From a legal perspective, the basic requirements that a commercial lease must contain are as follows: an identification of the parties to the lease, the legal description and identification of which portion of the property is being leased, the rental amount, and the lease term. Although these are the only strictly necessary provisions of a lease, virtually all commercial leases are much more comprehensive. This article outlines five of the key points you need to look for when drafting or negotiating a commercial lease:
- The Rental Amount – While this may seem like a straightforward term that would be easy to identify, many commercial leases require the payment of rent based on a number of factors and sometimes a complex calculation or formula. Most commercial leases can be characterized into one of three groups based on how payment of rent is required:
a. Some leases simply require the payment of base monthly rent, which is a set dollar amount that is specifically identified in the lease. This type of lease is called a “gross lease” and typically requires the landlord to be responsible for payment of the property taxes, insurance, and property maintenance, while the tenant is typically only responsible for the base rent each month. A gross lease can be very favorable to a tenant who values being able to budget its expenses and needs certainty as to how much rent will be paid each month.
b. Many commercial leases require the tenant to pay some or all of the landlord’s expenses in operating the property, including property taxes, insurance, and property maintenance. This type of a lease is called a “net lease” and in cases where a tenant is responsible for all of the landlord’s costs of operating the property, the lease may be referred to as a “triple net lease.” A triple net lease can be very favorable to a landlord who desires to budget its cash flow and net operating income, which are necessary to accurately value a rental property. Triple net leases are also attractive to landlords who want to be “hands off” and leave all the maintenance responsibilities to the tenant.
c. A third type of commercial lease requires payment of a base monthly rent, plus a percentage of the tenant’s business sales or revenue. This type of lease is called a “percentage lease” and is typically used for retail businesses. Percentage leases may be beneficial for a tenant starting a new business that wants to maintain a low base rent until the business takes off. If the business does well, the landlord and the tenant both reap the benefits of the percentage lease and both parties are motivated to keep the property well maintained.
As set forth above, the calculation of a tenant’s financial obligations under a commercial lease is not always as simple as looking at the base monthly rent. Most commercial leases require tenants to pay some form of additional rent, which could be reimbursement for property taxes, insurance, property maintenance (sometimes referred to as common area maintenance or “CAM Charges”), and utilities. In addition to carefully reviewing and negotiating the rental terms of a commercial lease, it is important to review and negotiate the terms of any personal guarantee that the landlord requires as a condition to signing the lease. Take a look at a more detailed discussion of personal guarantees in a commercial lease.
- Relocation and Expansion – A common provision in many commercial leases provides the landlord with the right to relocate the tenant to another space in the same building. For landlords, this provision is important to ensure that sufficient lease space can be offered to large tenants who may demand an entire floor (or floors) of the same building. Although these provisions typically require the landlord to pay for the costs of relocating the tenant to the new location, being forced to move your business after years of operation can be a huge distraction and can confuse customers. While some landlords may not refuse to remove this provision entirely, tenants should at least negotiate to minimize the potential effects of such a provision, such as limiting the landlord’s right to relocate the tenant to the first certain number of years of the lease and requiring the landlord to pay for the costs of the relocation and the buildout of the new space.
When negotiating a relocation clause, a tenant may also wish to negotiate the right of first refusal or an option to expand into adjacent vacant space within the building. This can be particularly important to new businesses who are hoping to expand at some point in the future, but may not want to take on the financial responsibility of a large lease right away. Negotiating an option or right of first refusal to rent additional space can be very valuable for a tenant and should be done at the outset of the lease negotiations before the vacancies in the building are filled by other tenants.
- Exclusives – When negotiating a commercial lease in a shopping center or large retail building, tenants should consider asking for an exclusive use provision. An exclusive use provision (often referred to simply as an exclusive) is a clause that prohibits a landlord from allowing any other tenants in the same building (or any other buildings owned by landlord within a certain radius) from renting space to operate a business that is competitive with the tenant’s business. For example, if a “mom and pop” drug store is leasing space in a large shopping center, the tenant may want to protect itself from the risk that a large national pharmacy could later rent space in the same center and effectively shut down the smaller family owned business. Some landlords may flat out refuse to grant an exclusive in fear that they may lose a more attractive tenant in the future. However, many landlords will offer an exclusive (or a limited exclusive) in exchange for a higher base rental rate. While no tenant wants to pay more for the lease than they have to, this is a business decision that must be made by the tenant as the failure to obtain an exclusive could potentially be devastating in the future. Exclusives must also be carefully drafted to avoid ambiguity and clearly identify which types of businesses are being prohibited. A poorly drafted exclusive provision can lead to litigation and disputes which can be difficult to settle once a new tenant has already signed a lease, completed a buildout, and/or opened up their business.
- Options – Negotiating a long-term lease has pros and cons to both the landlord and the tenant. From a landlord’s perspective, a long-term lease from a dependable and financially stable tenant means the landlord will not have to worry about filling vacancy, pursuing a tenant for unpaid rent, and allows the landlord to project its income years down the line, which may be important when refinancing or selling the property. From a tenant’s perspective, a long-term lease can be attractive when a substantial investment has been made in the business and relocation would be disruptive to the business. Regardless of how long the initial term of the lease is, that term will eventually expire.
One of the most important terms to consider when negotiating a commercial lease on behalf of a tenant is an option to renew. An option is a right granted to a tenant which allows the tenant the “option” to renew a lease for an additional term (for example 5 additional years following the expiration of the initial term). In many cases, the base rent during an option period is explicitly set forth in the original lease. Options are typically viewed as a benefit to the tenant since the tenant controls whether or not the option is exercised or not. If the market rent has increased in the area and the tenant wants to stay in the building, the tenant will likely exercise the option to renew at the set price which is below-market. However, if the market rent in the area has gone down, and the rental rate in the option period is above-market, the tenant may decline the option and look elsewhere for space or renegotiate a cheaper term with the landlord.
While options are generally viewed as a benefit to the tenant, landlords can put limitations in place to protect themselves if they are agreeing to grant a tenant an option. If a landlord is concerned about being locked into a below-market lease during an option period, the lease could be drafted to set the rental rate by certain market specific objective data. In addition, most options require the tenant to provide the landlord with written notice of the exercise of the option within a very specific period of time, for example at least 90 days prior to the expiration of the current lease term. Setting a time period for notice to be provided can be important to provide a landlord sufficient time to show the building and locate a new tenant if the option is not renewed. It is critical that tenants comply with the time requirements for providing notice to exercise an option, otherwise the tenant runs the risk of declining the option. Here is a more detailed discussion of options in commercial lease.
- Attorney’s Fees, Jury Trial Waivers, and Counterclaim Waivers – Under Michigan law, residential leases are subject to many more requirements than commercial leases. Under Michigan’s Truth in Renting Act, a residential lease agreement may not include a provision whereby a party waives their right to a jury trial (see MCL 554.633(1)(f)) and may not include a provision whereby a party is liable for legal costs or attorney’s fees in connection with a dispute in excess of the amount permitted by statute (see MCL 554.633(1)(g)), which is currently a maximum of $150.00 under MCL 600.5759. Similarly, Michigan’s Landlord and Tenant Relationships Act prohibits a landlord from taking a security deposit in excess of one and one-half months’ rent (see MCL 554.602). These limitations are in place to protect residential tenants who may be unsophisticated and lack the financial means to hire an attorney to negotiate or review their leases.
None of these requirements apply to commercial leases. As such, it is much more common for commercial leases to include provisions that permit the landlord to recover attorney’s fees and court costs arising out of a default by the tenant, provisions that require tenants to waive their right to a jury trial, and provisions that require tenants to waive the right to assert any counterclaim against the landlord in the event the landlord takes legal action to evict the tenant. From a tenant’s perspective, it is important to be aware of these provisions and try to negotiate or limit their scope to the greatest extent possible. For example, with an attorney fee provision, a tenant should ask that the attorney fee provision be two-sided and only permit the recovery of attorney’s fees to a prevailing party in litigation. Sophisticated landlords will rarely, if ever, agree to remove a provision requiring the tenant to waive their right to a jury trial, but less experienced landlords may underestimate the importance of such a clause. The same can be said for the provision requiring a tenant to waive its right to assert a counterclaim in litigation filed by the landlord. At a bare minimum, the tenant should make sure that the provision states that the counterclaim is not barred by way of a separate action and that the tenant has the right to file the counterclaim if it would be barred if not filed in response to the landlord’s lawsuit.
As set forth above, commercial leases are much more complex than an ordinary residential lease. It is not uncommon for commercial leases to exceed 30 pages and include many provisions that are prohibited or simply uncommon in the residential setting. The above 5 items are merely a sampling of some of the most important things to look for when negotiating a commercial lease. There are many other important provisions to be aware of and to negotiate, such as a detailed explanation of who is responsible for maintaining/repairing certain aspects of the building, tenant improvement allowances, the events of default and the landlord’s rights upon a tenant default, parking issues, signage issues, and requiring tenants to provide financial statements and estoppel certificates. Whether you are a landlord or a tenant, you should retain experienced legal counsel to protect your interest when negotiating a commercial lease.
Brandan A. Hallaq is an attorney with Hirzel Law, PLC where he litigates cases involving defective construction, contract disputes, shareholder/member disputes, quiet title actions to determine interests in property, enforcement of restrictive covenants, real estate foreclosure actions, and bankruptcy matters representing creditors. Mr. Hallaq is also a licensed Real Estate Broker in the State of Michigan and leads the real estate transactions department at Hirzel Law, PLC where he negotiates and prepares the necessary documents for business and real estate transactions, including purchase agreements, franchise agreements, loan/financing documents, and commercial and residential leases and mortgages. In each year from 2018 through 2021, he has been recognized as a Rising Star in the area of real estate law by Super Lawyers Magazine, a designation that is given to no more than 2.5% of the attorneys in the State of Michigan each year. He was also recognized as a 2020 Up & Coming Lawyer by Michigan Lawyer’s Weekly, an award given to no more than 30 attorneys in the state each year, and he was recognized in the inaugural issue of the 2021 Best Lawyers in America: “Ones to Watch” list for professional excellence in real estate law. Mr. Hallaq obtained his Juris Doctor degree, cum laude, from Wayne State University Law School where he served as an editor on the Wayne Law Review. Prior to joining Hirzel Law, PLC, Mr. Hallaq worked for a Federal Judge and in a Fortune 500 corporation’s in-house legal department. He can be reached at (248) 480-8704 or at email@example.com.