A new business enterprise seeking to lease space is often faced with a dizzying array of considerations, both strategic and operational — Where to locate? How much square footage is needed? For how long a term?
Once an office or other space is provisionally selected, the business owner must negotiate deal terms with its landlord and finalize a lease agreement. Generally, a lease’s “economics” —the rent and other financial obligations imposed on the tenant — are crucial considerations for a business owner.
Historically, a business lease was often referred to as either a “gross lease” or a “net lease”. In a traditional gross lease, tenant pays a fixed rental, and landlord pays all expenses of the leased premises—including utilities, operating expenses, taxes and insurance. Conversely, in a traditional net lease, tenant pays a minimum or base rent as well as other property-related expenses.
These descriptions have the virtue of simplicity. However, most contemporary leases don’t wholly fit into either category.
Although a contemporary arrangement may be colloquially referred as a gross lease, a landlord may nevertheless expect tenant to directly pay utilities separately metered to its suite. It’s also not uncommon for the landlord to want the tenant to cover increases in taxes and operating expenses over a predetermined base year (a so-called “modified gross lease”).
In an arrangement generally designated as a net lease, the parties may nonetheless agree that landlord rather than tenant will pay for certain major repairs and improvement costs, or that tenant’s obligation for certain items (such as operating expenses) will be capped annually based on a formula.
Where a tenant rents space in a multi-tenant property under a net lease, the tenant will usually only expect to pay a pro rata share of operating and other expenses. However, if tenant will have the exclusive right to certain parts of the property (e.g., a truck bay or parking lot), or special signage rights, landlord may require tenant to cover the specific costs relating to those elements.
Further, where a landlord agrees to install modifications or improvements to satisfy a tenant needs, the cost of the improvements are usually the subject of a separate negotiation and agreement irrespective of the basic lease form.
A landlord sometimes initiates negotiation of a new lease by issuing a term sheet outlining proposed terms. From the tenant’s perspective, the term sheet is a good shorthand way to see if there’s sufficient agreement on basic deal points to continue discussions. However, the tenant shouldn’t assume the term sheet lists all the important lease terms— or even all the important economic terms. Further, a term sheet (or, where used, a letter of intent) is typically not legally binding. The parties’ contract for lease of the space is only set forth in a formal, signed lease agreement.
For a fledgling business, leasing space is often a significant financial undertaking. If the business is just ramping up operations, or if its revenue stream is unpredictable, discipline and planning may be necessary for the tenant to timely satisfy its base monthly rent over the lease term.
Where the lease entitles landlord to charge tenant additional amounts periodically for, for example, increases in operating expenses or major repairs, it’s only prudent for the business tenant to prepare for that possibility. A good understanding of the lease’s economic terms is essential to do that.
Lease agreements are necessarily lengthy and comprehensive documents. A business owner will be well served to thoughtfully review its proposed lease agreement, and to seek legal assistance to review and negotiate the terms where appropriate, before entering into a business lease arrangement.
For more information about this please contact Kemp Klein.