What to Watch Out For in a Business Lease

Commercial and residential leases are very different.

Small business owners often make the mistake of confusing the two and think, just because they have seen a residential lease, that the commercial lease will contain similar terms and conditions so that they do not need legal review. This is one of the more costly mistakes a business owner can make.

Recently, a local business owner confessed that he didn’t seek the input of an attorney when signing a long-term lease with renewal options. As a result, he missed the time-frame within which he was to renew the lease. What was the result? The landlord was within his rights to terminate the lease and require that the tenant pay substantially increased rent for a new lease, or move.

Ordinarily commercial leases are of longer duration than residential leases. As such, the Tenant is looking at an obligation to make rental payments for as much as 10 or 15 years. The good news is that a long-term lease allows the Tenant to control rent costs; the bad news is that the Tenant is obligated to pay the rent for a very long time. It amazes me that many small business owners do not realize the long-term nature of their obligations and obtain a legal review of the commercial lease.

As always, the key to understanding is education. So, here are some definitions of terms you will see in a commercial lease:

Parties. The parties to a commercial lease are the Landlord, also known as the Lessor and the Tenant, also known as the Lessee. Ordinarily, both the Landlord and the Tenant are businesses. However, if the Lessee/Tenant is a new business, the Landlord/Lessor will customarily require that the Tenant’s owners execute a separate personal guaranty under which they guaranty that the business will pay the rent and meet other obligations under the lease. These guarantees are usually “joint and several.” What does that mean? It means that if the business is owned by four people, 25% each, and one of them fails to pay rent under the guaranty, the other three must pay all of the rent. So, know who the parties are and what is required of you as a party to a commercial lease.

Types of Commercial Leases. In a “Net” lease, the Tenant is responsible for paying Rent and Property Taxes. In a “Double Net” lease, the Tenant pays Rent, property taxes and insurance. In a “Triple Net” lease, the Tenant pays Rent plus their share of property taxes, insurance and operating costs. In a “Gross” lease, the Tenant pays one set Rent amount and the Landlord pays all owning and operating expenses (water, garbage, utilities, etc.). In a “percentage” lease, the amount of Rent the Tenant pays will vary as a percentage of gross sales—as the business succeeds, the Rent goes up. Of course, there are variations on variations.

Rent. In a commercial lease, the term “rent” can have many different meanings. For example, “full service” rent includes all Operating Expenses and Taxes. “Holdover rent” is the amount a Landlord can change if the Tenant stays on the premises beyond the term of the lease. This amount is typically 150-200% more than the base rent. Changes in rent over the term of a long-term lease are common—usually the rent will “escalate” by a certain percentage year-to-year or in increments. Rent and Rentable Square Feet are not the same terms. Rentable Square Feet means the total amount of square feet the Tenant pays for, not just the usable square feet the Tenant exclusively uses. Rentable square feet includes the Tenant’s proportionate share of the common areas such as the lobby, restrooms, etc. This is important because you may be paying the same rent for a new space but end up with drastically different usable square feet.
Subleases. Suppose your business gets into trouble and you cannot continue, even though you have a 10-year lease obligation. If the lease permits you to sub-lease the premises to another entity, the other business might take over your lease obligations. Ordinarily, the Landlord must approve any sublease in writing. This is because the Landlord has the right to know if the entity to whom you want to sublease is viable and can pay the rent. However, the Landlord can’t be unreasonable in withholding their consent so long as you include language in the lease saying that. It is important to know that just because the Landlord consents to a sublease and the Sublessee makes the rent payments, you, as the Tenant are not off the hook. You are still responsible for making rent and other payments under the lease until the end of the term. The only way an original Tenant can shift responsibilities to another is if all parties agree to a “novation.” With a novation, the new Tenant assumes all the obligations of the prior Tenant under the lease and the Landlord consents. Usually, under a novation, the rent remains the same for the new Tenant.

Assignment of the Lease. If the Landlord prevents assignment of the lease, the Tenant may be unable to sell or transfer its business to a third party. Even if the Landlord consents to an assignment, the original Tenant will still be the responsible party under the lease. The only way the Tenant can be released from its obligations is through a novation.

Operating Expenses. If the lease calls for the Tenant to pay its share of the operating expenses, the Tenant needs to know what those are. Operating expenses include the costs of janitorial services, snow removal, maintenance on the building. Etc. This term will vary based on the type of lease.

Trade Fixtures. Trade fixtures are equipment installed by the Tenant to run its business. If the trade fixtures become permanently attached to the building, they become the property of the Landlord. If the Tenant can remove them, they are the property of the Tenant.

Landlord’s Lien. If the lease has a Landlord’s Lien requirement, the Landlord has the right to take or levy the personal property of the Tenant to pay back rent owed. This becomes a tricky area. Certainly, the Tenant’s personal property such as computers can be levied against by the Landlord, but what about equipment that the Tenant has financed through a bank? The bank is the entity that has first claim to the equipment as collateral for any loan and the Landlord will take a second position on the collateral, meaning the bank takes possession and sells the equipment to pay the loan first and if there is anything left over that goes to the Landlord to pay back rent.
There is so much more to learn about commercial leases. My best advice to any business, large or small, is to have any commercial lease reviewed by an attorney. Meanwhile, as a business owner, educate yourself about the terms used in commercial leases and what they mean for you as a Tenant.

GRC58920-Striegel, Lynda P2About the Author: Lyn Striegel is an attorney in private practice in Chesapeake Beach and Annapolis. Lyn has over thirty years experience in the fields of estate and financial planning and is the author of “Live Secure: Estate and Financial Planning for Women and the Men Who Love Them (2011 ed.).” Nothing in this article constitutes specific legal or financial advice and readers are advised to consult their own counsel.