Negotiate the Best Lease for Your Business
Negotiate the Best Lease for Your Business
Fred S. Steingold, Attorney and Janet Portman, Attorney
June 2005, 2nd Edition
When it comes to business, there is no standard lease!
Ready to haggle for the best deal possible? Turn to Negotiate the Best Lease for Your Business -- you’ll find the information, advice and strategies you need when negotiating with an experienced landlord.
This practical handbook explains how to analyze space needs, find the ideal location and then get the best possible terms. Learn how to:
- determine the real cost of renting
- keep future rent at manageable levels
- get the most out of your broker and attorney
- suggest alternatives to hefty security deposits
- allocate responsibility and cost of fixing up your space
- negotiate flexibility to expand, renew or leave early
- ensure costs are shared fairly among tenants
- avoid dealing with costly code compliance and clean-ups
- save your lease if you can't live up to it now and then
The 2nd edition provides new strategies and advice throughout, plus new checklists that will help you at every step of your negotiation.
Comprehensive and written in plain English, Negotiate the Best Lease for Your Business is essential for entrepreneurs on the hunt for a fair and workable lease.
- A. How Leases Are Made and What They Look Like
- B. How This Book Can Help You Negotiate a Favorable Lease
Part I: Finding and Evaluating Space and Developing a Negotiation Strategy
1. What Kind of Space Do You Need?
- A. Do You Need to Move Now?
- B. Setting Your Priorities
- C. Rent, Deposits, and Improvements
- D. Location
- E. Length of the Lease and When It Begins
- F. Size and Physical Features
- G. Other Tenants and Services in and Near the Building
- H. Parking
- I. Building Security
- J. Image and Maintenance
- K. Expansion or Purchase Potential
- L. Preparing Your Rental Priorities Worksheet
- M. Subleasing Space
2. Looking for Space and Using Brokers
- A. How to Find Space on Your Own
- B. Working With a Real Estate Broker
- C. The Value of Hiring Your Own Broker
- D. How to Find a Real Estate Broker
- E. How to Choose a Broker
- F. Signing a Contract With Your Broker
- G. Handling Problems With Your Broker
3. Evaluating the Space and the Landlord
- A. Visiting and Evaluating Prospective Space
- B. Further Investigation of Promising Space
- C. Environmental Issues to Consider When Evaluating Space
- D. Learning About the Landlord
- E. Management Companies
- F. Holding the Space With a Deposit
4. Understanding the True Size and Cost of the Rental
- A. How Landlords Measure Square Feet
- B. Additional Rent: Gross Versus Net Leases
- C. Percentage Rent-Sharing Income With the Landlord
- D. Computing the True Rental Cost
5. Setting the Stage to Negotiate
- A. How Much Clout Do You Have?
- B. Your Landlord's Compliance With the Executive Order on Terrorism
- C. Getting Past Deal Breakers
- D. Letter of Intent
- E. Finding and Paying for a Lawyer
6. Your Negotiation Strategy
- A. Your Negotiation Strategy Worksheet
- B. How to Use Your Negotiation Strategy Worksheet
- C. How Your Lawyer Can Help With Negotiations
- D. How to Modify the Landlord's Lease
Part II: Common Lease Terms
7. Lease Basics
- A. Naming the Landlord and Tenant: Parties to the Lease
- B. Describing the Leased Space
- C. The Use Clause and Exclusive Clause
8. The Length of Your Lease
- A. When Do Your Legal Responsibilities Begin and End?
- B. The Crafty Use of "As of" [Date]
- C. How to Keep Track of Dates With a Timeline
- D. Staying After the Term Ends: Holdover Rent
- A. Basic Rent
- B. Taxes As Additional Rent
- C. Insurance As Additional Rent
- D. Operating and Common Area Maintenance Costs As Additional Rent
- E. Audit Rights
10. Security Deposits
- A. Where the Landlord Will Keep the Deposit
- B. How the Landlord Will Use the Deposit
- C. When the Landlord May Use the Deposit
- D. The Fate of the Deposit at the End of the Lease
- E. Letter of Credit: An Alternative to a Cash Deposit
11. Improvements and Alterations
- A. Improvements Versus Trade Fixtures
- B. Renting Space in a Building Under Construction
- C. Improvements to Your Space
- D. Paying for the Improvements
- E. The Tenant Improvement Allowance (TIA)
- F. The Building Standard Allowance, or "Build-Out"
- G. Paying a Fixed Amount for Improvements
- H. The Landlord Pays for All Improvements
- I. When Do You Start Paying Rent?
- J. Making Alterations During Your Tenancy
12. Maintenance, Utilities, and Code Compliance
- A. Maintenance, Repairs, and Janitorial Services
- B. Utilities
- C. Compliance With Building Codes and Other Laws
- D. Compliance With the Americans With Disabilities Act (ADA)
13. Parking, Signs, Landlord's Entry, and Security
- A. Parking
- B. Hours of Operation
- C. Signs
- D. Landlord's Right to Enter Your Rental Space
- E. Building Security
14. Option to Renew or Sublet and Other Flexibility Clause
- A. Restrictions on Your Flexibility
- B. Option to Renew the Lease
- C. Option to Expand Clause
- D. Rights of First Refusal and First Offer
- E. Option to Lease Less
- F. The Assignment and Sublet Clause
- G. Termination Clause
- H. Option to Purchase
15. Insurance Clauses
- A. Property and Liability Insurance
- B. Insuring Your Trade Fixtures and Inventory
- C. Rental Interruption Insurance
- D. Business Interruption Insurance
- E. Leasehold Insurance
- F. Waivers of Subrogation Rights
- G. Indemnity or Hold Harmless Clause
16. Breaking the Lease, Disputes, and Attorney Fees
- A. The Landlord's Remedies If You Fail to Pay Rent or Breach Another Lease Term
- B. The "No Waiver" Clause
- C. Your Remedies If the Landlord Breaches
- D. Mediation and Arbitration
- E. Attorney Fees
17. Foreclosures, Condemnations, Guarantors, and Other Clauses
- A. Subordination and Attornment
- B. Estoppel Certificates
- C. The Condemnation Clause
- D. Surrender Clause
- E. The "Entire Agreement" Clause
- F. The "Severability" or "Survival" Clause
- G. Lease Guarantors
- H. Signatures
Understanding the True Size and Cost of the Rental
A. How Landlords Measure Square Feet............................................................................... 4/3
1. Are You Renting Thick Walls Besides Usable Space?........................................... 4/3
2. Paying for Common Areas ........................................................................................... 4/4
3. How to Check Square Footage..................................................................................... 4/8
4. Importance of the Layout............................................................................................. 4/8
B. Additional Rent: Gross Versus Net Leases.................................................................... 4/10
1. Pure Gross Lease........................................................................................................... 4/10
2. Gross Lease With Stops.............................................................................................. 4/11
3. Net Lease........................................................................................................................ 4/12
4. Net Lease With Caps or Ceilings.............................................................................. 4/12
C. Percentage Rent—Sharing Income With the Landlord.............................................. 4/13
1. Calculating the Breakpoint........................................................................................ 4/13
2. Negotiating the Breakpoint....................................................................................... 4/14
D. Computing the True Rental Cost.................................................................................... 4/15
Read This Chapter If …
This chapter is for tenants whose rent will be figured by the square foot. It explains the odd ways landlords measure space and the two broad ways tenants pay rent—in one steady sum each month, or a base rent plus an ever-varying portion of the land-lord’s operating costs. And, for shopping center tenants, it explains percentage rent. This chapter is especially useful in the following situations:
• You are renting by the square foot and want to learn (or question) how the landlord measured the space.
• You need to learn the difference between a simple, monthly rent and monthly rent that changes depending on the landlord’s operating costs.
• You will be paying “percentage rent” as a tenant in a shopping center.
• You would like some tips in calculating the true rent you’ll face over the length of the lease.
You can skip this chapter if
you are renting an entire floor or building, where rent is not based on square footage; you understand the difference between a gross lease and a net lease, and can estimate the total cost over the lease term; and you’ll not be paying percentage rent (or if you will, you know all about it).
Once you’ve found space that looks promising and worth pursuing,
it’s time to figure out the true cost of the rental. Isn’t the monthly rent all you need to know? Unfortunately, it’s not that simple. For starters, the monthly rent can be a complicated figure, comprising various factors and calculated in downright Byzantine ways. And there are other expenses, which may not be called rent, but nevertheless feel like rent when you pay them on a regular basis. On the positive side, if you’re lucky, there may even be some savings—like free rent for the first month or two—that should be taken into account.
There are at least two important reasons why you need to determine the true cost of leasing a given space. First, since no small business is likely to have unlimited funds, you need to make sure that the cost fits your budget. Second, if you’re comparing two or three different spaces, you need to know the true cost of each if your comparisons are to mean anything. It may take some -effort to reach the answer, but if you -approach the task systematically, you’ll find it’s not too tough.
This chapter covers important issues you’ll want to understand before you head into serious, clause-by-clause lease negotiations:
• How has the landlord priced and measured the space (how many square feet will you really have available)?
• What other charges will be tacked on to the dollars-per-square-foot amount to make up the monthly rent?
• How can you estimate the true cost of a rental once you factor in the land-lord’s methods of calculating the square feet?
Other aspects of the deal will be important too, such as the amount of money the landlord is willing to put into your improvements (Chapter 11) and whether you’ll be expected to provide some or all of the property maintenance (Chapter 9).
A. How Landlords Measure Square Feet
Commercial space is often advertised and rented on a cost-per-square-foot basis, rather than a descriptive basis (such as “the first floor”). For example, an ad might describe space as “2,000-Square-Foot Office Suite in New Building” or “2,000 Square Feet of Prime Retail Space.” However, 2,000 square feet doesn’t always mean that you’ll pay for and occupy exactly 2,000 square feet. It all depends on two factors:
• how the space you’re paying for is measured, and
• whether you’ll be paying for a portion of the building’s common areas (hallways, lobbies, and the like) in addition to the space you occupy.
This section describes the measuring techniques that can greatly affect the true meaning of the advertised square-foot figure.
1. Are You Renting Thick Walls Besides Usable Space?
Strange as it may seem, many landlords—especially in office buildings—take their measurements from the middle or even the outside of exterior walls. It’s a bit like the butcher who charges you for the bone and fat as well as the edible portion of the steak. Obviously, if a landlord uses this method of measurement, you’ll wind up paying not only for usable space but also for some or all of the thickness of the walls.
If you’re comparing two properties, and one landlord includes wall thickness in the square-foot figure but the other doesn’t, you’ll need to recompute the size of one of the properties so that it’s measured the same way as the other. This is the only way to realistically compare each property’s cost. Sometimes you’ll find that a space with a higher per-foot price is actually cheaper than a space that charges less per square foot but charges you for the thickness of the walls.
Example: Landlord A advertises 1,000 square feet in Building A for $20 a square foot per year. Landlord A doesn’t include the walls’ thickness, which means that Tom Tenant will get 1,000 feet of usable space for $20,000 per year.
Landlord B advertises 1,000 square feet in Building B at $17.50 a square foot per year. However, Landlord B measures from the outside of the exterior walls and does not subtract the thickness of several interior walls. Tom will be paying $17,500 per year—but is this really a better deal than the one offered by Landlord A?
Before beginning lease negotiations, Tom Tenant takes his tape measure to Building B and, with the help of a space planner, remeasures the space from the insides of the exterior and interior walls. He now has measurements for Building B comparable to the way that Building A was measured. In Building B, he finds that he will have only 800 square feet that he can actually use. At $17,500 per year, this means that Tom would really be paying $21.87 per foot of usable space. On the basis of rent per square foot of usable space, Building A turns out to be a better deal.
2. Paying for Common Areas
In many buildings, there are parts of the structure or grounds that you’ll share with other tenants. For example, you and other tenants may share lobbies, hallways, elevator shafts, bathrooms, and parking lots. When you add these spaces up, they can amount to a hefty chunk of the property. Don’t -assume that the landlord is going to let you use these shared facilities for free.
The landlord may charge individual tenants for a portion of the nonprivate space by using either a loss factor or a load factor. (Many times the loss factor is also incorrectly referred to as the load factor.) -Depending on which method the landlord uses, you may either
• pay for the amount of advertised space, but actually get less square footage (by virtue of the loss factor, explained below in Subsection a), or
• get the full square footage advertised, but pay for more square feet (pursuant to the load factor, discussed in Subsection b).
We’ll explain how each method works. Don’t be put off by the math—the concept is what matters. If you come away from this discussion understanding that the terms “loss factor” and “load factor” mean that the cost of the rental will go up, you’re half-way there.
a. Using a Loss Factor to Reduce Your Square Feet
One way the landlord gets paid for the common area space you’re entitled to use but don’t pay for directly is to simply reduce your amount of exclusive space—but charge you for the number of square feet quoted in the ad. Here’s how it works. Look back to the example above and assume that both Buildings A and B have 10,000 square feet available to individual tenants plus 2,000 square feet of lobbies, hallways, shared bathrooms, and elevator spaces. The non-private space (2,000 square feet) is one-sixth, or 16.67%, of the total building size of 12,000 square feet. The loss factor is 16.67%.
Now, the landlord subtracts 16.67% from 100% (yielding a balance of 83.33%) and multiplies this times the square feet advertised (.833 x 1,000). The result is the square footage that will be exclusively available to Tom, our tenant. To finish our example, Tom will end up with only 833.3 square feet of his own (1,000 x 83.33%) but he’ll pay for 1,000 square feet.
The sidebar, Computing the Real Cost of a Rental Using a Loss Factor, shows how the loss factor -affects the rent per square foot. You’ll see what happens if Landlords A and B figure in the loss factor, which is 16.67% for each building. And when Tom Tenant takes the wall thickness into account in Building B (remember, by using his tape measure he discovered that a full 20% of the advertised space was not usable), the true cost per foot in Building B goes way up.
Take a minute to think about what the numbers in the sidebar tell us. At first, Tom might have thought that Building A was more expensive than Building B, which was advertised at $2.50 per foot less. But the picture changed a lot when Tom considered how much space he would actually use in Building B—only 800 square feet, which made the per-foot cost jump to $21.87. And when the landlords applied a loss factor to compensate them for the unrented common areas, Building A jumped to $24.00 per square foot. But look what happened to Building B—when the loss factor and the adjustment for the thickness of the walls was figured in, the true cost per square foot rose to $26.26. Clearly, Tom will do better renting from Landlord A if rent per square foot is the only factor that’s important to him. As we explain later in this chapter, however, other factors will nearly always come into play, including the layout of a particular space and additional charges such as maintenance.
b. Using a Load Factor to Charge You for More Square Feet
We’ve just described one way that a landlord may make sure that tenants pay for their share of the common spaces—that is, by -reducing the space you get to use exclusively (but charging you for the entire -advertised space by including common -area space in the rent). Using a load factor is another way. Rather than reducing your amount of usable space, there is an additional charge for the tenant’s proportional share of the non--private or common areas.
How do landlords use this type of load factor? Landlords A and B both have 2,000 square feet that they cannot rent out to individual tenants, but they wish to pass on the “rent” for this space to their tenants. They divide this 2,000 square feet by the 10,000 square feet available for private use and find that they must increase each tenant’s rent by an additional 20% to cover their proportional share the common area. The sidebar below shows what happens to Tom’s rent when this method is used.
Computing the Real Cost of a Rental Using a Load Factor
This table shows what happens to the cost of a rental when the landlord uses the load -factor to add to the square feet that the tenant pays for.
Building space for individual tenants’ offices = 10,000 square feet
Non-private space (lobbies, hallways, elevators, etc.) = 2,000 square feet
Load factor = total nonprivate space/total office
space (2,000 ÷ 10,000) = 20%
Cost Without Load Factor Cost With Load Factor
(Annual Rent ÷ Rented Area) (Cost Before Load Factor x 1.20%)
Building A $20.00 ($20,000 ÷ 1,000) $24 ($20 x 1.20)
Building B (including walls) $17.50 ($17,500 ÷ 1,000) $21 ($17.50 x 1.20)
Building B (excluding walls) $21.88 ($17,500 ÷ 800) $26.25 ($21.87 x 1.20)
c. The Importance of Discovering the Loss or Load Factor
As you can see from the sidebars above, the use of a loss or load factor has a significant impact on the real cost per square foot of your rented space. Under either method—reducing your exclusive space, as shown in the sidebar Computing the Real Cost of a Rental Using a Loss Factor, or charging you for a portion of the common areas, as shown in the sidebar Computing the Real Cost of a Rental Using a Load Factor—you end up getting less or paying more. You must find out early on whether the landlord will apply a loss or load factor. The method a landlord picks may depend on -several factors:
• Loss method. If the space is wide open and easily divided into rentable pieces of varying sizes, such as a new office building with no interior walls in place yet, it will be easy for the landlord to advertise one size but, -applying the loss factor, actually turn over a smaller space.
• Load method. If the space in the building is permanently divided into rentable “chunks,” as is true in an older, multitenant retail space, it’s likely that the landlord will use the method described in Subsection b, since the square footage for each space can’t be reduced without major recon-struction.
If you must have the full square footage
as advertised or represented by the broker, make sure that the landlord doesn’t apply the loss factor, which decreases your usable space. For example, if you need a full 1,000 square feet, you don’t want to learn that the loss factor will used to charge you for that size but actually deliver less. You’ll prefer to have the landlord use the load factor, which will result in your getting the full 1,000 square feet but charging you for more. Raise the issue early on.
Be aware that you may not always be -informed of the loss or load factor in your first dealings with the landlord (you may not see it in the ad, for example). But the broker (if there is one involved) will -probably know if either factor is operating -behind the scenes and should be able to help you compute the true cost of the space.
3. How to Check Square Footage
Now that you understand the different ways that the landlord may measure the building (including walls or not), and that the landlord can ask you to pay for non-private space (by using either the loss or load factor), you’re in a position to assess the rental with a critical eye. A floor plan drawn to scale will allow you to check the square footage for yourself, and it’s not -unreasonable to ask the landlord to supply one. It’s also a good idea to double check the drawing by measuring the space itself, if you can, with a tape measure or yardstick.
4. Importance of the Layout
The way that a space is laid out—not just its size—will have a lot to do with whether you’re getting your money’s worth. For -example, awkward angles, interrupted work-spaces, or narrow corridors will be less use-ful than wide-open areas and passageways that can accommodate bookshelves, office equipment, dividers, and well-designed work areas. Your rental cost may be less for a $20-per-square-foot space that’s efficiently laid out than for an $18-per-square-foot space with an awkward configuration, -simply because you’ll need less of the $20 per square foot space.
Example 2: Tom Tenant is still considering Buildings A and B. He learns that neither landlord is using a loss or load factor. Tom knows that Building A will cost him $20 per square foot (since he’s not paying for the walls), and he’s get-ting a full 1,000 square feet. But Building B’s true cost is $21.87 per square foot—and, since the 1,000-square-foot figure includes the walls, he’s getting only 800 feet of usable space.
Tom’s first thought is to conclude that Building A is a better deal—after all, its cost per square foot is lower and he gets a full 1,000 square feet. But the space in Building A is chopped up and not conducive to the way Tom wants to arrange his offices. He’ll end up paying for a lot of wasted space if he takes Building A. The space in Building B, on the other hand, is laid out just as Tom would like it. In fact, he won’t even need all 800 square feet, and can suggest to the landlord that a portion of it be rented to someone else. In the end, Tom may do better renting less space in Building B, even though the price per square foot is higher than in Building A.
B. Additional Rent: Gross Versus Net Leases
If this is your first foray into the world of commercial leasing, you may be surprised to learn that the rent doesn’t necessarily mean what it does when you rent an apartment or house. In a residential situation, rent is normally one fixed amount. You’re rarely asked to pay additional rent—sums to cover operating expenses such as building insurance, maintenance, or real estate taxes. These costs are, of course, taken into consideration when the landlord sets the rent for an apartment, but they’re not added on as separate charges. In a commercial situation, however, you may be asked to pay for some or all of these additional sums.
This section explains the four basic ways that landlords charge for such costs as -insurance and property taxes. We start with the most basic method (which corresponds most closely to the typical residential rent) and proceed to the more complicated ones. In Chapter 9, you’ll find extensive explanations of the lease clauses that correspond to the method your landlord has chosen. When you’re ready to negotiate the lease, you’ll need to learn the details as set out in that chapter.
1. Pure Gross Lease
In a pure gross lease, you pay only for the use of the square feet that you rent. If, like Tom Tenant, you are renting 1,000 square feet at $20 a square foot, your rent is $20,000 per year. (Remember that this may not be 1,000 square feet of completely -usable space, as described in Section A.) The landlord’s operating expenses are not added on, although certainly they were considered when the landlord set the price per square foot. Pure gross leases are relatively uncommon—especially when you’re dealing with an experienced landlord. If you’re offered a gross lease at all, it most likely will be in the context of a one- or two-year lease. On the other hand, you have nothing to lose by proposing a pure gross lease if it would suit your needs.
It’s understandable why some landlords are reluctant to propose a pure gross lease. Most commercial tenancies last at least five years—and ten- or 15 year terms are common. During those years, operating costs can rise unpredictably (but the rent is locked in for the duration of the term). The landlord stands to make less profit as the costs of owning and running the property increase. So when gross leases are used, landlords often build in some sort of regular rent increase—such as one tied to the rise in the Consumer Price Index—as a buffer against rising costs. (Chapter 9, Section A, explains how rent escalation works in -detail.) But a more effective way for a landlord to cover high operating costs is to put some of them directly on the tenant’s plate, as described in the following sections.
2. Gross Lease With Stops
A landlord may be willing to set a fixed rent (a gross lease) if the tenant will be helping out in the event that operating costs rise above a certain level. It works like this: If the landlord’s taxes, insurance, and other operating costs exceed a predetermined amount, the tenant begins to pay. In real estate lingo, the point when the tenant starts to contribute is called the stop level (because that’s where the landlord’s share of the costs stops).
The expense that the landlord will be most anxious to cap is the property tax bill (although insurance and common area maintenance costs can be factored in, too). Typically, the landlord and tenant agree that the landlord will pay the taxes for the first year (called the base year). If the taxes go up in succeeding years, the tenant will pay the difference as additional rent.
Example: Bleak Chic, a trendy clothing store, pays $2,000 a month for its space in a suburban shopping mall. The five-year lease began in 2005, which Bleak and their landlord agreed would be the base year for purposes of property taxes. The tax bill for 2006 is $500 higher than it was in 2005. Having agreed to pay for any property taxes above those -assessed in the base year, in 2006 Bleak pays the $500 as additional rent.
Another way to handle increased taxes is for the landlord to agree to absorb a specified amount of property taxes (called a base amount), but if the actual tax bill is higher, the tenant pays the added amount.
Example: Bleak Chic signs a three-year lease at a second location in 2006. The lease specifies that the landlord will pay property taxes up to a base amount of $4,000 per year. If the tax bill exceeds that, Bleak will pay the -difference. Sure enough, in 2007 the taxes are $5,500, so Bleak pays $1,500 in additional rent to cover its tax obligation.
A gross lease with stops puts some of the risks of rising operating costs on the tenant, but if the stop level is high enough (or the base amount big enough), you might never have to chip in. But regardless of where the stop level is placed, the landlord will absorb at least the initial tax amount.
You can imagine that a landlord might want the tenant to absorb the entire cost of taxes, insurance, and maintenance costs—not just the periodic increases in those items. The mechanism for doing this is a net lease, described below.
3. Net Lease
The landlord may expect you to pay for the use of the space (the square feet) and -operating costs (property taxes, maintenance, and building insurance). This arrangement is known as a triple net lease (sometimes just called a net lease), because typically all three of the usual -operating costs—taxes, maintenance, and insurance—are passed on to the tenant.
In multitenant properties, each tenant typically pays a proportionate share of -operating costs according to the amount of the total rentable space each occupies. For example, a tenant occupying one-tenth of the total rental space would pay one-tenth of these costs. In single-tenant rentals, the tenant sometimes pays the entire cost, or may share it with the landlord. Triple net leases are very common in large properties such as office buildings or big shopping malls, but are widely used in other situations as well.
Since taxes, maintenance, and insurance costs are variable and almost never -decrease, it’s obvious that a net lease favors the landlord. But it may be possible for a tenant to bargain for caps, for the same reason that a landlord with a gross lease will ask for stops—neither side wants to be obligated to an open-ended expense.
4. Net Lease With Caps or Ceilings
If you rent with a net lease, you may be able to insist on a limit to the amount of your increased obligations. For example, you may be able to negotiate an agreement that an increase in taxes beyond a certain point will be borne by the landlord. The same kind of protection can be designed to cover increased insurance premiums and maintenance expenses. If your prospective landlord hands you a net lease, you’ll want to press for some protections when you -negotiate the lease. Negotiation strategies are explained in Chapter 9.
Example: Bleak Chic leaves its outpost in the suburbs when its lease expires. Bleak finds space in a renovated warehouse in The Flats, a light industrial area of town. Bleak’s landlord uses a net lease, which obligates Bleak to pay a portion of the landlord’s property taxes, property and liability insurance premiums, and building maintenance (other tenants in the building pay a proportionate share as well). A year -after the lease begins, The Flats experiences a renaissance, with coffee bars, bookstores, and restaurants moving in and doing well. Property taxes go up, but fortunately Bleak foresaw this -develop-- ment and negotiated a cap on the amount of taxes it would be obligated to pay—Bleak will pay only 50% of any increase over its first year obligation.
C. Percentage Rent—Sharing Income With the Landlord
Shopping center landlords often demand a share of a retail tenant’s profits in addition to the monthly rent. If you have a retail business and are headed for the mall, you may be asked to pay what’s known as -percentage rent.
You can skip this section unless you’re
a retail tenant leasing space in a shopping center or mall. Not all such tenants will pay percentage rent—typically, only rather large and sophisticated tenants, with hefty sales, fall into this group. If the landlord expects percentage rent from you, you’ll find out early in your dealings with the owner or management company.
With a percentage rent lease, you first pay a minimum rent under a gross or net lease, as described above in Section B. Then, when your gross sales surpass a specified mark, you begin to pay a certain percent of every additional dollar in sales as additional rent. The percent that’s -applied is usually an industry standard and isn’t subject to much variation. The breakpoint is the amount of gross sales you must reach before the landlord will begin to apply the percentage multiplier and exact a share of your income.
1. Calculating the Breakpoint
There is a standard way to calculate the breakpoint, used by most real estate brokers and professional landlords. This accepted method yields what’s known as the natural breakpoint. Here’s how it’s calculated: The landlord computes your yearly minimum sales, then figures out what you would have to make in gross profits if you were paying only 7% of sales and had to come up with that same minimum rent amount. That figure is your natural break-point. If your gross receipts never get to that point, you never pay percentage rent. But if your gross sales meet and exceed that figure, you begin paying percentage rent on every additional dollar.
Example: Moonbucks Coffee leases space in a shopping center and pays $5,000 a month ($60,000 a year) on a gross lease. In addition, Moonbucks is subject to percentage rent of 7%, with a natural breakpoint.
The natural breakpoint is the point where the base rent equals the percentage rent. To calculate it, divide the base rent by the percentage. In this case:
$5,000 ÷ 7% = $71,428
When Moonbucks’ sales exceed $71,428, it must pay the landlord 7% of every dollar it brings in as sales.
2. Negotiating the Breakpoint
Many landlords will calculate the natural breakpoint and leave it at that—charging you a minimum rent and collecting percentage rent only after your gross receipts have surpassed the natural breakpoint. But there is no law requiring you to stick to the -natural breakpoint when you negotiate the lease. Landlords and tenants can negotiate the breakpoint higher (which means that you won’t have to share until you gross more than you would if you were using the break-point based on 7%) or lower (in which case you’ll begin sharing your income with the landlord sooner than the natural breakpoint).
You may want to take the lead in suggesting a percentage greater than 7%. You may, for example, offer to pay a higher percentage of rent if you think that your income will not be rising rapidly and when it does, it will be sufficient to cover the extra expense (remember, up to that point the income is all yours). You may want to “trade” this concession for an important gain on another issue. For example, agreeing to a higher rate in exchange for a lease renewal option right might be worth it to you.
Conversely, you may want to bargain for a higher minimum rent in exchange for a breakpoint that’s above the natural point. Especially if you think your income will rise quickly, you won’t want to share it with the landlord until the last possible -moment.
D. Computing the True Rental Cost
Once you understand how a prospective landlord measured the space and what kind of rent computation you’re being offered (gross or net, with or without variations), you’ll be ready to roughly compare the rental costs for two or more places you’re considering.
For most small businesses, the best figure to use for budgeting and comparison -pur--poses is the average cost of the lease per month over the life of the lease. -Ordinarily, you won’t include the security deposit in your calculations because this money will come back to you if you pay your rent on time and meet your other lease obligations. (Chapter 10 discusses -security deposits.)
Be aware that in computing lease costs, you may have to estimate some items. If you’re being offered a net lease and are paying a portion of the building’s property taxes, for example, you can find out what the taxes are for the current year by asking to see the landlord’s tax bill (or by checking it yourself in the local property tax -office), but you’ll have to make an estimate for future years, since taxes can fluctuate. Similarly, asking about the building’s maintenance costs and the current property -insurance premium will give you an idea of what to expect when you begin chipping in for maintenance and insurance; of course, these amounts can also change.
The following method can help you -analyze the true costs of a rental. To make valid comparisons, you have to go through this process and prepare a Rental Cost Worksheet for each space you’re considering. Rental Cost Worksheet for Buildings A and B, below, show how Tom Tenant, who is still debating Buildings A and B, compared the cost of renting these properties.
Step One: Determine how many years you’ll be occupying the space. Usually, this figure will be a matter of negotiation -between you and the landlord, as discussed in Chapter 8. We recommend that you use a figure of 36 months—unless you’re signing a shorter lease. Projecting numbers -beyond 36 months becomes difficult, even if you firmly believe you’ll exercise a lease option to stay on for an additional two, three, or even more years.
Step Two: Determine the basic rent for the space. Here you’ll have to do the calculations described in Sections A, B and C.
• Gross lease. If rent is quoted solely as a rate per square foot, you and the landlord will need to compute how many square feet you’ll be paying for.
• Net lease. If you’ve been given a net lease, you’ll need to also have some idea of the maintenance, insurance, and tax costs you’ll be facing (although, as explained above, you may have to make do with rough estimates).
• Percentage rent. If you’re asked to pay percentage rent, you’ll need to know where the landlord will set the breakpoint and what the multiplier will be. Then you’ll have to estimate your gross receipts and compare that figure with the breakpoint. Figure your percentage rent for the receipts that exceed the breakpoint.
Step Three: Determine the total estimated rent. Once you’ve estimated the basic rent, under any type of lease, you should figure out the total rent for a three-year (or shorter) period. Remember that even a gross lease may include a built-in rent increase in the second or third year, so you’ll need to include this in your computations. That chore is relatively easy if the lease states the new rent amount. It will require some estimating if the lease bases the increases on changes in a cost-of-living index or on increases in the landlord’s operating expenses. For -example, you might be able to project a cost-of-living increase based on the increases of the previous one or two years. And if the landlord’s maintenance expenses have risen gradually over the past few years, you may be able to project expenses based on this trend.
In figuring the rent for three years, deduct any incentives the landlord is offering during the first few months—free or reduced rent, for example, or a moving allowance. (These incentives are explained in Chapter 11, -Section E.) Once you’ve figured the -total base rent cost for three years, you’ll need to divide that figure by 36 to determine the average monthly cost for rent.
Step Four: Include the cost of utilities. If you’re renting in a single-tenant property, you may have to pay directly for utilities (gas, electricity, and water). In a multi-tenant situation, you may be separately -metered for utilities and will likewise pay these costs directly to the providers, or you may pay a share of building-wide expenses based on your share of the total space. Question the landlord about the expected cost of supplying the space you’re considering. Of course, you’ll need to take into account the nature of your own business and how much gas, electricity, and water it consumes. For example, a laundro-mat with energy-gobbling washers and dryers will use more of these resources than a shoe store.
Step Five: Include other direct costs. If you’re going to be the sole tenant in a building, you may have direct costs besides utilities, such as security or neighborhood business association fees. Add these in.
Step Six: Factor in your share of renovation costs. Most of the time, you’ll need to fix up your new space to suit your business needs. Some properties will need a lot of work; others will need less. Your improvements can be as extensive as adding walls or removing them, or as simple as new -carpet and paint. They may also include special lighting and wiring, including computer wiring, and equipment and furnishings designed specifically for the space. At this point, you probably have some idea of what a particular space will need in order to make it usable for you. (Checking out your space with a planner, which you should have done early in your investigations of this property, is covered in Chapter 3, Section B.)
You and the landlord may negotiate, -perhaps long and hard, over who will pay for your improvements. Hopefully, you have an idea now of what the landlord will expect you to contribute. Unless you are reasonably expecting some dramatic concessions when you reach the bargaining table, use this figure for purposes of this worksheet.
Step Seven: Include other costs. There may be additional costs associated with one space that you won’t see in another. For example, you may be expected to arrange for your own janitorial service in one -location, but have it provided at a building-wide cut rate at another. Parking, too, may be included in the rent at one spot but added on at another. And your business -insurance costs may vary depending on the location (insuring your business is covered in Chapter 15). Include these miscellaneous costs of doing business in this category.
Now, total up these additional costs for the three-year period and divide the figure by 36. Add that number to the figure for the average monthly base rent and you’ll have a good idea, for budgeting and -comparison purposes, of the true cost per month of leasing the space over a three-year period.
Example: Tom Tenant decides to give some serious thought to renting Buildings A and B. Both landlords are willing to give him a three-year gross lease without a load factor. Tom knows that Building A will cost him $20 a square foot per year (since he’s not paying for the walls), and he’s getting a full 1,000 square feet. But Building B’s true cost is $21.87 per square foot—and, since the 1,000 square foot figure includes the walls, he’s getting only 800 feet of usable space. The real annual rent for A is $20,000, or $60,000 for the life of the lease. The real annual rent for B is $21,870, or $65,610 for the life of the lease.
Next, Tom checks on whether either landlord will grant him any period of free rent (both landlords say no). Landlord A expects Tom to pay his own utility costs (Tom figures they’ll be around $200 a month), but Landlord B tells Tom he’ll have to pay his share of the building-wide usage (his share is estimated to be $250 a month). Tom knows his renovation costs will be high in Building A (about $10,000 total), since the space is poorly laid out. But the improvement costs in B, which is arranged just right, will be less ($2,000).
Finally, Tom adds in some other -direct costs. Landlord A will charge him $1,200 per year for parking; Landlord B had no parking to offer so Tom will have to pay $1,500 a year for parking at a nearby garage. Insurance costs for Tom’s business in A’s neighborhood are low (about $600 per year), but higher ($900 per year) in B’s area, which has a higher crime rate. The costs of cleaning his office suite will run about $2,000 a year in Building A, where Tom can sign on to the building-wide janitorial service, but higher ($3,000 a year) in Building B, where Tom will have to arrange for cleaning on his own.
Tom notes these figures on his Rental Cost Worksheet and compares the -results. From a purely financial standpoint, Tom concludes that Building A is a slightly better deal.
Rental Cost Worksheet for Buildings A and B
Cost for 3-Year Term
Building A Building B
Rent for entire term $60,000 $65,610
Utility costs, total $ 7,200 $ 9,000
Improvements $10,000 $ 2,000
Parking $ 3,600 $ 4,500
Insurance $ 1,800 $ 2,700
Janitorial $ 6,000 $ 9,000
TOTAL for 36 months $88,600 $92,510
Average monthly cost $ 2,461 $ 2,569
There is no such thing as a good “below-market” deal. If you’ve found space at below-market rates, it’s because the space cannot command a market price for good space. In other words, something is fishy. Find out before you commit more time and effort to this deal.
Checklist for Determining the
Real Cost and Size of a Rental
Good work! You’ve soldiered on through the arcane methods landlords use to measure square feet, and are now well prepared to accurately understand the three main ways landlords can charge rent and how much this rental will cost. You’re ready to prepare your negotiation strategy, once you:
• understand the landlord’s measurement system and have applied it to this rental—that is, you know exactly how much space (including common areas) is available
• have determined that the layout works for you (or can be redesigned within a reasonable cost)
• are comfortable with gross and net ways to charge for rent, so that you are ready to negotiate in the system used by your landlord
• understand percentage rent, if you’re facing it, and
• have put together the various costs of doing business in this space and know roughly what it will cost you to rent here.