Leasing commercial property is different than leasing residential property because business owners have different needs, rights, and responsibilities than residential tenants.
Renting to a commercial tenant means you’ll likely have a more comprehensive screening process, for one. The negotiations of the lease terms, such as the way you sort out rent, also tend to be more extensive because each agreement will differ based on the tenant, the size of the space, and the tenant’s intent for the property.
In this article, we’ll cover the basics of leasing commercial property, the types of leases, and how costs are divided between landlords and tenants, so that first-time landlords can dive into the commercial real estate market with better understanding.
What Kinds of Property Can You Use a Commercial Lease For?
A
Commercial Lease Agreement is used when a tenant rents out property for the purpose of conducting business activities.
Typically, commercial properties are categorized as:
- Office space
- Retail store
- Restaurant
- Industrial building
- Warehouse
- Multi-use building
Other types of commercial property can include any spaces not intended for residential use, such as self-storage facilities, recreational facilities, gyms, medical clinics, and more. It’s also common, especially in urban centers, to have larger commercial properties with retail spaces and warehouses on the first floor and offices or even apartments occupying the floors above.
What is Commercial Zoning?
Commercial zoning refers to specific zones in a city that are dedicated to properties built for commercial purposes. Zoning laws determine how land and property can be used, and typically these ordinances (or land use regulations) fall under municipal jurisdiction.
City planners can determine how a city is divided into residential, mixed residential-commercial, commercial, and industrial zones. Each zone can have specific limitations as to what kinds of spaces can be built there, their size, their use, and the density of development. Commercial zones often have regulations on noise emissions, parking, and waste management.
For example, a developer looking to build a shopping mall would be limited to building in commercial zones rather than residential, and they might be further constrained by various sub-categories of zones. Perhaps they want to build the mall on a specific street downtown, but if that street is zoned for small retail shops or for lodging use like hotels or condos, they could be prohibited from developing there.
Of course, this information would apply more to a real estate developer or landowner looking to build than to someone purchasing an existing space to lease to commercial tenants. Just be aware of the location of your building and any zoning restrictions it might have when you’re looking over
Commercial Lease Applications during the screening process, because it will affect which tenants you can accept.
What is the Difference Between a Commercial Lease and a Residential Lease?
From a legal standpoint, commercial tenancy can be quite different from residential in a variety of ways, based on how commercial tenancy terms differ from their residential counterparts.
For instance, there is no singular standard for commercial leases. Of course, there are some generic characteristics (which will be discussed in a later section), but the lease terms can be unique for each tenant based on the needs of both the tenant and the landlord. When it comes to tenant-landlord disputes, courts tend to favor the terms set out in the lease agreement, even if those terms are considered unfair or unreasonable by one party. This is also why creating commercial leases tends to take longer than residential ones, and why prospective tenants need to be more diligent when they’re negotiating terms.
Tenants and landlords might need to compromise on terms like who is responsible for utilities, operating costs, and property taxes so the breakdown of costs works for both parties. A lot of discussion between the parties might also center on the special features business owners tend to require in their spaces that residential tenants don’t need.
For example, someone looking to open up a clothing boutique or a corporate office space might require additional power terminals for point-of-sale systems or structured cabling for office-wide telecommunication networks.
Some other things landlords and tenants might discuss include:
- Rent increases
- Renewal and purchase options
- Maintenance schedules
- Insurance details
- Property improvements
- Signing incentives (often in tougher economic times)
The above list comprises things that a landlord would typically discuss with residential tenants as well, but the terms in a commercial lease tend to be more flexible or negotiable based on the needs of different tenants and the different types of commercial properties.
What Types of Commercial Leases Are There?
The types of commercial leases fall on a spectrum due to the flexibility of terms in the lease agreements. However, there are some characteristics, based on two different types of rent payment methods gross or net, which help categorize the types of leases.
Gross Lease
Simply put, in a gross lease (sometimes referred to as a full-service lease), the tenant pays a higher price point for an all-inclusive rent. This means the landlord is responsible for paying most of the costs associated with the operation of the property such as maintenance, insurance, and property taxes.
Of course, some of these expenses depend on the arrangement between the tenant and the landlord. For instance, you might include janitorial services in the rent but limit those services by frequency or type. If a tenant requires daily rather than weekly cleaning, or special services like floor waxing, then you’ll have to discuss a change in the rent price or make them responsible for covering the costs.
In this kind of Commercial Lease Agreement, the tenant’s responsibility extends to paying rent and growing their business, while the landlord retains total responsibility of paying for and maintaining the building.
Modified Gross Lease
A modified gross lease tends to balance responsibilities between the landlord and tenant and is more common in multi-tenant buildings. In this type of arrangement, the tenant pays a lump sum for rent and then various costs directly related to their specific unit, including maintenance, repairs, and utilities, while the landlord pays for other operating costs like common area maintenance, landscaping, and lot care (as well as insurance and property taxes in many cases).
Units in office buildings often operate under this type of lease because it tends to be more fair for all tenants.
For instance, in a building that only has one electric or natural gas meter, the heating bill would be evenly split between all tenants, or they would each pay a proportional share of the bill based on their unit’s square footage.
Net Lease
In a net lease, tenants agree to a lower rent payment while assuming responsibility for some or all of the other "usual" expenses such as utilities, janitorial services, taxes, property insurance, and so on.
The three nets in net leases refer to property tax, property insurance, and property maintenance. These additional expenses can differ from agreement to agreement, and which expenses a tenant takes on depends on the kind of net lease being made.
There are three types of net leases:
- Single Net Lease (N Lease)
- Double Net Lease (NN Lease)
- Triple Net Lease (NNN Lease)
Each type of net lease differs slightly in how "usual costs" are divided between landlord and tenant. With the flexibility of commercial leases, the terms of who pays what can be unique to every agreement, regardless of the parties’ intent to create a specific type of net lease.
Single Net Lease (N Lease)
In a single net lease, the tenant pays rent plus the costs of one net: property tax. In this case, the tenant pays a portion of the building’s property tax based on the proportion of square footage being leased. The landlord typically covers all other building expenses while the tenant pays for utilities and janitorial services.
Double Net Lease (NN Lease)
A double net lease typically requires the tenant to pay base rent and a proportional share of building property tax (like in the single net lease), in addition to property insurance (the second net). The landlord covers structural repairs and maintenance for common areas like building lobbies and bathrooms. The tenant is also usually responsible for covering utility and extra janitorial expenses.
Triple Net Lease (NNN Lease)
This type of net lease places most of the responsibilities on the tenant rather than the landlord. In addition to base rent, the tenant is also responsible for some or all real estate ownership costs. These costs comprise all three nets, i.e. property insurance, property taxes, and property maintenance. The tenant also typically pays for utilities, maintenance, repairs, and operation costs.
In this arrangement, the landlord’s obligation is to provide space and charge the tenant to conduct business out of that space. Virtually every other cost is left to the tenant to sort out.
Triple Net Lease vs. Gross Lease
It’s easier to think of commercial leases as being on a spectrum where on one end the cost-bearing responsibilities are mostly on the tenant, and on the other end, they are mostly on the landlord.
In a gross commercial lease, the tenant pays a higher base rent in order to cover the three nets (property tax, property insurance, and property maintenance), additional rental expenses such as utilities, and the cost of the landlord’s time spent handling administrative duties. An example would be the landlord liaising with an internet company to set up the routers for the tenant and then managing the payment of the bills.
On the other end of the spectrum, a triple net lease puts all of those responsibilities on the tenant. So the tenant will be the one to set up their internet and utilities, handle the bills, obtain insurance, and arrange property maintenance.
The most important thing to consider, regardless of the framework of the lease, is the specific terms of the agreement. Each party should be diligent in reviewing the terms to understand how those terms affect them and negotiate accordingly.
For example, if a tenant runs a barbecue restaurant and uses a lot of natural gas, it might be in the landlord’s best interest to offer a triple net lease where the tenant pays for and handles utilities, and it would be in the tenant’s best interest to have a gross lease where the landlord is responsible for utilities.
The trick in this scenario, and a common aspect of commercial lease negotiations, is to find an acceptable compromise for both parties.
How Does a Tenant Pay Operating and Utility Costs in a Commercial Lease?
To help clarify which party is responsible for which expense, many Commercial Lease Agreements devote specific sections in the terms to properly describe each party’s obligations. There are three common ways to divide utilities and operating costs: tenant pays direct, tenant pays landlord, or landlord pays.
Tenant Pays Direct
The tenant makes payments for the utility or cost (like security, janitorial services, window cleaning, etc.) directly to the provider without going through the landlord.
Tenant Pays Landlord
The tenant pays a share of the building’s costs (typically proportionate to their usage based on their leased square footage) to the landlord. This means if a tenant leases one space in a multi-tenant building, they pay their proportional share, and if one tenant leases an entire building, they pay the entire cost. In this scenario, the landlord facilitates the service through a provider and uses the tenant’s money to pay for it.
For commercial tenants, the landlord will often make yearly estimates for operating costs and either include them in the rent price or split them into a monthly flat fee. Then at the end of the year, the landlord compares the sum paid by the tenant versus the actual costs for the various services and balances them. In other words, if actual costs are higher than estimated, the tenant will owe money at the end of the year, and if the costs are lower, the landlord will refund the tenant.
Landlord Pays
As the title suggests, the other common scenario is for the landlord to cover the expenses, meaning they provide the service directly or handle payments to the supplier or service provider without going through the tenant. Security or garbage disposal costs tend to fall into this category.
However, it should be noted that these types of costs are often worked into the tenant’s rent, including the landlord’s time and trouble handling the logistics of the various services.
How to Calculate Commercial Rent
As with the lease agreements themselves, rent calculations can differ based on the tenant, the business, and the type of property. For instance, a tenant leasing a multi-suite office tower might pay rent based on square footage, while a tenant with a popular clothing store might pay base rent and a percentage of their gross retail income.
Rent per Square Footage
This form of rent is a little more common than the percentage lease model.
The calculation for rent based on square footage is quite simple. You charge a price for each square foot and multiply it by the total square footage of the space to get the annual rent total. Then divide that total by 12 to get your monthly base rent.
For example, if you have a 2,000 square foot office space at $12.50 per square foot, the calculation would be:
2,000 x $12.50 = $25,000
The total ($25,000) would reflect the yearly amount, which you would then divide by 12 to get the monthly base rent:
$25,000 / 12 = $2,083.33
If you’re unsure how much to charge per square foot, ask some business owners in your building’s area how much they charge or ask some tenants renting the same type of space you own how much they pay.
Do your best to stay within the same geographic location when you’re investigating, as prices can fluctuate between neighborhoods.
Percentage Lease
There are a couple of ways to calculate percentage leases. Often a landlord will calculate a base rent that they absolutely need (usually lower than what they would charge based on square footage), and then add a percentage based on total gross retail income or after a certain revenue threshold.
The percentage calculations mentioned above usually look something like this:
Base Rent + Percentage of Income Threshold
For example, let’s say you charge $950 for base rent and then 5% of all revenue receipts over $30,000 (the threshold) per month. If you have a tenant who earns $50,000 one month, their rent would be calculated as follows:
$50,000 – $30,000 = $20,000
$20,000 x 0.05 = $1,000
$1,000 of income percentage + $950 base rent = $1,950 for that month’s rent
Or
Base Rent + Percentage of Total Retail Income
Let’s say base rent is still $950. You then charge 2.5% of the total monthly revenue (the percentage is typically lower than in the first scenario because you’re charging a percentage of all transactions). So in the same $50,000 month, rent would be calculated as follows:
$50,000 x 0.025 = $1,250
$1,250 of income percentage + $950 base rent = $2,200 for that month’s rent
It’s up to you and the prospective tenant to decide which arrangement works best for you. Some tenants prefer a static rent, while others like the idea of a variant rent because it can match up well with their revenues. So if they have a bad sales month, the rent they owe will at least reflect that.
How Long Does a Commercial Lease Last?
Commercial leases don’t have "standard" fixed term lengths like residential leases often have. Much like every other aspect of commercial renting, the duration of the lease is negotiable. However, commercial landlords typically want their leases to have longer terms, usually three, five, or ten years.
Longer leases tend to work well for both the landlord and the tenant because they require a great deal of trust and commitment between the parties. Some tenants don’t like the idea of being locked into a lease for five or ten years, but you can always reassure them that their lease terms can be renegotiated with a
Lease Amendment.
Other Forms for Commercial Landlords
In addition to the lease agreement, there are a few other forms that commercial landlords can benefit from having in their arsenals.
The following is a list of useful forms, some of which you might be familiar with if you’ve already had residential tenants:
Commercial Lease Application: This document is used by landlords or property managers to collect information on potential commercial (or business) tenants before agreeing to lease the property.
Rent Receipt: This simple document provides proof of rent payment. It’s a great way to keep a record of income (for the landlord) and expenditures (for the tenant). Receipts can help settle any disputes over late or partial payments.
Lease Amendment: An amendment details changes made to an existing lease agreement. It demonstrates agreement to specific changes or additions without cancelling or negating the original lease.
Landlord's Consent to Sublease: If a tenant wants to lease their space to a new tenant, they will require the landlord’s permission. This letter grants formal permission to sublet.
It should be noted that landlords can prohibit subletting entirely with a clause in the lease agreement.
Landlord's Consent to Lease Assignment: Sometimes existing tenants can find new viable tenants to take on their lease obligations so they can move out. This letter is a form of written permission allowing the original tenant to transfer those rights and obligations.
Similar to subletting, a landlord can prohibit lease assignments in the lease agreement. Tenants should refer to the terms of their specific lease as a first step to subletting or assigning a lease.
Depending on the lease terms, landlords must provide reasonable notice of certain events like notices of entry, lease violations, or late rent payments.
How to End a Commercial Lease
There are a few ways to end a commercial lease. The first one is for the tenant to remain until the lease term ends, at which time they can either renew the lease or look for tenancy in a different property. Many commercial leases require anywhere from 30 to 90 days’ notice from the tenant if they are choosing not to renew the lease. This gives the landlord time to begin the process of finding a new tenant.
If a tenant wants to end a lease early, things can get a little more complicated. While there are some legally valid reasons for breaking a lease, those laws can vary by state. Therefore, it’s important to know the landlord-tenant laws in your jurisdiction in case a tenant claims their right to leave early. But as long as the lease is intact, your tenant is responsible for paying the rental costs of the space regardless of whether or not they are occupying the space.
However, depending on your state law, you might be legally obligated to mitigate costs by looking for a new tenant. If that’s the case, you can encourage your tenant to help look for a replacement tenant to save them some money. Your tenant might know someone in the market for a new rental or might be able to find someone to sublet the space until a permanent tenant can be found. So long as someone is leasing the space (at the same rent price or higher) for the remainder of the original lease agreement, the original tenant can relieve themselves of the economic consequences of ending a lease early.
It should be noted that subletting or assigning a lease still holds the original tenant liable (i.e. on the hook for rent and other expenses) if the subtenant or assignee cannot fulfill the obligations of the lease.
You can also decide if there’s a satisfactory price for the tenant to buy their way out of the lease. You could ask for a few months’ rent in one lump sum and nullify the lease entirely, and this could buy you time to find a new tenant on your own without having to deal with a tenant who just wants out of the space for whatever reason (e.g. maybe their business has outgrown the space, or perhaps they just no longer like the location).
In such cases, you can use a
Termination Agreement to address any outstanding obligations of the parties before terminating the contract.
Commercial Lease Negotiations
Commercial leases are more complex than residential leases because of how flexible they can be. Regardless of the type of lease you’re planning on contracting with a tenant (e.g. gross, modified gross, triple net, etc.), the specific terms of the lease are what’s important.
Be sure that you are clear with the expectations of your tenant and your respective responsibilities, but also don’t forget to take your potential tenant’s needs into account. The best type of commercial lease is one that works for both landlord and tenant because renting is always a better experience when the relationship between the parties is balanced.
