Guide to Commercial Real Estate Leases

Guide to Commercial Real Estate Leases

A lease is an integral part of many commercial real estate investments and outlines all the obligations of the tenant and of the landlord.

This sounds simple, but many questions arise when drafting leases. If, for example, property taxes increase, does the tenant pay all of the increase or only part of it? If the property must be modernized, who pays for the improvement? Can the tenant be moved out during the renovation? If the costs of servicing the property rise, should the tenant pay none, all, or part of the increased costs? How should inflation be handled—with automatic rental increases? With increases tied to some index, perhaps the Consumer Price Index?

Types Of Leases

Here are some of the variations of leases commonly used for commercial and industrial properties:

  • Flat Rate Lease. This is the traditional lease in which the tenant agrees to pay a flat periodic rate for the term of the lease. This might work with a very short lease, say one year.
  • Net Lease. Some investors try to protect their net income flows by requiring the tenant part (double net) or all (triple net) of the expenses. For example, the tenant may pay the property taxes; or property taxes and insurance; or property taxes, insurance, and all maintenance and operation expenses. When a net lease is mentioned, always ask what the landlord pays and what the tenant pays.
  • Sandwich Lease Or Subordinated Lease. The tenant leases all or a portion of the property to a third party who pays to the original tenant. The sandwich lease may be at a rate slightly higher than the original lease payments, thus allowing the tenant to make money from such an arrangement. For this reason, some leases do not allow subleasing.
  • Percentage Lease. The amount of rent is related to a fixed amount, plus a share expressed as a percentage of the gross or net sales or profits of the business to be paid as additional rent.
  • Ground Lease. Only the land is rented. The tenant owns the improvements. When the lease ends, provisions are made for allowing the tenant to buy the land or the landlord to buy the improvements.
  • Leasehold Estate. The value of the lease to the tenant. If the tenant has negotiated a rent below market the tenant has a valuable right (perhaps by subletting at market rents). If the rent is above market the landlord has an advantage, but if the tenant is a strong, credit-worthy tenant the lease may be subject to renegotiation.
  • Index Lease. The lease amount is related to an index and changes as the index changes. For example, banks located in shopping centers cannot be charged on the basis of percentage of sales because there are none. In such cases an index such as the Consumer Price Index might be used.
  • Renegotiable Leases. The rents are subject to review and renegotiation at a particular event or after a given number of years. These are usually related to inflation measures and indices.

Improperly drawn leases may not produce enough income to cover the costs of owning and operating the property. And long-term leases in particular present problems when prices, costs, and money rates are fluctuating. There is no substitute for a lease prepared by a skilled professional.