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HARDWICK — Commercial real estate leases — pros and cons

There are three basic categories of commercial real estate leases. In this column we will explore the pros and cons of each to help you decide which one is right for you and your business.

Let’s begin by pointing out that a lease is a contract. In general, all contacts involving the sale of real estate or contracts that take over a year to complete must be in writing to be enforceable. The main point here is that you should make certain that all agreements with the landlord are in writing. Otherwise, it may be difficult to prove that you were told that 20 parking spaces were reserved for your company, for example, when the landlord says you were promised only 15 spaces.

Almost all leases are negotiable. Nevertheless, I have seen some retail space leases that are not negotiable. For example, some upscale shopping center developers tell prospective tenants that if they want to have a store in their shopping center then they must abide by their leases or go somewhere else. These type leases are few in number, but some retail space is in such demand that the developer/landlord has that much control.

For discussion purposes, let’s use an example to illustrate how the different types of leases might be used. The tenant in this case is the owner of an art gallery. She wants to lease 4,000 square feet of retail space on the ground floor of a 10-story commercial building near the downtown area. The building has 8,000 square feet on each floor. There is a total of 12,000 square feet of common area in the building. There are 100 parking spaces at street level adjacent to the building and a four-story parking garage. The average rent for the building is $20 per square foot. The landlord has offered to lease her the space she desires for $25 per square foot as a flat rate or something less depending on negotiation. Some of her alternatives are listed below.

THE GROSS LEASE. This is a type of lease in which the tenant pays only one amount for the space, the utilities, etc. The landlord is responsible for all expenses. The pros of this type lease are that the owner knows what the rent will be every month and can budget accordingly. There are no concerns about increases in utilities or other operating expenses of the property. The cons are that the owner may be able to save money by being able to control some of those expenses better than the landlord, who is building in a cushion for rising or unexpected expenses.

THE NET LEASE. In a net lease the tenant pays for some of the expenses. In this case, let’s say that the tenant has a separate electric meter and believes that she can control her utility bill better than the landlord. She may want to negotiate a lower rate in exchange for paying the utilities herself. The owner would then not have to worry about how the tenant controls utility costs. A variation on this lease would be one where a base rate is established and the tenant pays only for the increase in the utility bill. Such leases can be troublesome for landlords if the base rate is manipulated by the tenant. Nevertheless, the point here is that all leases are negotiable.

Some retail leases base part of the lease payment on the sales or profit of the tenant. For example, our art gallery owner might reach an agreement with the landlord to pay only $18 per square foot, plus five percent of sales. If she had no sales during the year her rent would be only $76,000. In order to equal the same rent amount as a gross lease she would need to have $480,000 in sales. This is certainly and advantage to a tenant who may have a bad year in sales. On the other hand, if sales are really good, then the tenant may have overpaid. Obviously, these type leases pose the greatest risk for both parties.

THE MODIFIED NET LEASE. In some markets, you will hear the terms net, double net and triple net. Generally, that refers to who pays the expenses of taxes, insurance and maintenance. A triple net lease is one in which the tenant pays all of the expenses of the property. This type lease is more common where there is only one parcel of real estate instead of multiple tenants such as our example above. The pros of such a lease for the tenant is that they have more control over the expenses, are assured that the property expenses are being paid and usually pay a lower rate. The cons for the tenant is that they have more administrative work and therefore less time to run their own business.

These examples serve to only scratch the surface of commercial real estate leases. And because leases are contracts it is always advisable to have an attorney review any lease prior to signing.

Phil HardwickAnother resource worth mentioning is the Mississippi Commercial Association of Realtors, an organization comprised of commercial real estate agents who are Realtors and who specialize or have commercial real estate as a significant part of their practices. Remember, not all agents are Realtors, meaning that in addition to the usual license law requirements these practitioners  subscribe to a code of ethics. More information can be found on the association’s website at www.mcar.ms.

» Phil Hardwick is coordinator of capacity development at the John C. Stennis Institute of Government. Pease contact Hardwick at phil@philhardwick.com.


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