Commercial Lease Terms
When you purchase commercial real estate you are purchasing the leases that are already in place. In order to properly evaluate the investment, I have highlighted a few terms to assist you with the analysis.
Gross vs Net: Look at this the way you would look at your paycheck. When a lease is a Gross lease you as the landlord still need to pay expenses such as repairs, and taxes and insurance from the rent you receive.
With a Net lease the tenant pays rent plus additional costs so you as the landlord are able to keep all the rent charged. From a Due Diligence standpoint it is important for you to understand exactly what is to be paid by the tenant and what is to be paid by the landlord. The most common types of Net Leases are a single Net, which means the tenant will pay either Common area maintenance, real estate taxes, or building insurance. Double Net or NN is when the tenant pays two of the above, and triple net is when the tenant is responsible for a share of all three.
This is definitely a case where not everything you see is what you get. You may have a lease that appears to be a five-year lease, but on closer examination you will see that it is really a two-year lease commitment and the tenant has the right to renew for 3 one-year periods, but not the obligation!
For instance the lease may say the tenant has a five-year lease through 2018. When you read the lease it states that the tenant agrees to lease the space through 2015 and reserves the right to 3 one-year renewals through 2018. What that means to you is that the tenants have locked you into a lease agreement long term and have given themselves the ability to cancel after two years.
As an Owner we typically want three types of insurance. Replacement insurance to replace structures or equipment, liability insurance to protect from the operation or an accident, and income replacement insurance that will replace lost income from an insurable claim. In order for you to get accurate quotes from your insurance agent, you will need to know what insurance your tenants are required to carry. By example, if the lease states that your tenants are required to carry 3 million dollars of liability insurance you cannot purchase a policy that requires them to have 5 million. You will also need to know what your lease states that the landlord and tenant obligations and rights are if the rental unit cannot be occupied. This will make a difference in the type of income replacement insurance you may purchase.
The “Break Clause” allows either party to terminate the lease early under certain conditions. By example, some well-known national tenants will sign long term leases but will build in a termination clause after 3 years. This clause will allow the tenant to evaluate the market and determine if it is better to pay a fee, close up operation and move on or to continue the lease.
In most cases the termination fee should be significant in order to force the tenant to only terminate the lease under extreme circumstances. I have, however, seen a few leases where the termination fee was as little as six months.
While the Break clause may sound scary it may also be used by landlords to eliminate tenants that are not adding value to a property. This is especially true of a retail tenant. Very often retail leases have performance clauses that state if the sales of a tenant drop below a pre-established amount, the landlord has the right but not the obligation to terminate the lease.
As a landlord you will want a subordination clause that states, “The tenants subordinate their rights to allow future financing and sale of the building.” Most lenders will not look at financing a property unless this clause exists because the Mortgage would then be in second position to the leases.
Does the lease state what will happen if the lease term expires and the tenant remains in the unit? The value of your commercial rental may be negatively impacted if you do not have leases in place. Your goal is to have your tenants sign a lease renewal or give proper notice of intent to vacate so you can find another tenant. If the tenant is indecisive and does not sign a renewal or give a notice of intent to vacate, they are deemed to be in a holdover period. Many times a landlord will have a clause in the lease that states if the tenant goes into a holdover period the monthly rent will go to two times the last contract rent. The goal of this clause is to force a tenant to make a decision.
Hopefully these few tips will help you to move forward in your analysis and I look forward to hearing about your progression.
Rich Dad Education Elite Commercial Course Instructor