Understanding Commercial Leases

Understanding commercial leases

Negotiating a commercially viable lease requires you to know and understand the key terms and conditions contained in the lease clauses.

Some of the key terms and conditions typically included in a lease are:

  • lease duration (or term) and options to renew
  • rent and rent reviews
  • permitted use
  • tenancy mix and competition
  • costs
  • repair and maintenance
  • compensation for disruption caused by the landlord’s works
  • assignment and sub-leasing
  • default and breaches
  • redevelopment and relocation
  • termination

Your proposed lease is also likely to include other terms and conditions. Read our publications on commercial leasing regarding property management for more detailed information.

TIP: Before signing a lease or lease-related documents, taking possession of the premises or paying any monies, you should obtain independent legal, financial and business advice.

Lease duration and options to renew

You need to ensure the duration (term) of the proposed lease is long enough for you to recoup your investment and make your required profit. Remember, once your lease has expired, the landlord is under no obligation to renew it, and you may need to find alternative premises. Much of your business goodwill could be attached to your premises, so it is important to protect this.

Options

Ensure that the proposed lease provides you with options to renew so that you can continue trading from the premises after the end of the initial term.

If you are starting in business and don’t have a proven track record, you may decide to negotiate a short initial term and short options to renew, such as a one-year lease followed by two, two-year options.

However, if your business is established and you seek security, you may prefer to negotiate a longer-term lease, for example, a two-year lease followed by a three-year option and a five-year option.

For many leases covered by the Commercial Tenancy (Retail Shops) Agreements Act 1985 (CT Act), a tenant entering into a new lease for a retail shop has the right to a minimum tenancy period of up to five years. If the lease does not provide for five years, a tenant can extend it (statutory option).

To exercise this statutory option, a tenant must complete a Notice of Exercise of Option and give it to the landlord at least 30 days before the end of the lease.

Exercising your option

Your lease should include information on how and when you will need to inform the landlord that you want to exercise your option. Typically, options are usually exercised (actioned) in writing between three to six months before the end of the lease period.

The CT Act requires the landlord to provide you with at least 6-12 months notice before you must exercise (action) your right to renew.

TIP: Failure to exercise an option by the due date or in the manner set out in the lease may result in your lease not being renewed by the landlord.

Rent and rent reviews

You will need to negotiate the rent and frequency of rent reviews with the landlord. Rent reviews are usually annual, but you can negotiate for them to be less frequent.

Leases covered by the CT Act must only have one basis of calculating a rent review.

Some of the most common types of rent reviews to choose from are:

  • consumer price index (CPI)
  • fixed percentage increase
  • fixed amount
  • market rent

It is important to ensure you can afford any proposed rent increases over the period of your lease and any renewal period.

Market rent

Suppose a market rent review applies upon the exercise of an option to renew your lease. In that case, it is important before deciding that you first establish the market rent with the landlord to ensure the proposed rent is acceptable and commercially viable.

Percentage rent

In negotiating a lease, try to avoid rent reviews based on a percentage of turnover. This means that you agree to pay a base rent and once a certain level of turnover has been reached, additional rent is paid based on a percentage of turnover.

If this clause is included in the lease, you will be required to provide details of your turnover to the landlord. This information could be used against you in later negotiations or if you decide to sell the business.

Permitted use

A lease usually includes a clause that outlines the permitted use of the premises.

You should ensure that the permitted use allows you to do all the activities required to operate your business. This includes all the types of goods you want to sell and the services you want to provide.

Don’t just think about your current activities; consider what you may want to offer to expand your business in the future. For example, if you are only permitted to sell pizza, this could cause problems if you’re going to add hamburgers or coffee to your menu.

The permitted use may limit your opportunities to assign the lease to another person if you want to sell the business or leave the premises before the lease expires. You should try to negotiate a permitted use that is sufficiently broad enough to protect your future business interests.

Tenancy mix and competition

Carefully consider the mix of tenants in a shopping centre or precinct. Ideally, the combination of businesses should complement rather than compete with your business.

It’s a good idea to include an ‘exclusivity of trade’ clause in your lease. This prohibits direct competition and gives you the sole right to sell a particular product category or conduct that type of business in the shops controlled by the same landlord.

Anchor tenants

You may be attracted to particular premises because there is a significant tenant in the same location, such as a supermarket chain or department store (known as an anchor tenant). Your business may even rely on the foot traffic generated by them. If so, negotiate a clause in the lease that gives you the right to terminate the lease or receive a rent reduction if the anchor tenant leaves or reduces tenants’ overall number within the building or shopping centre.

Costs

Other costs associated with commercial leasing premises also need to be considered in your negotiations. These costs are additional to the rent and can be significant. In some cases, they may be ongoing and increase during the lease. Some of the common additional costs are:

  • operating expenses or outgoings
  • insurance
  • legal costs
  • security bond
  • fit-out
  • refurbishment
  • marketing and promotional funds

Operating expenses or outgoings

Operating expenses are generally the landlord’s costs in operating, repairing or maintaining the leased premises. These costs may include land tax, council rates, water rates, security, cleaning common areas, and general repairs and maintenance.

You need to be aware of any operating expenses that you will be required to pay before signing a lease as they can significantly add to your overall costs.

Try to negotiate so that you aren’t obliged to pay for operating expenses incurred by the landlord. If this isn’t possible, try to limit them so that it is only those that will be of benefit to your premises. Also, negotiate a maximum level of increase over the term of the lease.

Costs such as structural repairs and capital items (something considered an asset) should be strongly argued as being at the landlord’s expense as the landlord has the ongoing benefit of these items.

Leases covered by the CT Act must individually itemise any operating expenses you will be required to contribute towards.

The lease should also stipulate that you should have access to invoices and receipts to confirm the actual operating expenses.

Insurance

You may be required as a term of the lease to take out insurance to cover such things as damage to the building and public liability. You should avoid any indemnity clauses in a lease that require you to compensate the landlord in the event of any loss, unlawful act or damage.

These clauses can breach your insurance policy. It is a good idea to discuss any insurance clauses with your insurer before agreeing to them.

Legal costs

In general, the legal costs associated with preparing and negotiating the lease can be agreed upon between you and the landlord. It is an excellent idea to negotiate that each party pays their legal costs, or at the very least there is a limit on your contribution to the landlord’s costs.

You should also avoid any clauses that require you to pay the landlord’s legal costs if there is a dispute.

However, for leases regulated by the CT Act, a landlord cannot require you to pay legal costs associated with:

  • the preparation, negotiation, execution, renewal or extension of a lease
  • obtaining consent to the lease from their financial lender (if there is a mortgage on the property)
  • complying with the CT Act

The landlord can claim any legal costs and other expenses associated with an assignment of lease or sub-lease from you.

Security bond

You may be required to provide a security bond at the start of a lease; the amount is usually negotiable. If you agree to a bond, the lease should outline the conditions for the use, withholding and repayment of the bond.

Fit-out and condition of premises

‘Fit-out’ is the process or action of preparing the leased premises for occupation as required by the tenant and agreed to by the landlord. It can include installing things such as the shop front, wall and floor coverings, fixtures and fittings.

It is possible to negotiate who is responsible for fit-out or parts of the fit-out. It is important that the lease specifies the fit-out requirements and who will be responsible for the associated costs. Try to negotiate as much as possible so that the fit-out items you purchase will remain your property (can be taken with you) at the end of the lease.

Fit-out costs can be a significant cost. Be sure to allocate sufficient budget towards it when considering leasing premises.

For leases regulated by the CT Act, you are not required to contribute to the cost of the landlord’s finishes, fixtures, fittings, equipment or services unless you are notified of these costs in the Disclosure Statement provided to you at least seven days before entering into the lease.

TIP: Allow time for delays in completing the fit-out. There may be seasonal shortages of tradespeople (for example at Christmas) which could delay your fit-out being completed.

Refurbishment

You may be required to refurbish the premises during the lease period. This is most common in shopping centres where the overall image of the centre is kept updated. In your negotiations, try to limit refurbishment to every five or six years.

For leases regulated by the CT Act a clause requiring you to refurbish or refit the premises will not be legally valid unless sufficient detail, including the nature, extent and timing of the refurbishment or refit is included in the lease.

Marketing and promotional funds

You may be required to contribute to marketing or promotional funds if specified in the lease. These funds generally are for advertising or other promotional activities of a shopping centre.

You should clearly determine your contribution to marketing or promotional funds before entering into the lease. Try to negotiate terms that limit your contribution and allow you to have a say in how the funds are spent.

Repair and maintenance

Responsibility for repairs and maintenance should be clearly outlined in your lease. Try to negotiate for the landlord to be responsible for the building’s structure and significant capital items (i.e. roof, walls, air-conditioner, exterior fittings such as gutters and downpipes, plant and equipment that are their property, etc.).

As a tenant, you may be responsible for the repairs and maintenance of the internal surfaces such as floor coverings, doors and windows and any equipment and fixtures provided by the landlord for your use.

Equipment such as air-conditioners and fire sprinklers should be negotiated to be replaced by the landlord when their useful life span is over, but the day-to-day maintenance is your responsibility.

TIP: Have the premises independently inspected before entering into the lease. A condition report, including photographs, should be accepted by you and the landlord. This report can be useful if there is a dispute when the lease ends about the condition of the premises or equipment, and whether this has been caused by fair wear and tear.

Compensation for the disruption caused by the landlord’s works

If your landlord carries out works that disrupt your business (including general maintenance work or building redevelopment), you may be entitled to compensation.

Assignment and sub-leasing

You may need to assign the lease (another person takes over the lease) if you decide to sell your business or can no longer keep operating. You will need the landlord’s permission to do this, so make sure your lease states that they cannot unreasonably withhold their consent.

Reasonable grounds for refusing the assignment may include the prospective new tenant having a poor credit rating, them being unlikely to conduct the business successfully or intending to use the premises for a purpose other than the use permitted by the lease.

If you assign a lease, you may still be liable if the new tenant defaults on the lease. Retail leases covered by the CT Act clauses that allow the landlord to withhold consent unless you agree to accept liability for the new tenant’s default are illegal.

However, for leases not covered by the CT Act ensure that you are released from any liability after the date of assignment.

If you sub-lease part or all of your premises, you are still liable for the lease. This may mean that you will need to pay rent if your incoming tenant fails to pay. It is important to undertake a credit check and ensure that the incoming tenant is able to meet the lease requirements.

If the CT Act regulates your sub-lease, you essentially assume a landlord’s responsibilities under the Act. You must provide the appropriate documentation, including a Disclosure Statement and Tenant Guide to the new sub-tenant.

If you are assigning a lease or sub-leasing, you may be required to pay the landlord’s reasonable legal costs and other associated expenses..

Defaults and breaches

You will be in default of your lease if you fail to pay your rent on time. This will allow the landlord to take action to recover the rent. In many leases, the landlord will also have the right to enter the premises and lock you out without notice.

The landlord can claim the loss of rent up to the end of the lease period and the costs associated with reinstating and re-letting the premises. If the premises are re-let at a lower rent, the landlord can claim for this plus any other loss and legal costs associated with your defaulting.

When negotiating your lease make sure the default clauses specify that you must be given written notice of any default and that you are given sufficient time (at least 14 days) to rectify the default before any action is taken against you.

You can also breach your lease (breaking part of the agreement) if you do not undertake specific requirements, such as failing to repair or maintain the premises. Once again, you should negotiate in your lease to have written notice and sufficient time to rectify any breaches before any action is taken against you.

Redevelopment and relocation

A redevelopment clause may allow the landlord to terminate a lease early to carry out significant works to renovate or redevelop the premises. In these circumstances, you could find yourself without premises or relocate to alternative premises. This could severely affect your business.

If possible, you should try to negotiate to have the redevelopment and relocation clauses removed from the lease. If you can’t, make sure the lease provides compensation for loss of trade or goodwill associated with relocating your business, along with payment for relocation and other costs and losses.

You should also consider negotiating a reduction in rent if appropriate. Generally, the redevelopment clause should provide sufficient compensation so that you are in substantially the same position as if the redevelopment did not occur.

There are comprehensive requirements for leases covered by the CT Act relating to the redevelopment and relocation of a tenant’s business and the early termination of a lease.

TIP: You should give serious consideration to the risks associated with redevelopment and relocation. If you cannot negotiate adequate compensation, you should consider whether your business’s potential risks make it worth entering into the lease.

Termination

When negotiating a lease check, whether there are any clauses that allow the landlord to terminate the lease early. If there are, try to arrange to have them removed.

Researching the area, landlord and lease details

Before you sign a commercial lease agreement, you’ll have to do some research. Make sure to take the following steps while investigating.

1. Understand the area.

While looking for a new property, if you’re selling a specific product or service to the public, analyse the area and get a good idea of your potential clientele, location means everything for a small business to thrive, so when you’re shopping around for the right properties, take the time to find the right new home for your business. Gumersell said this process could take two years or even longer, so make sure you plan accordingly if your current lease’s end is in sight. 

2. Find out more about the landlord and building owner.

Gumersell also said that one of the most important aspects of research that is often overlooked is learning more about the landlord and building owner. Sometimes, your direct landlord may not be the true building owner. Either way, find out as much about the landlord and building owner as possible. You’re entering a business partnership together, so make sure you have an idea of who they are, what their financial situation is and whether they’re making good on their payments.

In some states, for example, if a landlord fails to make his or her payments to the building owner, or fails to make mortgage payments to a bank, the business or tenant can end up getting evicted in the event of foreclosure – even if the business has been on time with every payment. That’s just one example of how the relationship among a landlord, tenant and building owner can go awry. Gumersell said businesses can conduct a public-records search to find out more about the landlord. You can also request documents related to the landlord’s limited liability company or business entity to learn more about whether it’s an ideal partner for your business. 

3. Research zoning laws.

Another component to look into is the zoning laws. While your landlord may designate your space for, say, running a restaurant, you have to make sure the landlord’s aims are consistent with your municipality’s laws. There are scenarios in which a landlord or building owner may think they can lease their space to a certain business type, but it doesn’t match standard zoning laws in the area. By aligning these two details, you can ensure that your business can operate without any significant legal headaches from the town or city in which you’re operating.

4. Learn about nuisance laws and the environment.

One of the most important aspects of signing a lease is operating business to its fullest capacity once you open your doors. Many leases have extensive points on noise, smells and equipment. Ann Brookes, a tax attorney, said that she had to negotiate an “offensive odors stipulation when she signed a lease for a restaurant.”

“The building rules said no offensive odors,” she said. “Whether a smell is offensive is subjective, so I made sure there was an exception for smells ordinary to a restaurant.”

It’s also important to research basic environmental laws regarding the property before you sign anything, Gumersell said. Landlords often miss these laws, and they could be used against your business.

Key takeaway: Before signing a lease agreement, do your due diligence on the property. Make sure to research the local area, the landlord, the zoning laws for the area, and any other nuisance and environmental laws the property manager is subject to.

Important commercial lease statutes to keep in mind

There are some key points to keep in mind when you are reviewing your lease. Rent structure is probably the most basic and most important aspect of any lease. By determining how much you pay per month, as well as how much your rent will increase each year, you can better determine budgets and get a full understanding of whether you can stay in business in this new space.

The lease terms are also very important. Consider short-term versus long-term leases. Long-term leases can be a great investment if you’re opening a business in an emerging or growing area. In contrast, short-term leases provide you with the flexibility to move locations or shutter your business if it doesn’t pan out in the way you hoped.

Both with payment structure and term, make sure you understand exactly what you’re on the hook for each month. Ask your potential landlord about how the following expenses are paid:

  • Insurance
  • Property taxes
  • Maintenance (both interior and exterior)
  • Repairs
  • Security
  • Parking
  • Local nuisance laws (noise or scent)
  • Utilities (water, gas, electric)
  • Modifications (whether you can adjust the interior or exterior of your space)

Once you’ve established some introductory pricing and term structures, it’s time to dive into some of the less-obvious details. While your lease will likely vary by state, here are some excellent examples of statutes to be aware of before signing a lease:

  • Transfer structure. Iron out how your lease will be transferred if you want to leave the space or your business closes. There are generally two structures for sharing, according to Gumersell: assignment of the lease, and subletting. Assignment of the lease means the entire lease is transferred to a new tenant. Subletting is when a current tenant keeps his or her name on the lease but receives payment from a new tenant and transfers that money to the landlord. In both instances, you usually have to establish prior written consent before the lease transfer. This is a very important aspect of your lease to work out.
  • Personal exposure. In some cases, you may be required to sign personal guarantees when you sign a commercial lease. These agreements mean you’re personally on the hook for aspects of the lease even if your business defaults. Work with legal counsel to negotiate this aspect of your contract. If possible, you only want your entity or legal business to take on the risk when signing a business lease.
  • Holdover rent. Holdover rent is a rent increase when a tenant stays after the lease has expired. It’s hard to find a lease, and sometimes when businesses are moving spaces, they end up staying longer than their current lease allows while the new one is being set up. In many contracts, landlords include a clause stating that, in these instances, businesses are responsible for up to 250% of their normal rent payment per month. So, if you stay beyond your allotted time, it could cost you tens of thousands of dollars. Gumersell recommended negotiating this aspect down to around 125%.
  • Nondisturbance agreement. In many cases, if the landlord fails to pay his or her mortgage on the property, your business will still be evicted even if you’re making all of your payments. With a nondisturbance agreement, if this occurs, you’ll be permitted to stay and continue paying whatever entity has taken over the building from your landlord, Gumersell

Key takeaway: While reviewing the lease, be sure to take special note of how payments are made, as well as additional clauses, such as transfer structure, personal exposure, holdover rent and nondisturbance agreements.

Everything can be negotiated.

While these are some good examples of things to be aware of, there are likely many aspects of your lease that can be negotiated. Work with your potential landlord – and, if necessary, an attorney – to make sure you get the best deal for you and your business.

“Where a residential lease has a fixed term, a commercial lease is often negotiable and can have a longer or shorter term depending on the conditions set,” said Allan Borch, founder of Dotcom Dollar. “Commercial leases also have fewer legal protections because the consumer laws that apply to residential lease agreements do not cover commercial leases.”

Key takeaway: Don’t hesitate to negotiate the terms of the lease. Many aspects of the contract, especially the length of the term, are negotiable.

Commercial lease agreement terms to know.

Borch and Dan Bailey, president of WikiLawn, listed some key terms that small business owners should know regarding commercial lease agreements. The list does not include every possible term you may encounter on a commercial lease agreement, but it’s an overview of the ones you are most likely to see.

Rent amount/base rent. This amount is calculated based on the square footage of the space. Make sure the number the landlord is using actually represents usable space. This rent is not dependent on revenue.

Usable square feet. This refers to the amount of space actually reserved for the business as a tenant, in cases of shared spaces.

Rent increases. Rent increases are usually based on a percentage of the total rent, and that can change from year to year. You can negotiate with the landlord to put a cap on rent increases.

Security deposit. This is the amount to hold the space until the paperwork is finalised. The amount should be specified both ahead of time and in the lease agreement.

Length of the lease. The length of a commercial lease is usually somewhere between three and five years, as commercial landlords prefer longer lease terms. The lease agreement also often specifies the start and end dates of the lease.

Improvements. This part of the commercial lease agreement lays out the types of improvements and upgrades that can be made to the space and who is responsible for the costs. Many aspects of this section can be negotiated.

Bottom line. Make sure you understand all of the terms in a commercial lease contract and are comfortable with them before signing on the dotted line.

Grant of lease. This is the clause that states that the landlord will turn the property over to the tenant once all of the conditions (e.g., paying the security deposit) have been met and the tenant accepts the property from the landlord.

Commencement date. This is when the tenant takes over the property, more commonly stated as the first day the tenant becomes responsible for paying rent and maintaining the rental property.

Extension. This can be a flat fee or a percentage of the monthly rent.

Taxes. This section outlines all of the taxes associated with the property (property taxes, real estate taxes) and who is responsible for paying them. Within this section, there could be subtopics, like Contest of Taxes (the tenant can contest the amount of personal or real property tax they are responsible for paying), Payment of Ordinance Assessments (the tenant usually pays for all ordinary assessments, which are obligatory, and extraordinary, which are by choice) and Change in Method of Taxation.

Obligation for repair. This section states what types of repairs the landlord is obligated to make – like defects, deficiencies, failures or deviations in materials – that are vital to the operation of the property. It also outlines the repairs that tenants are responsible for.

Permits. Both parties are to acquire all necessary permits and licenses for making improvements or repairs at the location being rented.

Covenants. These terms are different for the tenant and the landlord; each has a separate set of covenants. For example, a covenant may state that the tenant is required to pay rent even if the landlord fails to uphold some of their responsibilities as stated in the lease.

Indemnity by tenant. This clause essentially removes all liability from the landlord in the event of injury, loss, claims or damage, unless those things are a direct result of willful acts or omissions or gross negligence on the landlord’s part.

Rent abatement/adjustment. This section states if the rent will be adjusted or eliminated in the event of property damage from a fire or other natural disaster.

Condemnation. This clause is often overlooked, but it’s important. It determines what happens if the rental property is taken from the landlord by a government agency for public use, either by condemnation or eminent domain.

Option to purchase. This clause states that the tenant has the right to buy the property at any time during the lease at an agreed-upon price. This clause isn’t mandatory, but it doesn’t hurt to include it. The clause can also state that the tenant does not have the right to purchase the property during the term of the lease. Either way, it’s good to have it in writing.

 

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