As an investor, negotiating a commercial lease is a complex process.
That’s because while a purchase agreement may continue numerous points, it defines only one event – the purchase of the property. A lease, on the other hand, sets up the expectations for a relationship with a tenant, defining what the response should be by both parties to both planned and unplanned events.
Because a commercial lease covers both day-to-day events and legal liabilities, it is essential that you carefully consider the wording of your lease.
Lease extensions, renewals, and options, in particular, can have a huge impact on your ROI. It behooves investors to ensure that any changes made to the lease offer security in case of a non-performing tenant.
Long Or Short Term Commercial Lease?
The length of the lease is one of the first things tenants consider when reviewing a commercial lease. As a tenant, a longer commercial lease is preferable, as it allows the tenant to the security of not having to move after a short period. If the new commercial lease continues based on the same terms as the old lease, tenants will also save money.
However, for landlords, a commercial lease could be advantageous, as in the case of a high-quality tenant who draws other quality businesses. But it could be a disaster, in the case of a non-performing tenant who takes up valuable space and is difficult to remove.
The easiest way to avoid this is to add a “kick-out clause,” which specifies the conditions under which a tenant’s lease becomes null and void. So for example, if a tenant underperforms despite repeated warnings and advice, a kick-out clause allows the owner to remove the tenant.
Keep in mind that if the tenant insists on a co-tenancy clause, which ties one tenant’s performance to the presence of a second business, then the tenant cannot be removed from the property.
Renewals Clauses: Trap Or Security?
A renewal clause gives a tenant the option to renew a commercial lease for a set period after the initial lease ends. Generally, renewal clauses start on the same day as the previous lease and offer the same terms and conditions.
Experienced owners add wording that doesn’t allow the renewal clause to continue. Otherwise, the lease could be extended forever. Instead, tenants can choose between more options.
Some owners allow renewal clauses because it is easier than searching for a new tenant. However, if you are not careful to add what the rent during the renewal term is based on, you could end up losing a significant amount of money.
Instead, it’s best to negotiate a rent that is based on the market at the time of the lease renewal, using language that makes clear how market rent will be defined. Some landlords add that the rent should not be lower than the present or initial rent, in case the market has fallen instead.
Right Of First Refusal
If you’re concerned about losing profit by lease options that allow a tenant the chance to rent additional space (often below market prices, since asset value may have risen since the lease was signed), then a “right of first refusal,” is an ideal solution. A right of first refusal, or ROFO, gives the tenant first dibs on additional space, as long as they are willing to meet the terms offered by the first party.
Because a ROFO is weaker than an option, the owner can not only control when he chooses to notify the tenant of a third party offer, but the price of the property is not set at the time of the lease. However, in order to qualify as an offer, it is important to make sure you specify what legally constitutes an offer.
There are downsides to a ROFO, however. The main disadvantage is that spaces with a first right to refuse are sometimes harder to market. Both brokers and potential tenants aren’t enthusiastic about having to wait for the other party to refuse the offer before they can proceed forward.
The owner must also allow the present tenant a period of time in which to accept or decline the offer, which often further deters potential tenants.
A careful consideration of your tenants as a whole, the market in your area, and your investment goals will help in deciding what to include in a commercial lease.
When in doubt, feel free to contact a Buyer’s Agent, who will be able to check the language of the lease and notify you if there are items in the lease that may affect your ROI.