Leasing Commercial Real Estate? Read This First!

In the world of commercial real estate, understanding how to calculate commercial rent can appear as a complex puzzle with several moving pieces. Each lease comes with its own set of variables, from understanding square footage to recognizing different lease structures. The goal of this Brief is to simplify this process, providing you with the tools to understand and navigate these complexities with ease.

Commercial Real Estate Terminology

Just like any specialized industry, commercial real estate is replete with its own terminologies. Phrases such as "triple net" or "cap rate" may seem alien if you're a newcomer. For instance, when a property owner quotes a property price as "$32.00 per foot, triple net", it can be baffling. Many often wonder: why not just state the total monthly rent?

However, there's a rationale behind the per-square-foot basis. Often, commercial spaces undergo divisions or combinations, and the per-square-foot pricing allows professionals to quickly compare rent prices across various properties, providing a clearer picture of the property's size and the components of the base rent.

Crunching the Numbers: Rent By Square Footage

In many places, commercial rents are typically quoted on an annual basis, while some markets may provide monthly quotes. To break down the calculation:

Price Per Square Foot×Total Square Feet=Total Annual Rental RatePrice Per Square Foot×Total Square Feet=Total Annual Rental Rate

For a property quoted at $32.00 per foot and having 3,000 square feet, the math would be:

$32.00/sq. ft. \times 3,000 sq. ft. = $96,000

Dividing this by twelve, the monthly rental would be $8,000. However, factors can complicate this seemingly straightforward calculation.

Decoding Square Footage: Usable vs. Rentable

Commercial properties can offer prices based on Usable Square Footage (USF) or Rentable Square Footage (RSF). While USF refers to the exclusive space a tenant can use, RSF includes common areas accessible to all tenants. The RSF is derived by accounting for shared spaces and then dividing it by the property's total area. Typically, RSF is more commonly applied in office buildings, whereas retail tenants, especially those not in indoor malls, often deal with USF.

Lease Structures: The Pillars of Commercial Rent

Commercial deals are nuanced and diverse. There are four predominant types of commercial lease structures:

1. Full-Service or Gross Lease:

• Definition: In a gross lease, the landlord pays most of the building's expenses, including property taxes, insurance, and maintenance. The tenant only pays the rent.
• Pros for Tenants: Tenants have predictable monthly expenses as they only pay the stipulated rent.
• Cons for Tenants: Rent might be higher to compensate for the building expenses the landlord is covering.

2. Net Lease:

• Definition: In a net lease, the tenant is responsible for the rent as well as some of the property costs. There are three primary types of net leases:

1. Single Net Lease (N): Tenants pay rent plus one additional expense—often property taxes.
2. Double Net Lease (NN): Tenants pay rent plus two additional expenses—typically property taxes and building insurance.
3. Triple Net Lease (NNN): Tenants pay rent plus all three primary expenses—property taxes, building insurance, and maintenance.

• Pros for Tenants: Base rent can be lower since they're shouldering some of the property's expenses.
• Cons for Tenants: The tenant's monthly expenses can fluctuate based on the variable costs they are responsible for.

3. Modified Gross Lease:

• Definition: This is a blend of the gross and net leases. Tenants pay base rent and some (but not all) of the building's additional expenses. Which expenses are covered by whom is negotiable.
• Pros for Tenants: More flexibility and the potential to negotiate which expenses they're responsible for.
• Cons for Tenants: Potential for some variability in monthly expenses, although not as much as a net lease.

4. Percentage Lease:

• Definition: In a percentage lease, tenants pay a base rent plus a percentage of their monthly sales. This type of lease is common in retail, especially shopping centers and malls.
• Pros for Tenants: If sales are low, rent decreases, which can be beneficial in downtimes.
• Cons for Tenants: During high-sales periods, the rent can significantly increase.

When negotiating a commercial lease, it's crucial for both landlords and tenants to clearly understand the terms and the potential risks and rewards associated with each lease type. It's also beneficial for both parties to be represented by legal counsel or a commercial real estate professional to ensure they're getting a fair deal.

Lease Clauses: Fine-Tuning the Agreement

While commercial leases can be exhaustive, certain clauses warrant special attention:

• Sublease Clause: Allows tenants to lease a portion of their space to another party, usually with the landlord's consent.
• Exclusive Right: A protective clause, especially in retail, ensuring a tenant remains the only provider of a particular service or product in the vicinity.
• Rent Escalation: Details the potential increase in rent over the years.

Understanding Delivery Conditions

When a commercial space is leased, the terms under which the space is handed over from the landlord to the tenant are known as "delivery conditions". These are important as they define the state of the property at the time of possession. Here are some common delivery conditions:

1. As-Is Condition: This means the property is handed over in its current state at the time of signing the lease, with all its existing flaws and merits. It's imperative for tenants to inspect the premises beforehand so they are aware of what they are committing to.
2. Broom-Clean Condition: The space is emptied of all debris, personal property, and generally cleaned up, but not necessarily renovated or repaired. It's basically ready for a tenant to move in, but might not be refurbished.
3. Shell Condition (or Vanilla Shell, Cold Shell): This typically means that the space is delivered without any interior improvements or finishes. The floor is raw, there might be no interior walls, no finished ceiling apart from a basic slab, and sometimes, no electrical or HVAC systems. It's a blank canvas for tenants.
4. Warm Shell: It's a step up from the cold shell. While there are still no final finishes, basic utilities like electrical and HVAC might be present. It's somewhere between a completely raw space and a fully finished one.
5. Turnkey: This is a fully finished space, ready for business operations. The landlord provides all the necessary fittings, finishes, and fixtures based on specifications agreed upon with the tenant. Once delivered, the tenant can "turn the key" and start operating immediately.

Tenant Improvement Allowance (TI)

Tenant Improvement Allowance refers to the amount a landlord is willing to contribute towards modifications or improvements to the leased space to make it suitable for the tenant's use. TIs can cover a range of improvements, from basic fixtures to more extensive renovations.

Here's a breakdown of its aspects:

• Agreement & Limit: Typically, the TI is agreed upon during lease negotiations. It can be a fixed sum or calculated based on a per-square-foot basis.
• Disbursement: The way the allowance is disbursed can vary. Sometimes the landlord directly pays contractors; in other cases, the tenant pays initially and then gets reimbursed.
• Above and Beyond: If a tenant's improvements exceed the TI, typically, the tenant would be responsible for covering the additional costs.
• Unused Allowance: Depending on the lease agreement, if the full TI isn't used, the tenant might not get to keep the difference. Alternatively, some leases might allow for unused portions to be applied to rent or other costs.
• Amortization: Sometimes, landlords might increase the monthly rent to recoup the TI over the term of the lease. This would mean the tenant is essentially paying back the TI over time.

1. Understanding both delivery conditions and the nuances of TI is crucial for tenants and landlords in order to strike a beneficial agreement. Always engage with an experienced commercial real estate professional or attorney when navigating these terms.

In conclusion, while commercial rent calculations may initially appear daunting, breaking it down step-by-step can make the process more comprehensible. Remember, it's not just about understanding numbers but also understanding the value and potential of the space you're looking to occupy. Armed with this knowledge, you're not just renting a space; you're making an informed investment in your business's future.

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