a transcript of an episode of the LeaseSmart Podcast.
Craig: Today I’m going to discuss a Lease Review Checklist. Covering all the elements of a commercial lease is too long for this podcast, but there are the Top 10 items that anyone reviewing a lease or a lease proposal needs, to make sure they have covered the most critical items carefully. I will share those with you today.
I usually like to start at the top of the lease, not necessarily the most important thing first, but cover things in chronological order. In a typical lease or lease proposal, what comes first? The first thing we always look at is the entity.
Now I didn’t used to cover that element so much, because it really should be done already with your CPA and your attorney, and the main question would be, “Are you going to lease this space in the name of a fresh, new LLC, or a company that has been around a long time and has substantial assets and/or owns multiple locations?” There are operational and tax issues that affect your decision, such as insurance issues, liability issues, all kinds of things. And in fact, many times when we’re in the initial lease proposal stage, as far as the entity is concerned, we’ll say “an LLC to be formed”, because it depends on the name of the property, or the city that we’re in, or something like that, and the tenant doesn’t want to go through the trouble and expense of forming an LLC until we have a deal. So that element ends up taking more time in thought, in some cases, than you would imagine. That’s the first thing we do.
Then, also, while we’re on the entity issue, we’ll skip to the next thing that is affected by the entity, and that is, of course, the personal guarantee. If you are going to sign a lease in a fresh, new entity that has no assets, it may be impractical to think that the landlord is going to do all kinds of stuff for you because he knows that you as a tenant could back out of that deal with no trouble. That’s something else to think about. If you want to do the fresh entity with no assets, that’s fine, but then the Landlord will want a personal guarantee, and that triggers further issues, like: limiting that guarantee to protect you. Does it have to go the full length of the lease? Not usually. It depends on all the terms of the deal.
That’s the first thing we cover in the lease. The second thing would be the size of the space, and this isn’t normally a big deal, but many people don’t realize there’s the leasable size, and then there’s the useable size. In a typical shopping center, you measure from the outside of the outside of the wall to the inside of the inside wall. There’s definitely some space there that you can carpet and you can use it, but you’re paying for more than that, and some people don’t realize.
Natalie: So the leasable space would be the whole exterior footprint, and the useable space is inside?
C: Yeah, in other words, the leasable space, if your walls are a foot thick, then you’ve got an extra foot on the front of the building, and an extra foot on the back of the building. If you’re at an end cap, you get an extra foot on the outside of one side, and if you have a tenant next to you, then maybe you have to go into the wall halfway, six inches or so.
C: So, the leasable is bigger.
C: Just be aware, and make sure things have been measured carefully. In fact, I’ve heard horror stories about some of the big cities where it’s like, “Well, gee, this space used to be 1,800 feet, and now all the sudden, the landlord has the exact same space at 2,200 feet. How did that happen?” Spaces keep shifting in size depending on who’s measuring it, and how they’re measuring it, and how it’s going, that type of thing.
N: Yeah. That can really confuse things if you’re looking at price per square foot.
C: Yes, it sure can. Now if you’re in an office building, the size of the space differs also because there will be common areas that you’re going to be paying for. For instance, you’re going to be paying for your share of the elevators, and the hallways, and common area bathrooms, and lobbies and things like that. You just want to make sure you’re comparing apples to apples and getting what you think you’re getting. That difference can be quite a bit larger. You might be renting 2,000 feet of usable space but paying for 3,000 feet of space when you include all that nice lobby and everything. My example is higher than average, but it could happen depending on if it’s a real fancy shmancy building or not. Just so you’re aware.
The other thing we look at is the condition of the space. You don’t want to take the space “as-is”, because there could be things wrong with the building, and there’s certain wording that you need to be careful of or add in that says the landlord remains responsible for zoning code, building code issues, hidden defects, things like that. Because those change over time, and you just want to be careful of that.
The next issue would be the lease length and options. Generally speaking, a 5-year lease with a 5-year option is safer for a tenant than a 10-year lease. Shorter leases with more options are good too, so it’s not something to just skim over. The landlord typically likes a longer lease. The broker certainly likes a longer lease, but just be sure you’re doing what’s best for you as far as a lease length. There are different reasons you want longer, or shorter, and incentives the landlord will give you based on lease length – things like that. It’s something worth thinking about and we talk about it quite at length to make sure we get that right.
N: Yeah. There could be a situation where you kind of run into a deal breaker there, if people aren’t willing to compromise.
C: Well, yeah, exactly, and there are ways to compromise, but sometimes you’re at opposite ends. Of course, you have tenants that are scared, especially if they’re new in the business. “Well, I only want a 1-year lease.” Well, guess what, the landlord’s not going to do that. It’s too much time and trouble. You might be leaving. You’ve got to do probably a 3-year lease minimum, but we can put in some termination clauses or other protections, or there’s other ways to help deal with that. It would be impractical to go too short. Then also trying to get a broker to help you! They make three times the money on a 3-year lease than they do a 1-year lease, and at some point, it’s just too short. They will go broke working with short leases, tiny tenants, small spaces. They can’t do it. They’re not being mean or anything. They just cannot run their operation on tiny, tiny deals. In fact, that’s one reason we’ll work on the tiny deals – because no one else will help – but you’ve got to pay us cash up front. We’ll represent you and negotiate your deal for you, and it’s well worth it, but we have to be paid up front in order to make it work for our business model when we’re doing that.
N: Yeah. I think people get that, for sure.
C: Well, yeah, it’s just the way it goes. We’re happy to help, but we’ve got to be paid, or we won’t be in business, and then we can’t help.
C: So the next thing would be the timing of the lease. I look at it three ways: there’s executing the lease. In other words, when did you sign it? Then there’s the commencement of the lease – when does the lease actually start? This could be a month or two later, maybe even longer. And then there’s the rental commencement of the lease. So the lease can start, but your rent starts later. So, we sign it one day, the lease starts another, and the rent starts another. All that adds up, and it’s very legitimate, because you’ll be probably needing to fix up the space before you can use it, and it’d be nice to not be paying rent on it while you’re doing that. Sometimes, the landlord will build it out turnkey for you, so this changes a lot. It depends on the type of space and your situation. But you do want to build in enough time, and there’s flexibility that we put in there, like what if there are delays, how are those handled? You may need permits, you may need to hammer some nails, buy some equipment, get it installed. You really want to be careful.
Ideally you’d start paying rent when you open, or even after you open, depending on the situation with the landlord and what they’re willing to do for you.
N: Is there an aspect of this that would address how the landlord would feel if you don’t open on time? They’re not going to be happy, even if you’re paying rent to them, they’re not going to be happy if you’re not open, right?
C: Yes, you’re correct. Especially in retail, they want you there because of your synergy, because of what you do, it’ll attract other tenants, and there are times when the penalties are very severe if you don’t open up within “X” days of when you said you would.
C: Those are usually something we can water down some, but the landlord does have a point. It doesn’t make the center look good if you signed a lease and then there’s paper in the windows forever. They want you open, or they can cancel the lease, or they can impose penalties and things like that. Usually, for the office space, it doesn’t matter so much. “Just pay your rent, we don’t care what you do.” But retail is way different. That’s a good question.
The next thing you want to cover is the landlord’s contribution to tenant’s work. We call it Tenant Improvement Allowance (TIA). Many times there’s money available from the landlord, or many times they’ll convert that to free rent. (They’d much rather do that, actually). But when it is cash, and many times it is, then we also talk about when do you receive it? When do we get this money back? Because the landlord does not want to give you the money in advance. The landlord wants to reimburse you once you’ve spent your money, and there’s quite a bit of give and take on when that’s done, as you can imagine.
The next thing is rental rate. Make sure you’re getting a good rental rate. You’d think that would be the most obvious, number one thing, but I have seen instances where people were ready to sign leases, and it’s like, “Do you know what the rental rate’s supposed to be?” And they were paying way too much. That’s a real head scratcher. I don’t quite understand that, but you know, a little time spent not just taking one or two people’s word for it would be important. Especially, it’s sad when you work so hard to make a profit, but, “Oh I threw away a lot of it paying more rent than I needed to.” That affects the value of the business if you ever sell it, and so it can really leverage into bigger things. So do check that out carefully.
N: Yeah. Do you kind of give advice on comps, since you probably know the going rate for things?
C: Yes, that all comes with experience, although sometimes we deal in market areas that we don’t know well – we’re just handling the lease negotiations that are pretty similar throughout the country. But at that point, we can still see what asking rents are, and we can talk to landlords. We rarely get lied to, so we can ask them questions like, “What’s the last few deals you did?” They can either say, “None of your business,” or they can tell us, and then we can talk to other broker friends we have in the area and ask them, or bring someone in on the deal. It’s good to have boots on the ground if you’re at that stage, if you haven’t done that research. We can fix that problem quite easily in a number of ways, and we’re happy to do that.
N: Yeah, that’s cool. That would be helpful, I think.
C: No doubt. Then exclusivity is another thing that is very important, especially in retail. You want to fight for an exclusivity clause, so the landlord won’t be putting a tenant in close by or in the same center that competes with you too much head on. There’s a certain amount of give-and-take there, too, to find that properly. A landlord does not want to be restricted, but you can’t allow some other business to come in there and sell your product unless it’s just a small portion of their goods and services.
N: Oh. Yeah.
C: So, you need to be careful of that, and there are usually percentages involved, so you can usually get what you want and be protected. Same thing, we need to look at restrictions of things you can’t do that other tenants already have. We did lose a few deals recently because when we got right down into it, there were other tenants in the center that had an exclusive on that product, and we didn’t fall into the right percentage. Maybe 50% of sales are going to be something, and somebody else sells a lot of it, and says, “No, no, no. You need to sell way less than 50% before you’re allowed in here.”
C: So we hit a dead end there.
N: Yeah. I keep trying to think of some example, and I just keep coming to ice cream. Was it ice cream?
C: Well, you’re almost right. This one happened to be smoothies.
C: It was a tea shop that sells desserts and smoothies, and of course, this was a Florida deal, and I imagine that in the summer, people would rather have a smoothie than a hot tea. So they might sell 50% smoothies at some point, and the Smoothie King across the way said, “No, no, no. I have exclusive on smoothies. You can’t sell more than 50%. That’s not going to work for us.” And we couldn’t argue with them, so that blew that deal.
N: At what point did that even come up? You weren’t chatting with the Smoothie King.
C: No, that’s something that the landlord, the moment we start talking to them, is going to check. They’re going to go, “Oh, wait a minute. I need to check my exclusivity clauses from my other tenants.” We shouldn’t have had to spend any time on that deal. Right away, they should have said, “Nope, your use won’t work here. So let’s not even do that.”
C: But in this case, in my own, I hadn’t been working with this tenant too long, I did not realize that they might be selling 50% smoothies, so I’m telling Landlords, “We’re like a Starbucks, but it’s tea.” And their response was always, “Well, that we can do.” So I take some of the blame for that, because I wasn’t quite aware of what they did. I’d never been in one of their stores.
N: So a good landlord will be the one who tells you you’re not eligible.
C: Oh yeah, because he doesn’t want to waste his time, and he doesn’t want to be in a lawsuit. The last thing he wants is a new tenant in there, and then the first tenant comes back to them and says, “Hey, you promised.”
C: And it can be a problem.
N: Big problem.
C: So yep. The final – I guess I was going to give the top ten, and don’t need to go on here forever. We talked about this in a recent podcast, but we’re getting back to this co-tenancy thing, where if you’re there for a reason – because of a tenant that you want to be near – then you want to be sure that you could break that lease if something happens to that tenant. Because, no fault of your own, everything has changed for you. That would be one of a handful of termination clauses that we look at. And we get into expansion clauses and things like that.
Those are the top ten things we look for when we review a lease proposal, or a lease, and make sure those things are covered.
N: Awesome. Yeah. That’s so cool. I think these are really interesting.
C: Interesting and important, and some of these things will change your life, too. If you mess it up, and then you get caught in a bad situation, then you’re talking changes to your financial future, and future generations possibly. It’s no fun to go bankrupt, and if you’re between a rock and a hard place with the wrong words in your lease, you’re going to be damaged much more than you otherwise would have been. So it gets very important, and I’m always shocked how many people will just say, “Oh, well this is the landlord’s lease. He says everybody signs this, so yeah, I just signed it.” Okay. You know, they’re just trusting that things will go well, and they’re enthused about what they’re doing, and thinking, “Oh, no. Nothing bad can happen to me.” Except things do. You just need to be careful.
C: And we’re here to help.
N: That’s true. And it’s very important. Okay, thanks Craig. This is going to be really helpful to our listeners.
C: Great. I’m glad it is, and it’s nice talking to you, as always.