HARDWICK: Choosing the best lease as an entrepreneur
Published: May 24,2013
Whether you are a one person entrepreneur or the vice president of real estate for a national retail chain it is important to understand the basics of leasing, and the more common types of leases. In general, commercial and retail leases can be classified as a gross lease, a net lease or a percentage lease. Choosing the right one can be critical to your success.
Before discussing the types of leases mentioned above it is important to point out that a lease is a contract. Therefore, you should have an attorney review your lease agreement before signing it. Your lease should be in writing because that it what the court will look to in case of a dispute.
You should also know that the most important clause in any contract is the one that states the remedies for the breach of the contract. And in spite of what those Internet user terms of agreement may say about their products, one should never sign a contract that allows the other party to change the terms of the agreement without approval.
To illustrate the differences in types of leases let us consider a successful entrepreneur whose business is expanding rapidly. In our example, Matt and Mary are in the business of making and selling candles. They call it M&M Waxes. They have no sales in the first three months of operation, but after attending a festival market and being featured in a magazine their sales grow substantiality the remainder of the year. They now need to rent commercial retail space to sell their candles to the public. They will keep the manufacturing of the candles at an uncle’s warehouse outside of town.
They investigate local spaces available for rent and discover that a certain 2,000-square-foot space in a local strip shopping center will be perfect for their retail store. The landlord presents them with a choice of leases.
The first choice they are offered is what is known as a gross lease. It provides that they will pay a fixed rental of $20 per square foot, or $40,000 per year. The landlord will pay all taxes, insurance, repairs, utilities and any other operating expenses.
Their second choice is a net lease, which is a type of lease in which the tenant pays all or some of the operating expenses. In our example, let us assume that the landlord has concerns about the rising cost of utilities because he does not have a history of utility bills on this particular space. He can make an estimate and build that estimated cost in the gross lease, or he can have the tenant, M&M Waxes, pay it and then reduce their monthly lease amount. This reduces the risk for the landlord. It also can be a benefit to the tenant, who has the opportunity to have some control over how much energy is used. In this case, the landlord offers a net lease of $36,000 fixed rate, but the tenant pays all of the utilities. Net leases can be structured in many variations depending on what expenses the tenant pays for. In cases where the tenant pays all of the property expenses the lease is commonly known as a “triple-net” or “net-net-net” lease.
The third choice is a percentage lease, which is based on a percentage of the revenue or gross income that the tenant receives. In our example, let us assume that M&M Waxes has agreed to pay a fixed rate of $25,000 per year, plus five percent of sales. During the year, candle sales amounted to $300,000, five percent of which would be $15,000. Thus, the total annual rent would be the same as if the lease was the same as the gross lease mentioned above. Obviously, if sales are less, the tenant pays less rent, but if the sales are more, the landlord receives more.
Now just for fun, let us say that the landlord and M&M Waxes agree that the lease for the second year will also be a fixed rate of $25,000 per year, plus five percent of sales. During the second year, M&M Waxes again sells $300,000 worth of candles at the retail store. However, the landlord learns that M&M Waxes also sold another $300,000 worth of candles via the Internet and demands that an additional $15,000 rent payment be made. The tenant disagrees because it was assumed that only sales made at the leased location be counted against the rent. They pull out the lease agreement and discover that it states, “plus five percent of sales.”
Now we have a dispute and an illustration of why lease terms should be spelled out thoroughly. We also have a good illustration of why everything in a lease agreement is negotiable. Hopefully, the lease agreement in this example has a clause that determines how conflicts will be resolved.
Again, regardless of which type lease the landlord and tenant enter into, both parties should know that everything is negotiable and that because a lease is a contract it should be reviewed by an attorney who is familiar with real estate law.
Phil Hardwick is coordinator of capacity development at the John C. Stennis Institute of Government. Please contact Hardwick at email@example.com.
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