The Commercial Lease: Top Six Issues for Businesses
During the COVID-19 pandemic, many people had to shutter their businesses, and they had lots of questions about how to get out of their commercial leases. Commercial leases, especially for small business owners, often favor the landlord very, very heavily. Even for a space with a leaky roof, failing HVAC system, and crumbling walls, commercial leases usually lean in the landlord’s favor.
Sometimes the tenant has no recourse. Plus, lease terms of five or more years are very common. The COVID-19 pandemic hit small businesses very hard financially. On top of that, because of the pandemic, many business owners weren’t even allowed to use their spaces. It’s been the perfect storm for some terrible, sometimes devastating, commercial situations.
There have been some recent bright spots, though, for some of our clients. One salon owner completely closed her business and needed to get out of her lease. Fortunately, she was able to negotiate a “no personal guarantee” provision in the lease before she signed it. This means she wouldn’t be on the hook personally if something happened to her business. When she did have to close her business, she could walk away and not have to pay as many of the rent payments.
Another salon owner hired us to negotiate a lease for a new salon he was opening. After finding that it favored the landlord, we sent back some very reasonable changes. The landlord rejected them all and refused to budge. In the end, the salon owner found another space. He was really disappointed at first – when you find the perfect space, you have your heart set on it – but getting out of a bad situation with a lease can ultimately save years of headaches and conflict.
We see the most positive outcomes when a client comes to us ahead of time and we can negotiate their leases in advance. Often, this leads to a happy, or at least a collegial, landlord-tenant relationship. This article will cover the six biggest issues to look at and what you can negotiate before signing a commercial lease.
1) What’s the Difference Between a Residential and a Commercial Lease?
While residential leases benefit from many legal protections, commercial leases do not. People often enter into residential leases without reviewing them, and that’s usually okay. The law says the landlord must make sure the place is habitable and prohibits the landlord from doing certain things. For example, the roof can’t be caving in and the landlord can’t just come into your living space whenever they want to. Residential leases contain lots of protections for tenants.
Unfortunately for business tenants, commercial leases offer none of those protections. The law assumes the landlord and tenant will negotiate the lease and reach their desired outcome. The usual outcome, however, is quite different. Because landlords don’t have to include anything in particular in the lease, you frequently end up with very one-sided leases that favor the landlord. Then the tenant, unaccustomed to reviewing leases, simply signs it without seeing the dangers that await.
This situation can result in some very unhappy commercial tenants. Sometimes, a tenant would be better off if they simply decided not to continue with the lease after learning what it actually requires. Sometimes, though, a tenant can negotiate to get a better lease, which is always great for both parties – the landlord gets a tenant, the tenant gets a space, and everyone understands their roles. If a landlord refuses to negotiate a lease, however, that’s a red flag that the landlord might have some troublesome and problematic tendencies.
2) Personal Guarantees and the Commercial Lease
With a personal guarantee, the tenant agrees to be personally responsible for the financial ramifications of a broken lease. Business owners should avoid signing a personal guarantee, if possible. But somebody needs to sign the lease, so if not you personally, then who?
In these cases, you need to have your business as an LLC, corporation, or a similar entity. Creating one of these entities benefits you by separating your personal assets from the business. This means that if someone seeks damages against your business—for instance, if someone sues your business or if you end up breaking a lease you signed with your business—then they can’t also go after your personal assets. We highly recommend that each business form one of those entities for that kind of broad protection, including with commercial leases.
If you have one of those entities and no personal guarantee, you aren’t putting your personal assets at risk by signing a commercial lease. Landlords often resist the removal of a personal guarantee for a new business, and sometimes play hardball even for established businesses. However, some landlords may meet more established businesses in the middle by agreeing to phase out the personal guarantee at some point.
In short, setting up the proper legal entity for your business is always a good idea before you move into a space with a commercial lease. Whether a corporation, an LLC, or a PLLC, we can help you determine what kind of entity is right for your business and fill out the proper forms. Learn more about LLCs here, PLLCs here, or reach out to schedule a consultation.
3) Monthly Rent: Is It A Triple-Net Lease?
Let’s talk about rent. You would expect the amount of rent to be steady and clearly spelled out in the lease. However, much to the tenant’s surprise and chagrin, commercial leases often break with that expectation. Most leases will include various forms of additional rent. Most landlords only discuss additional rent after sending the lease, so it’s important to watch out for additional rent provisions. Different types of leases will include different rent costs. Triple net leases, for instance, have a nasty reputation as the costliest for tenants. Modified gross leases fall somewhere in the middle of the price range.
Let’s first explain triple net leases. In a triple net lease, the landlord passes three costs to the tenant: specifically insurance, taxes, and maintenance. The landlord essentially hands all of their risks to the tenant. With these types of leases, a tenant can sometimes get a reduced base rent, but it doesn’t always happen.
Some lawyers won’t even talk to you about the rent terms before you sign the lease, even though that’s usually the biggest concern. After all, you will pay rent every single month to use the space. A client once asked us to look at a triple-net lease she had entered into with the assistance of another lawyer. She thought the base rent was all she had to pay, but the additional rent actually added several thousand dollars more. Her initial attorney hadn’t told her about these terms.
If you find yourself in this situation and unable to negotiate these terms out, you can mitigate costs in a few ways. First, you have the right to audit the landlord’s records so you know that the costs being passed on are fair. Second, you can demand limitations saying that the landlord has to obtain reasonable pricing. Third, you also want to try to make sure the building is in good condition before you move in; otherwise, you might be on the hook for a roof repair immediately after opening your doors.
Be aware that your taxes and insurance rates could also increase. If you sign a lease saying that you’ll pay for those costs, then you’ll generally be stuck paying them even if they go up.
4) Term of a Commercial Lease
Business owners generally want to stay in the same location for as long as possible and build up their customer base. On the other hand, many may want to maintain the flexibility of a short-term lease. Signing a ten-year lease could be financially risky; the pandemic taught us that anything can happen to the economy in just one year, let alone in a decade. Of course, the importance of this term varies by industry. For instance, it may be worse for a restaurant or coffee shop to have to change locations than it is for a consulting services firm. Business owners often have conflicting goals. They want to stay in the same place for as long as possible, but also want the flexibility to downsize or grow.
The landlord will actually have similar desires. Landlords don’t want to have to look for new tenants, but also want to make sure they can get a new tenant if their current one doesn’t work out. One of your best tools as a tenant is an option to renew. What would that look like? After the regular lease term, whether two years or five years or ten, the lease contains an option to renew for a certain number of years. If the initial term ends and you want to stay, you can tell the landlord you want to use the option to renew and then stay for the term specified in the option. This term could be another two years, five years, or whatever you agree on.
You can sometimes get multiple options to renew, but it’s not particularly common. If the landlord won’t agree to one at all, you can try to negotiate for one by agreeing to a longer term. For longer-term leases, landlords might be more willing to do the construction. They may abate rent, so that you don’t have to pay rent for a few months while you do your construction and set up your space. The landlord might be willing to lock in a rent price or a very small increase each year. Those are some alternatives.
5) Landlord and Tenant Responsibilities
In the often lengthy and legalistic lease, perhaps the most important provision is the section that lays out each party’s duties and responsibilities. For instance, what happens if disaster strikes? What happens if the roof starts leaking, a wall crumbles, or the building gets bugs? What should business owners look out for in the sections related to landlord repairs? And what should and can the tenant negotiate?
Unfortunately, when people come to us with questions about the duties and responsibilities of each party, they usually do so after they’ve already entered into the lease, something went wrong, and they don’t want to be responsible for fixing it – something they could prepare for by knowing what kinds of repair and maintenance fall to whom. Landlords’ responsibilities vary a lot. Many landlords use leases that absolve them of all responsibility. Many will give you boilerplate leases or leases they’ve used forever.
As an example, we had clients come to us after entering into a commercial lease without negotiation and finding that they had to replace an entire parking lot. Or they had to replace the furnace and HVAC equipment to be compliant. Or they had to fix external electrical boxes. These are just a few examples.
As another example, take the recent court case Greggs USA, Inc. v. 400 East Professional Associates, LP.The plaintiff, a bakery, filed a complaint against its landlord asserting a breach of their commercial lease prevented the bakery from operating correctly and caused the loss of their renovation costs, which exceeded $100,000. However, the court ruled that the landlord acted in accordance with their duties and responsibilities as laid out in the lease. The plaintiff ended up paying back rent, late fees, and attorney fees. We haven’t seen their lease, but we expect that a more clearly written lease would have helped the plaintiff know what was coming.
Thus, one goal of negotiation is to make sure that things are in good condition when you move in. If something will need repairs immediately, you want to try to negotiate so the landlord will fix it before you move in. Landlords will commonly be responsible for a building’s structure, common areas like parking lots and hallways, and building systems like plumbing. Obviously, the more the landlord is responsible for, the better for the tenant.
Making sure the landlord’s repairs don’t interfere with your business is also important. One tenant came to our firm because the landlord left scaffolding in front of their shop during the holiday season. Our tenant had their storefront locked during the entire holiday season and saw a significant decrease in foot traffic.
6) Default in a Commercial Lease
We’ll start with a little embarrassing story: The landlord for our firm’s commercial lease recently switched their lease payment system. While we were changing our automatic payments from the old system to the new system, something was overlooked. A couple of months later, we got an email that we hadn’t paid rent for two months. Guess what? By the terms of many leases, we could have been in default. Oops!
Sometimes, such an accidental non-payment can put the tenant in default of the lease. This could give the landlord the right to terminate. Fortunately, for the most part, landlords will want to work with you. If you stay in business, you can keep paying them. But that’s not always the case.
When negotiating a lease, late fees are normal. Late rent is one thing; being in default is another. If at all possible, avoid being in default on a lease. It gives the landlord a lot of rights that can be harmful to the tenant. For example, default can make all the rent for the remainder of the lease due immediately. A defaulting tenant’s landlord may also have the right to take whatever property their tenant has in the space. Our firm can try to negotiate it down, but there’s no way to make default not terrible.
To avoid accidentally ending up in default, you can negotiate for a cure period. With a cure period in place, if you do accidentally breach the lease, then the landlord must give you notice and you have a reasonable period to fix it before you officially end up in default. We usually see very little pushback on a cure period in lease negotiations. People might argue over the length of the cure period and how many times the landlord has to give notice, but negotiating for a cure period in general rarely causes an issue.
In our case, because our landlord was required to give notice before we defaulted, we had time to pay the overdue rent before things got really bad. However, most leases are written so that you’re considered in default the second you’ve breached it. In most cases, you’ll need to negotiate a cure period for defaults into the lease.
What Are Some Standard Commercial Lease Terms?
We often get asked: “Is there anything in the lease that is always the case? Is there something that’s standard and can never, ever be changed? When we negotiate lease terms, often the attorneys will claim that their lease is standard, boilerplate, and included in all of their leases. The fact is, however, that there is no standard commercial lease and the terms can vary significantly. In other words, you can always try to negotiate. A landlord may try to push a tenant into their desired arrangement by arguing it’s normal to have it in there, but there are few things that are standard from lease to lease.
You should keep a few other considerations in mind when entering into a commercial lease.
Some cities have business licensing or other similar requirements. In these cases, make sure you can get zoning approval from the city. The city usually requires you to already have a space before giving its approval, so you want to make sure you can get out of the lease if your zoning or licensing falls through for some reason.
Also, you want to make sure you can get out if the landlord fails to make any agreed-upon repairs.
Some businesses also need to make sure that the landlord won’t allow competing businesses nearby. You don’t want a coffee shop right next door to a coffee shop, for instance. It’s always great to get such language in the lease, depending on what the landlord owns in the vicinity.
So, those are six important things you need to know about commercial leases. Most of all, remember, you can always negotiate, or at least try to negotiate, the terms of a commercial lease. If our firm can help you in any way, please get in touch! And if you are often entering into commercial leases, you might want ongoing legal services. Check out our Outside General Counsel Package for more information.
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