Understanding the Costs of Commercial Leases

When a small business owner is considering renting a commercial property (whether it’s an office, retail space or a warehouse), it’s important to know the kinds of payments that will be required. A commercial lease is a long-term commitment with significant financial responsibilities. Often times, a landlord requires a personal guaranty on the lease which creates personal liability on the business owner(s). If the business tenant does not pay rent (or other sums due) then the landlord can collect from the business owner(s) personally. This creates a significant financial risk and smart business owners pay close attention to the language in the lease agreement.

Here’s a rundown of some of the financial commitments that are often found in commercial leases:

Base Rent – Base rent can be set out in the lease as a specific sum every month or it can be set out as a specific sum per square foot of the leased premises. If it’s set out per square foot, to find the monthly payment, you multiply the square footage of the premises by the amount per square foot and that is the annual rental amount. You then divide the annual amount by twelve months to find the base rent per month. Sometimes, a commercial lease will set out the base rent amount per year of the lease term and other times it will only set out the base rent for the first year and provide for an annual increase by a certain percentage. For example, a lease could have a base rent at $16.00 per square foot with a 3% increase every year during the lease term.

Additional Rent – Additional Rent is a term that will be defined in the lease. Depending on the type of lease, it could include property taxes, insurance and common area maintenance fees (“CAM”), all of which are described below.

Percentage Rent – Percentage rent is not as common in today’s market, but we sometimes see this type of rent at high traffic locations. Percentage rent is in addition to the base rent and it is based on revenues of the business. Financial statements must be provided to the landlord and the amount of percentage rent is calculated monthly and sometimes quarterly.

Sales Tax – In Florida, sales tax is charged on commercial rent payments so a business tenant will pay sales tax on the amount of rent each month. Depending on how the lease is worded, sales tax may also be charged on the insurance and CAM payments.

Property Tax – In addition to sales tax, the lease may require the payment of property taxes for the location. The landlord normally will calculate estimated property taxes and charge a prorated amount each month. At the end of the taxable period, if there is a shortage the landlord will charge the difference. If there is an overage, the landlord usually applies that amount to the next payment.

Insurance – Most leases require a business tenant to have a certain amount of insurance coverage. These policies would be in the business tenant’s name and the premiums would be paid directly to the insurance company. (It’s always a good idea to get the insurance quotes before the lease is signed. Insurance premiums can be more than anticipated.) In addition to the business tenant’s own policies, some leases require the business tenant to pay the premiums for the landlord’s policies on the property (or a pro-rated portion).

CAM – CAM or Common Area Maintenance Fees are sometimes charged in shopping centers or multi-tenant properties. These are the operating costs that the landlord incurs in maintaining and repairing the areas that all tenants can access. Some, but not all, of these areas could include the sidewalks, parking lots, courtyards, elevators, stairwells, and landscaping. The lease should define what is included in CAM and what is not included (such as capital improvements). The amount of CAM a business tenant pays each month is based on an estimate by the landlord and it is reconciled at the end of each year. Often, small business owners underestimate the effect that CAM has on the total amount of rent they pay.

Repair & Maintenance – Depending on the type of lease, business tenants may be required to pay for maintenance and repairs to the leased premises. Some of the most expensive repairs can include repairs to utility pipes, electrical systems and HVAC systems. Knowing the condition of these particular parts of the leased premises before the lease is signed is critical. If possible, it is wise to set limits on the cost of repairs, especially for HVAC systems. In commercial properties, it is the luck of the draw as to the tenant who has to deal with a run-down or broken HVAC unit.

Our Practical Tip:  Before a lease is signed, create a spreadsheet of all of the definite and potential costs of renting the space. Include the above if they are required in the lease, but also include any additional obligations, such as trash collection, required service contracts, signage costs and costs of improvements and renovations. Once all of the costs and potential costs are listed, it is easier to compare different spaces and to determine the best location that fits into the business budget.

5 Common Mistakes with Commercial Leases

Almost all brick and mortar business owners have had to wrestle with a commercial lease. They are long and confusing and full of legalese.  So there’s a tendency for small business owners to “breeze” over the words on the paper.  Understandable.  Business owners are moving fast and a commercial lease is not a great read.

But a commercial lease is most likely THE most important contract that a business owner signs and here’s why.  First, it’s a long term commitment – financially and operationally.  It’s probably the longest lasting contract that the business has, so it better be a good deal.

And I don’t just mean a good deal financially.  I mean the terms regarding the use of the premises, the requirements and restrictions on signage, the amount of insurance required, the obligations for maintenance and repair – and so forth.  Those terms need to be a good deal as well.  Because how you run your business (or how you’re allowed to run your business) has a direct effect on your bottom line.

After you find a good location and you’re at least moderately in love with the space, think about some of the following issues (there’s so much more, but this is a good start).  Here’s the top 5 common mistakes business owners make when entering into a commercial lease:

  1. Not Planning For Growth. How long will this space accommodate your business growth?  Do you need to consider expansion rights?  Under what conditions can you terminate the lease early?
  1. Getting Locked in and Not Being Able to Adjust. Are you able to add services/products to your business model?  In other words, is the use of the premises described in such a way that you have flexibility to adjust your offerings?
  1. Not Realizing the Scope of the Financial Commitment. What are the “extra” items you have to pay for?  Common area maintenance fees? HVAC replacement? Service fees? How is “additional rent” defined?  What is the cost of the insurance required?
  1. Not Considering the Effect of the Landlord’s Rules. How restrictive are the landlord’s rules?  Will your business fit into the way the property is managed?  What are the rules on signage and parking?
  1. Not Negotiating the Personal Guaranty. Is the personal guaranty for the whole length of the lease term?  Is there an alternative to giving a personal guaranty?

When considering a lease agreement, be sure to read the lease carefully.  Keep in mind that a short “simple” lease is not always the best deal.  There are many issues that may not be mentioned in the lease – and they should be.

Bottom Line:  A commercial lease is too important and too long of a commitment to not take seriously.  Have an experienced business attorney review it for you and if possible, have them negotiate for you with the landlord.