On the surface, commercial real estate leases might not seem all that exciting. They tend to be long, formal, detailed documents filled with arcane real estate terminology and lengthy, intimidating legal clauses—not exactly most people’s idea of light bedtime reading. But, leases are the cornerstone of the commercial real estate industry, the starting point for every commercial real estate transaction. So, anyone who plans on working in commercial real estate should have a least a basic understanding of commercial real estate leases. This is true regardless of whether your role requires you to work with leases directly, as is the case with lease abstractors, lease administrators and property managers, or indirectly, like financial analysts and property accountants. For some real estate professions, like leasing broker, tenant representative or attorney, it’s not enough to have a basic, fundamental understanding of commercial real estate leases; you need to know leases and their various components and clauses, inside and out.
A Comprehensive Primer on Leases
Because leases are such a critical and foundational component of commercial real estate, our consulting team receives a lot of questions about them and our content and resources on commercial real estate draw a lot of interest. For that reason, we recently updated several posts from our popular and well-read series on commercial real estate fundamentals. Still, commercial real estate leases are complicated. There’s a lot to leases and our updated posts only cover a few topics, albeit some of the lease-related topics we are asked about the most. So, to supplement those posts and provide additional information on leases that might be helpful, we’ve decided to publish a new series of posts titled “The ABCs of Commercial Real Estate Leases”. The series is intended to be a primer on commercial real estate leases for those who are new to the industry or have worked in commercial real estate and are looking to refresh their knowledge. If you’d like more formal and in-depth training on commercial real estate leases, Realogic offers a training course called “Understanding Commercial Real Estate Leases”. You can find more information about it on the CRE Training page on our website.
First, some simple basics for those who are unfamiliar with commercial real estate leases. A commercial lease is a contract in which, for payment of rent, the party entitled to possession of real property (landlord or lessor) transfers those rights to another (tenant or lessee) for a specified period of time for retail, office, or other commercial purposes. An important comment to make, at this point, is that even though many leases contain much of the same information, rarely will two look exactly alike. A Building or a Landlord may have a particular form that is used as a foundation from tenant‐to‐tenant but, even then, changes get negotiated that can make a standard form unrecognizable to the reader. Certain lease provisions may vary regionally, to comply with local law or based upon standard local practice. For example, “Porter’s Wage” appears almost exclusively in New York leases. These variances can confuse the new reader, but they should not because essentially, all leases contain four main components that need to be identified, and regional differences will be understood with experience and time.
The Four Main Components of Every Lease
Almost all commercial real estate leases can be broken down into four main components:
Next, here are definitions and descriptions of some of the basic terms found in commercial real estate leases:
Identifying the parties is typically an easy task, as the landlord and tenant are identified in the lease preamble or in the first section of the lease. However, this “easy” task can get sticky with the addition of an assignment, name change, merger or consolidation, etc., that may have occurred months or years after lease execution. For this reason, it is important to carefully read the lease documents to ensure the party who is actually bound by the lease at that point in time is accurately depicted. An assignment document, for example, can be rather small in comparison to a lengthy commercial lease, and may be easily lost in the shuffle.
Next, you need to identify the space being leased to a tenant (location of space – i.e., Suite Number, and square footage of the space). Commercial leases often measure or quantify space by rentable square footage, although many government leases and other negotiated leases measure or quantify space on a usable basis. The definition of Rentable Square Feet is the usable square feet plus a load factor, i.e. a percentage (typically 7% to 20%, depending on the layout of the building) of such common areas as the building lobby, common hallways and restrooms. Rents are often provided on a per square foot basis. If the lease provides both the usable and rentable square footage, it is critical to identify which measurement the Landlord is using to calculate the rent
Terms are the basic dates and deadlines in the lease. To learn more, read our detailed post about Term Dates.
The minimum amount of Rent to be paid (typically referred to as “Base Rent” or “Minimum Rent”) may be stated in a variety of ways, namely annually, monthly, per square foot per year or per square foot per month. Base Rent may be fixed for the term, or may increase (a) pursuant to stated amounts for stated time periods in the lease, (b) based on a formula (i.e. 3% annual rent steps) or (c) by an index (i.e. CPI). Carefully read the lease documents to determine when rent steps will occur, especially if the term does not begin on the first day of a month. In certain instances, the landlord grants an abatement of rent or a rent credit. If the abatement is granted, determine what is to be abated (Base Rent only or Base Rent plus Additional Rent) and what period the abatement applies to. In addition to Base Rent, tenants are usually required to pay some or all of the expenses associated with their premises, including operating expenses, real estate taxes, insurance, utilities or common area maintenance (CAM). These expenses typically fall within the definition of “Additional Rent” and they are known as “Recoveries”. Generally, there are two classifications of leases with regard to how expenses are paid: (1) net leases, and (2) gross leases.
Net Leases vs Gross Leases
In a “net” lease, a tenant pays their full pro‐rata share of all expenses. In a “gross” lease, the landlord is responsible for the payment of all expenses for the building, and such expenses are typically included in the calculation of base rent. In some gross leases, the tenant never pays its proportionate share of expenses. In others, the tenant pays its proportionate share of expenses over an “expense stop,” or “base year” amount, which is simply a threshold amount of expenses that, once reached, requires the tenant to pay its proportionate share of the amount by which expenses exceed the expense stop or base year amount. This guide describes the differences between net and gross leases further in the Rent and Additional Recoverable Expenses section. In some retail leases, tenants are obligated to pay Percentage Rent. A Tenant pays Percentage Rent either in addition to Base Rent and Additional Rent (which is the most common scenario) or in lieu of Base Rent. Percentage Rent and examples of how percentage rent is calculated are contained in the Retail Provisions portion of this manual
Lease options are specific rights of either party to alter the Premises size or location as stated in the lease or alter the Term length. Included in Lease options are the right to terminate the lease early, extend the lease term, expand or reduce the Premises size or relocate the premises. The only option that falls outside this general definition is the right to purchase. When reading lease options, it is always vital to identify who holds the exercising right, when notice to the other party to exercise such option is due, when the effective date would be, what space is subject to such right, any events that might nullify the option and any financial consideration that must be paid in connection with the exercise of such option.
Rights and Obligations
There is no set “standard” of obligations or rights to be addressed by the parties in a commercial lease. Regardless of what may be deemed common or typical, all the rights and obligations provided in a lease are negotiable. However, the rights and obligations of the parties can be broken down into two categories: (1) obligations of the parties (the “must do’s”), and (2) exercisable options and rights of the parties (the “mays” or “can do’s”). Some standard obligations provided in a commercial lease include insurance requirements, maintenance and repair obligations, late fee payments, default provisions, notice requirements, security deposits, sublease and assignment provisions, use provisions, subordination rights and holdover provisions, although this is only a partial list of what clauses may be contained in a lease.
Exercisable Lease Options
Exercisable options or rights of the parties can be granted to either the landlord or tenant, and they are typically exercisable upon the occurrence of a certain event, or within a certain time‐frame, and subject to specific notification requirements. If not exercised, such options or rights may expire upon a specific event or date, or upon the term’s expiration, or they may be continual and capable of being exercised repeatedly, depending upon what the parties agree to in the lease. Some common tenant options include the option to renew the term, terminate the term, expand (via an expansion option, right of first offer, or right of first refusal) or contract the premises. Common landlord options include the option to relocate the tenant’s premises, or to terminate the tenant’s term. When identifying a lease option, it is important to distinguish between a default remedy and an actual exercisable option for a party. For instance, many abstractors make the mistake of showing the landlord an option to terminate, when in fact, the landlord’s “option” to terminate is a remedy for the landlord if the tenant defaults on a term of the lease. A default remedy is not an independent, exercisable option or right.
Next Up: Rent and Recoverable Expenses
Next, we’re going to dive deeper into commercial real estate leases and look at Rent and Additional Recoverable Expenses. Meanwhile, if you’re interested in learning more about commercial real estate leases, there are two resources in our Library you might be interested in: our comprehensive primer on leases called “The ABCs of Commercial Real Estate Leases” and our glossary of commercial real estate lease terms.
By Terry Banike, Marketing Manager, Realogic