Commercial lease basics for small business owners

For most new small businesses, it’s hard enough to raise the capital needed to pay for inventory, tools, initial wages, equipment and cash flow through break-even, let alone the funds to build a facility from scratch or to re-purpose an existing building to meet your needs. And so most new businesses start out in leased facilities.

As always, there’s good and bad news. The good news is that in most times and markets, there is a substantial inventory of existing commercial real estate in need of tenants just like you! The bad news is that negotiating a commercial real estate (“CRE”) lease is challenging. CRE leases differ in important ways from residential leases. First of all, there are many types of CRE leases. Each type results in a different allocation of risks and benefits between the landlord and you. Here are the most common:

Gross Leases. If you’ve ever leased a home or apartment, you’re familiar with a “gross lease.” Under a Gross Lease, the rent you pay covers all of the landlord’s costs (upkeep, repairs, insurance, land taxes, etc.) as well as his profit on the property you occupy.  

Net Leases. Net Leases begin with a basic rental payment just like a Gross Lease, but with a twist. Each of the three common types of Net Lease transfers an increasing amount of liability and risk from the landlord to your business. In a Single Net lease, in addition to the base rent, your business is responsible for paying a percentage share of the real property taxes on the building proportionate to how much of the building you lease. A Double Net lease makes your business further responsible for a share of basic insurance on the building, including fire, general liability, etc. A Triple Net lease adds a proportional share of the cost of the necessary maintenance and upkeep of the property (without necessarily giving you a voice in deciding what is necessary).

Participation Leases. Participation Leases, also sometimes called “Percentage Leases,” represent a whole new level of involvement of the landlord in your business. With a Participation Lease, in addition to collecting the monthly base rent and possibly other fees and charges, the landlord is entitled to a percentage of the monthly sales you generate from business conducted on the leased premises. Note that this payment is usually based on your gross sales, not your net income.

As with every other aspect of business ownership, CRE lease negotiation requires knowledge and skill on your part as the owner. It is your job to:

1) Evaluate your business needs. Carefully analyze the square footage of floor space that each component of your business requires. Understand the flow and movement of people and goods throughout the space. How does the new space advance your business goals? How long do you expect to need the space? If you have a detailed Business Plan, it will be invaluable in figuring out your needs. If you don’t have a Business Plan, you’re not ready to sign a CRE lease! Develop a sound, comprehensive Business Plan, then think about leasing space.

2) Research the building and the surroundings. How suitable is the space? What’s the landlord’s reputation? Is the tenant mix compatible with your business? Are they competitors? Is there synergy between you and other tenants? Is there adequate parking? 

3) Involve a real estate lawyer. Always get a real estate attorney’s opinion on the lease before you sign it. Leases can be tricky and misunderstandings can be costly, so use a real estate attorney, not Uncle Fred who writes wills and trusts for a living. Legal services are a one-time cost with long-term consequences. You must understand all the terms and conditions of your lease. Be sure you understand what happens if the building is sold, a payment is missed, you wish to sub-let or extend the lease, economic conditions change, etc.   

4) Understand the costs and risks. Carefully review every single provision of the lease, and understand how it affects the profitability of your business. Task your attorney with this as part of his review. Compare these costs to your Business Plan’s projections. Update your Business Plan and P&L, and verify that the all-inclusive costs of your CRE are affordable. Know what each lease provision means and what you are potentially responsible for. What are your rights regarding early termination and extension? Is there a competitor clause? Are there inducements for signing, e.g. one or more months’ free rent, cost-sharing for improvements? Are you required to provide a personal guarantee?

5) Know what you can afford. How much can your business reliably afford to pay under a CRE lease — month in, month out? Your best and only reliable guide to this is your pro-forma Profit & Loss (“P&L”) statement. If you don’t have a pro-forma P&L covering at least the first full year of the proposed lease, you’re not ready to sign a CRE lease! 

6) Get additional professional help as needed. In addition to a real estate attorney, you might involve a real estate broker, leasing agent, insurance agent, tax and accounting professional, etc. The amount of help you need depends on the complexity of the lease as well as your skill and experience. 

7) Finally, take your time. A CRE lease is a major expense and a long-term commitment. Don’t be rushed. Take the time to get expert advice, as well as the time it takes to understand and evaluate that advice. Good luck!

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Linden Burzell is a business coach at the Idaho Small Business Development Center located at North Idaho College. The NISBDC offers resources and training, no-cost business coaching, and serves the five northern counties of Idaho. Its mission is to accelerate business in the community through business resources, training and no-cost one-on-one coaching in leadership development, strategic planning, financial management and more. Reach us at 208-665-5085 or visit nisbdc.com.