The commercial property lease is a financial instrument. The property’s cash flow and ultimate value are established through the terms of the lease. The landlord walks a fine line between having a vacant unit and maximizing the financial terms of a lease. It is important for the landlord to maximize the financial terms of each by knowing the market conditions while creating the best tenant mix for the property. In the long term, this will maximize the value of the property and provide tenants with the best environment in which to operate their business. Because commercial leases are for extended periods, the negotiated terms become much more consequential for both the landlord and the tenant. With a month-to-month lease, the landlord can change the terms to meet market conditions every 30 days if desired. A month-to-month lease has a downside, though: the landlord and the tenant may cancel the lease with 30 days’ notice. On the other hand, a lease with a major retail tenant that has a 25-year term, with five options of five years each, provides little or no opportunity for the landlord to adjust the rents to market conditions. The tradeoff for the landlord is that the development has a major tenant. If the development is a shopping center, the major tenant is critical to the development of the project. From the tenant’s perspective, the long-term lease provides the opportunity to build a long-term business with a known and controlled occupancy cost for many decades. Tenants, on the other hand, must negotiate a lease term that ensures that their business will not be disrupted with an unexpected relocation if their lease is not renewed, while also allowing the ability to relocate when their business
either outgrows their space or another location becomes better suited for their business. The tenant must carefully analyze the right lease length to meet the above-mentioned concerns. The tenant does not want to be saddled with an onerous lease—especially if the economy is headed for a downturn. Both sides of any negotiation should keep the other party’s position in mind, and both should work towards a win-win deal.
The lease renewal is one of the most important transactions in commercial real estate, and yet it often does not get the attention it deserves from the landlord or the tenant. Both parties frequently leave the renewal until the last minute, taking for granted the other side’s desire to extend the lease agreement.
Each party often assumes that the only necessity is for both parties to agree on the new rental rate. The consequences for this lack of foresight are often severe. The party desiring a lease renewal often pays a high price when the other party chooses not to renew. For tenants, the result can be major disruptions to their business, including severely impacted cash flow and profits. For landlords, some of their building’s gross income is lost and, if the vacating tenant occupies a large space, the building’s cash flow may become negative. A recent study of mid-sized office buildings shows that, on average, the cost of a renewal lease is less than half the cost of a new lease.
Muhlebach, Richard; Alexander, Alan (2010-06-14). The Leasing Process (Kindle Locations 4348-4860).
Institute for Real Estate Management. Kindle Edition.
Lesson Learning Objectives
By the conclusion of this Lesson you should be able to:
- Evaluate various lease terms such as rent, billbacks and length of lease
- Analyze percentage rent and breakpoints
- Understand the importance of planning ahead for lease renewal
- Evaluate lease renewal terms in light of evolving business needs such as location, space, tenant
mix and cost
The following Assignments should be completed and submitted to the course faculty via the learning platform for evaluation and grading. Submit your responses to these questions in one WORD document. List the question first, and then your response.
1. Describe the concept of “percentage rent” in retail leases including the breakpoint. Your paper should include examples of specific types of locations where a percentage rent clause is normally expected and the types of businesses which could reasonably be expected to pay percentage rent. What are some typical percentage rents by type of business? You should answer the question “Why is it necessary to know a business’ approximate “gross profit” or “gross margin” before signing a lease with a percentage rent clause?”
2. Explain the terms gross lease, net lease, double-net lease, and triple-net lease.
3. What are some of the considerations a landlord must consider when deciding to renew a tenant lease?
4. What are some of the considerations a tenant must consider when deciding to renew a lease?