Entering into a commercial lease in Colorado is a big commitment for any business. Unlike most residential leases, most commercial leases last for many years – often decades. Accepting unfavorable terms in a lease can detrimentally affect a business, especially a fledgling business that is just starting out.
A smart Colorado commercial tenant will review the proposed lease carefully to ensure that the lease will not be a detriment to the owner’s business. The school of hard knocks or attempting to learn about leases by trial and error is a dangerous course of action as the first error may lead to business failure.
This article outlines 20 things you should know and watch out for when negotiating a commercial lease.
#1. Get it in writing, or it didn’t happen
Ultimately, a lease is a contract. As such, a lease is only as good as the provisions contained in the actual document. Even if the tenant and the landlord orally agree to specific terms anything not physically contained in the writing is unlikely to be legally enforceable.
For example, if a landlord orally agrees not to lease to another tenant offering similar services, but the exclusivity agreement does not make it into the final written document that agreement is unlikely to be upheld by a court. Thus, if the landlord rents a space to a similar business the tenant has no dependable legal recourse available.
Anything that does not exist in the final written document does not exist legally.
#2. Determine the power of the property manager
Sometimes a commercial tenant deals with the actual owner of the premise; however, it is far more common that the tenant will not deal with the actual owner. Commercial properties are expensive investments, and as such, often have multiple owners or are owned by a legal entity, such as a corporation. So, often, dealing directly with the landowner is impractical.
More often than not, the landowner or landowners hire a management company. Management companies handle all of the work involved in operating and maintaining a building: signing leases, arranging maintenance, collecting rent, notifying tenants of lease violations, etc.
However, a smart tenant will determine exactly what powers the property manager actually has related to the property. Not determining what power the property manager has can negatively affect the overall success of the lease. For example, a management company typically has the power to lease out the premises. However, if the management company does not have this power and enters into a lease that lease may be invalid.
#3. Research and investigate the parties involved in the lease
A smart tenant will take the initiative to research and investigate the party claiming to be the landlord or owner. This research may inform the potential tenant that a property owner has financial issues and tends to pass those issues onto unsuspecting tenants.
#4. Know exactly what you are leasing and ensure that the lease reflects your knowledge
As mentioned above, everything must be specifically written in the lease to have any legal effect. So, when renting a commercial property, a smart tenant will ensure that the property and space that it believes it is leasing is accurately reflected in the actual, written lease agreement.
Therefore, it is important to double-check absolutely everything. Double-check the address. Double-check the unit number. Double-check the physical description. Double-check the square footage. Double-check the common area inclusions. Ensure that what is written in the document is exactly what you bargained for with the landlord.
Double-checking everything will help avoid problems in the future.
#5. Physically inspect the property
A smart tenant will physically inspect a property prior to signing a lease. Commercial properties do not have the same habitability requirements of residential properties. A physical inspection can alert a tenant to unacceptable physical conditions on the property that the landlord did not necessarily reveal voluntarily.
A tenant that does not know exactly what they are receiving is at risk of receiving a nasty shock.
#6. Understand that permitted use typically means only use
Sometimes lease agreements include a “permitted use” clause. A permitted use clause will specify exactly what activities can be conducted on the leased premises. When a permitted use clause is present, it typically means that the activities listed are the only activities that the tenant can conduct on the property, i.e. any activities beyond the list of permitted uses are presumably prohibited.
Permitted use clauses may present problems to tenants because they can significantly affect how the tenant conducts his or her business. For example, if a tenant sells handmade lotions and the lease specifies that the tenant is permitted to sell handmade beauty products with nothing else listed, the tenant will likely be limited to selling only handmade beauty products. Thus, if the tenant later wants to expand the business to also sell handmade clothing, the landlord may not allow this business expansion.
If a landlord insists on including a list of permitted activities the smart tenant will ensure that the list is as inclusive as possible.
A tenant that wants to conduct activities not included in the permitted use clause may have to:
- Get the landlord’s permission to amend the lease.
- Forgo expand because the activity is not specifically allowed.
- Move to a new location this may result in legal consequences and financial difficulties associated with early lease 3 termination.
Dealing with a permitted use clause can be difficult, particularly when the landlord is uncooperative or unable to expand the clause.
#7. Understand that prohibited uses are not allowed
Sometimes, a commercial lease will include a list of prohibited activities on the premises. Landlords often have many reasons for prohibiting certain activities. For instance:
- Obligations to other tenants
- Coding obligations
- Commercial building goals
- Business Plan
- Obligations to lending and mortgage companies
However, lists of prohibited activities can present problems to a tenant, especially if the list of prohibited activities is overly expansive.
A lease that prohibits a tenant from conducting activities can prevent the tenant from expanding. As such, a smart tenant will ensure that the list of prohibited activities does not include any activities that it may choose to do at any point during the lease. Additionally, the business might want to ensure that the prohibited activities do not include anything similar to or a reasonable expansion of, the business in case the business grows or expands in an unexpected manner.
#8. Understand how rent is calculated and what rent obligations you might face
In a commercial lease, base rent is generally calculated based on a price per square foot of leased space.
A smart tenant will spend time determining how space is calculated and what is included in that calculation. For instance, some landlords will include wall space in its square footage calculation, while other landlords do not. Thus, if two premises are listed with the same square footage at the same price if one includes walls in the square footage calculation it is actually a more expensive lease based on cost per usable square foot.
#9. Understand that rent will increase and know how it will increase
Due to the length of most commercial leases many will contain provisions which escalate the rent amount. For instance, a lease may specify that rent will increase every year or it may specify that rent will increase only every five years. Knowing how often rent will increase allows the tenant to plan for the rent increase and include it in the budget.
While rent escalation might be normal, a smart tenant will ensure that it is done based on a fair and objective standard. For example, a lease could specify that a rent will change based on changes to the Consumer Price Index (CPI) or the rent change may be based on the subjective decision of the landlord.
#10. Determine what rent obligations you will have
A smart tenant will determine exactly what rent obligations it will face over the duration of the lease. Sometimes, the rent will be just the price per square foot in that case the costs associated with maintenance, property taxes, and common area utilities will be absorbed by the landlord out of the rent amount. More commonly the landlord asks the tenant to pay the costs associated with the property in addition to the price per square foot. The other costs, commonly referred to as CAM charges, often include:
- Property Taxes
- Insurance Costs
- Property Management
- Property Maintenance
When signing a lease that obligates the tenant to pay some of the property costs, a smart tenant will ensure that the other tenants are similarly obligated to pay the operating costs. A tenant who occupies 10% of the building space likely does not want to get saddled with the operating costs of the entire building. Additionally, a smart tenant will attempt to limit the amount that the operating costs can increase. This will prevent CAM charges from dramatically increasing from year to year or even over the life of the lease.
Rent amounts and rent obligations are not necessarily confined to the section of the lease discussing rent.
#11. Know what improvements will be done and how to get them done
Often a space will need improvements before a tenant can conduct business in the space. For example, when an orthodontist rents out office space, the space will likely not have the areas or modifications that the orthodontist needs, unless the space were previously rented by an orthodontist. As such, the orthodontist will likely need the space modified make the waiting area comfortable for patients, a nice area for a receptionist, office space for administrators, special orthodontist chairs installed, laboratory area, etc.
When a space must be modified or improved prior to the tenant’s use, a smart tenant will ensure that the lease specifies:
- Who is responsible for making the modifications
- Who will pay for the modifications, and
- If the improvements are to be removed at the end of the lease.
For example, a lease could specify that the tenant will pay for all improvements, but that the landlord will arrange for the improvements to be done and the improvements remain with the premises at the end of the lease. Alternatively, a lease could specify that a landlord will pay for improvements up to a certain amount and will arrange to have the improvements done, but that the tenant needs to remove the improvements at the end of the lease.
No matter what arrangement the tenant and landlord arrive at, a smart tenant will make sure that the agreement is satisfactory. If the tenant wants to keep any of the improvements at the end of the lease, the lease must reflect that. For example, if a dentist has very special, state-of-the-art dental chairs installed into the leased space, she might want to keep them when the lease ends. As such, if the dentist is a smart tenant, she will ensure that the lease specifies that the dental chairs installed into the leased space remain the property of the dentist at the end of the lease term.
More often than not, the landlord will keep improvements done to the property; if the tenant wants something different the lease needs to say that!
#12. Modifications are necessary
In addition to improvements made at the beginning of a lease a tenant may want to make modifications during the lease. A lease should also specify the process by which the tenant may make modifications during the lease. Often, modifications will need to be approved by a landlord, especially if it will affect a building permanently. However, if a tenant wants to paint a wall, he probably does not want to have to go an approval process with the landlord. As such, a smart tenant will negotiate for the ability to make minor improvements without landlord approval.
Getting a provision in the lease to make minor modifications can allow the tenant to make simple changes to the space without going through a lot of hoopla.
#13. Ability to sublease and assign
While it is nice to imagine that nothing will go wrong with the business or the leased premises during the term of the lease, a smart tenant will plan for the worst when signing a lease. Particularly, a smart tenant will ensure that it has the ability to assign the lease to another tenant or sublease a part of the lease to another tenant.
An assignment is when a tenant assigns all of its obligations under a lease to another party. For instance, maybe the tenant signed a lease believing that its services were needed on a certain side of town, only to discover that business would be much more lucrative if it were located on the other side of town. In that instance, the business might want to move to the other side of town, but is obligated under the current lease. However, it finds a similar business that is willing to take over the tenant’s lease obligations believing it will be more successful in an area than the current tenant. If the current tenant assigns its lease to the new tenant, the new tenant has all of the obligations that the current tenant has under the lease the current tenant signed with the landlord.
On the other hand, a sublease is when a tenant only gives away some of its obligations under the lease. For example, a business might rent out office space with the intention to grow. However, the growth did not happen as expediently as the business expected, and the business ends up paying for a lot of unused office space. If the business is a smart tenant, they will have the ability to sublease that office space to another business.
Often, if a landlord allows a tenant to sublease or assign a lease, the landlord will make that sublease or assign subject to the landlord’s approval. However, a smart tenant will ensure that the landlord is only able to withhold approval when the withholding of the approval is reasonable.
#14. Guarantees happen, but don’t let them get crazy
Occasionally, landlords demand guarantees that a tenant is going to pay rent and other financial obligations. In these instances, the landlord might require a personal guarantee or a third party to ensure that the rent will be paid. In the event that rent is not paid, anyone who guaranteed can be held personally liable for the default amount. For instance, if the owner of an LLC personally guaranteed that the LLC would pay rent, the owner will have to pay rent in the event that the LLC fails to.
Guarantees are a part of business, especially for a business that does not have a reputation for success in an area. However, a smart tenant will try to ensure that it knows exactly what obligations the person guaranteeing will be liable for and will then try to get those obligations reduced to the bare minimum.
For instance, a guarantee could obligate a person to cover all of the financial obligations of the business. If the business fails, the person will have to cover absolutely everything. Alternatively, the guarantee might only cover the rent obligations of the business. Then, if the business fails, the person will only have to cover the business’s rent obligations. Obviously, the less the person guaranteeing the success has to pay in the event that the business fails, the better it is for the person.
#15. Insurance obligations
Buildings and businesses often require many different types of insurance. A smart tenant will check the lease to determine what insurance the landlord will carry and what insurance the landlord expects the tenant to carry. Often, it is a good idea to have an insurance company review the insurance clause on a lease to determine what coverage the lease requires and give an estimate on how much that coverage will cost.
Typically, a tenant can expect that the landlord will carry property or liability insurance. A landlord might also carry rental interruption insurance that will pay the landlord if the tenant is unable to pay rent. Sometimes, the lease will provide that the tenant will help cover the landlord’s insurance premiums, so a smart tenant will double-check who pays for the insurance.
There are also some insurances that the tenant should be expected to obtain under a lease; these insurances can also be extremely beneficial to a tenant, even if the landlord does not require them in the lease:
- Trade fixture and inventory insurance. In the event of an emergency, such as a fire, the landlord’s property insurance will cover any losses to the building. However, that insurance will not cover the loss of the tenant’s inventory. But, if the tenant has trade fixture and inventory insurance, the insurance company will cover the costs of lost inventory.
- Business interruption insurance. If some sort of emergency happens where the tenant is unable to conduct business for a certain amount of time, e.g., a fire that closes the building until renovations are done, business interruption insurance will pay the tenant while it is unable to operate.
- LeaseholdiInsurance. This is not a popular requirement by landlords, but it can be a good idea for a tenant to obtain this type of insurance. In the event that a disaster occurs and the tenant is unable to move back into the building, leasehold insurance will compensate the tenant if it has to pay a higher lease amount in order to obtain a new location. For example, maybe the market changed substantially and rent on a comparable space is much higher than the tenant was paying in their condemned space.
A smart tenant will determine what insurance it is obligated to hold under the lease and will plan ahead with insurance costs.
#16. Ensure that any subrogation is a two-way deal
Another insurance issue that tenants face has to do with subrogation. Subrogation is when a third party has the ability to sue on someone else’s behalf. Generally, subrogation is how an insurance company recovers the money it paid to its insured from the offending party. For example, in the event of a car accident that is the fault of an uninsured driver, the insurance company will pay for the damages done to the insured person. However, it will then sue the uninsured driver on behalf of the insured to recover the amount that it paid to the insured.
Often in a commercial lease, the landlord will insist that the tenant waive its right to subrogate. When the right to subrogate is waived, the insurance company would be unable to sue the landlord on the tenant’s behalf. A smart tenant will allow a landlord to insert this subrogation, however, the tenant will insist on the subrogation being mutual. So, if the tenant waives it right to subrogate, the landlord does as well.
#17. Watch for indemnification and compliance obligations
Smart tenants read the lease carefully and search the lease for any indemnification clause. Indemnification means that one person or company agrees to be financially responsible for the financial obligations of a third party, (i.e., landlord).
#18. Lease term and renewal
Commercial leases last for a very long time. For an established business that knows the market and knows exactly what it needs in a commercial property, signing a lease obligating it for twenty years might not be a huge deal. However, for a business that is just starting out, the prospect of obligating the business for thousands of dollars a month for twenty years may not be a great idea.
But, when negotiating a lease of shorter duration a smart tenant will ensure that it has the opportunity to renew or extend the lease at the end of the lease term. By negotiating a shorter term lease with a right to renew or extend a tenant gains the flexibility of less time obligation combined with the right to continue in place if that he or she chooses to do so at the natural expiration of the lease term.
#19. Specificity is key to the success of a lease
In a commercial lease, specificity is extremely important to the overall success of the lease. Specifically defining what the tenant and landlord mean by certain provisions is helpful. Also, specifically delineating expectations also helps ensure peaceful relations between the landlord and the tenant.
For example, landlords and tenants often get into a dispute over which improvements remain with the premises at the end of the lease. When the lease specifically delineates which improvements are the property of the landlord this dispute is avoided saving both parties time and money.
#20. Hire an attorney
Commercial leases are often very long and complex documents. Nuances contained in those provisions can mean the difference between a business’s success and its failure. Determining negotiating for better terms with an institutional landlord can be extremely difficult, especially for someone who is not familiar with commercial leases.
As such, smart tenants hire attorneys with experience in drafting and negotiating commercial leases. An attorney looks out for the best interest of his or her client and will advise the client of the risks involved with accepting a landlord’s proposed lease as well as providing options of how to negotiate for more favorable terms.
The knowledgeable commercial lease attorneys at Robinson & Henry have valuable experience drafting and enforcing complex commercial leases. They can help you ensure that you are not obligating yourself and your business to terms which may not be in your best interest. Call (303) 688-0944 to schedule an assessment.