A Guide To Understanding Commercial Real Estate Leases

Commercial real estate leases are long-term commitments with a lot of legal language, often including many complex clauses that can materially impact the economics of a deal.

And with many of these leases having terms of 5, 10, 15 years or more, making sure you understand all parts of a lease agreement is extremely important when buying commercial properties, or when signing a new lease on a property in your portfolio.

So if you’re not as familiar with commercial leases as you’d like, or you just want to make sure you have the big-ticket items covered before getting into the industry, this article covers four of the most important things you need to know about commercial real estate leases, and how each of these can impact a property’s cash flows and returns.

If video is more your thing, you can watch the video version of this article here:

Commercial Real Estate Leases Can Rely on Each Other

The first thing to note about commercial leases is that some commercial lease clauses will be heavily contigent on other leases that exist (or don’t exist) at the property overall. This can prevent a property owner from signing leases with certain tenants, or make a tenant’s rent payments contingent on performance, either of the tenant itself or other tenants at the site.

Some retail leases will include what are referred to as “exclusivity” clauses, which grant a tenant the right to be the only occupier at the property that engages in a particular type of business or sells a certain type of merchandise. This can end up being extremely restrictive for the landlord and can also cause issues when cash flow is tight and vacancy is high.

Co-tenancy clauses are also important to look out for on retail deals, which usually allow a tenant to pay either a reduced rental rate or no rent at all for a period of time if another tenant at the property (that they rely on for foot traffic) ends up vacating or “going dark”. This can make what may already be a very difficult financial situation for a property owner even worse, and can ultimately cause a domino effect of rent losses.

However, performance-based rent isn’t always a bad thing for landlords, and percentage rent clauses on retail leases can be a huge benefit to property owners when market conditions are strong.

Instead of reducing the amount of rent a tenant is required to pay, percentage rent clauses allow a property owner to participate in a portion of the sales a tenant generates over a predetermined “breakpoint” amount, which helps align the interests of the owner and the tenant overall.

These are just a few of the most common examples of intricate commercial lease structures, but the key takeaway here is that commercial leases can be very dependent on the performance and the operations of the property as a whole, and it’s important to know exactly how this might come into play within a deal you’re analyzing.

Commercial Leases Include Rent Escalation Schedules

The next thing to keep in mind about commercial leases is that, unlike residential leases that will typically stay flat throughout the entire lease term, commercial leases often include scheduled rent escalations, with base rent changing at predetermined intervals.

Many commercial leases have multi-year terms, with some leases spanning 25, 50, 75 years or more. And as a result of this, the base rent in these leases will almost never stay the same throughout the entire lease term.

And to make sure the details of these increases are made very clear up-front, most commercial leases include what’s referred to as a rent escalation schedule directly within the lease document itself. This schedule will specify exactly what the rent will change to with each individual escalation, and when each of these increases is scheduled to occur.

Sometimes these will include annual percentage increases, sometimes these will include fixed annual dollar amount increases, and sometimes these will include larger, more irregular increases every 5-10 years. In other cases, these increases may be directly tied to changes in the consumer price index (CPI), to protect the property owner against rising costs in an inflationary environment.

Options To Renew

Commercial leases also usually include tenant options to renew, which give a tenant an exclusive option to renew their lease at the end of the lease term, usually in 5-10-year intervals at predetermined rates.

These rates are often based on what’s referred to as “Fair Market Value” (FMV), which represents the rate at which the property owner could re-lease the space when the lease expires (if the tenant were to vacate the property and choose not to exercise their option).

And to make sure the property owner is protected in the case that rental rates drop substantially during the lease term, renewal option rents will also often be calculated as the maximum value between the FMV of the space at the time of renewal, or 90%-95% of the base rent owed in the last year of the lease term.

Commercial Leasing Costs Can Be Massive

Retail, office, and industrial leases often come with two really big lease-up costs that can significantly impact the economics of a deal, which are tenant improvement (TI) allowances and leasing commissions.

TI allowances are funds that are paid from the property owner to the tenant, in order to reimburse the tenant for a portion of the build-out costs required to get the space ready for operation. These are usually used to incentivize a tenant to sign a long-term lease by reducing the up-front capital investment required, and also by showing that the property owner is invested in their success at the site.

TI allowances are often expressed on a dollar per square foot basis, and I’ve seen these range anywhere from $5/SF for very large spaces that don’t need much work to over $100/SF for smaller spaces that need to be almost completely repurposed. And when you start to run the math on these numbers, TI allowances on even a relatively small commercial suite can start to get expensive very, very quickly.

In addition to TI allowances, leasing commissions can also be huge cash outflows for investors, since these are generally based on a percentage of the contractual base rent owed during the entire lease term, and typically owed in just one or two lump sum payments at the beginning of the lease term. And with 10-15-year leases being common in the industry and commission percentages that usually range anywhere from about 3% to 6% of the total contractual base rent of the lease, these costs can often end up being even bigger cash outlays than TI allowances for commercial real estate investors.

When you hear someone in the industry talking about office or retail properties being “capital-intensive”, this is usually what they’re referring to, and understanding both when you’ll have to incur these costs and how much these are likely to be is an extremely important part of underwriting a deal.

Commercial Tenants Often Reimburse Operating Expenses

The last point I want to bring up in this article is related to what happens after a commercial lease is signed, and this is that commercial leases will often call for tenants to be responsible for their pro rata share of some or all of the operating expense load on a commercial property.

Unlike residential leases, which usually only call for tenants to pay their own utility and/or trash bills, commercial leases will often require a tenant to pay a portion of the total operating costs associated with the entire property, usually in relation to the specific percentage of the leasable area that each tenant occupies.

Some of the most common expense reimbursement structures you’ll see in commercial leases include:

  • NNN Stuctures: In these structures, the tenant is responsible for reimbursing the landlord for their pro rata share of all property operating expenses.
  • Modified Gross Structures: In these structures, the tenant is responsible for reimbursing the landlord for their pro rata share of only a certain portion of property operating expenses (for example, only property taxes and insurance).
  • Base Year Stop Structures: In these structures, the tenant is responsible for reimbursing the landlord for their pro rata share of all property operating expenses above a designed “base year” amount.

In most cases, this structure is going to be decided based on standard leasing practices in the specific area the property is located within, with each clause being negotiated on a deal-by-deal basis.

How To Learn More About Commercial Leases

Commercial real estate leases can be very complex, and there are a lot of things to look out for and factor into your underwriting on these types of deals.

And if you want to learn more about commercial lease structures and how to model these in Excel when analyzing and valuing commercial real estate acquisition or development opportunities, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam. This exam covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.

As always, thanks so much for reading, and make sure to check out the Break Into CRE YouTube channel for more content that can help you take the next step in your real estate career.

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