A lease is a contract between an owner and a user of property. In business lease agreements, the owner (lessor) receives financial compensation and in exchange, the tenant (lessee) is given the right to operate his or her business on the property. There are many different types of property lease arrangements and many different considerations that business owners should weigh before entering into such a contract. But leasing is very popular with small business owners: such arrangements allow new or financially-strapped businesses to divert their capital to other business needs. Indeed, many small businesses operate in leased facilities for their entire existence. Leasing property, of course, may itself be a small business activity.
TYPES OF PROPERTY LEASES
This type of lease is used primarily in multi-tenant office buildings. In essence, lessees who agree to such arrangements pay a single lump sum for a wide range of supplementary services in addition to the lease payment. Under the terms of full-service leases, the landlord is responsible for providing a number of different services for his or her tenants, including security, maintenance, janitorial, and various utilities (water, electricity, air conditioning, heat).
Under the terms of a gross lease contract, the lessee pays the lessor a gross amount for rent (as well as sales tax when applicable). Property costs such as property taxes, insurance, and maintenance are the landlord's responsibility; the tenant is responsible for utilities. Sometimes the lease contract will include provisions that require the tenant to cover property costs that go over a certain specified level.
Variations of this basic lease arrangement include the flat lease and the step lease. The flat lease is the most basic type of agreement and generally the most popular with small businesses. It calls for the lessee to pay a flat set price for a specific period of time. The step lease, on the other hand, calls for a gradual escalation of the base rent payment over time in recognition of the likely rise in owner expenses in such areas as taxes, insurance premiums, and maintenance. A related lease contract, usually known as the cost-of-living lease, includes rent increases based on general inflation figures rather than increases in specific expenses.
The net lease is the most ubiquitous of the various lease contract types. Under the terms of a net lease, the tenant pays the landlord a base rent plus an additional sum that covers the tenant's share of property taxes. When taxes increase, it is the tenant's responsibility to cover those costs. The obligations of each tenant are figured by determining what percentage of the total facility is occupied by each tenant; thus a tenant occupying 20 percent of the facility pays 20 percent of the increase.
Variations of the basic net lease include the "double-net" and "triple-net" lease. Under a double-net lease, the tenant is responsible for picking up added insurance premiums as well as tax increases; under triple-net leases, tenants are responsible for covering insurance premiums, tax increases, and costs associated with maintenance and/or repairs of the building, the parking lot, and other areas used by the lessee. The triple-net lease is popular with landlords for obvious reasons; small business owners should note that such arrangements sometimes make landlords less attentive to upkeep in these areas than they might be if they had to foot the bill themselves.
This arrangement calls for tenants to pay a base rent and/or a percentage of the lessee's gross revenue. This percentage, which can run as high as 10-12 percent in some contracts, is paid on an annual, semiannual, or quarterly basis (some malls and shopping centers, however, call for even more frequent payments). This arrangement is a favorite of lessors with property in coveted retail areas; tenants are less favorably inclined, but the laws of supply and demand often make it possible for owners of desirable property to insist on it. Small business owners should fully understand what the contract defines as "gross revenue." "Be specific in how you define gross sales," wrote Fred Steingold in Legal Guide for Starting & Running a Small Business. "Depending on your type of business, certain items should be deducted from gross sales before the percentage rent is determined. Here are some possibilities:
- returned merchandise
- charges you make for delivery and installation
- sales from vending machines
- refundable deposits
- catalog or mail-order sales
- sales tax
In short, make sure your lease excludes all items that overstate your sales from the location you're renting."
ADVANTAGES AND DISADVANTAGES OF LEASING
The Small Business Administration (SBA) counsels small business owners to consider a variety of factors when weighing whether to lease or buy property. These considerations include:
- Operating requirements—if the business's operating requirements are expected to change significantly over the next several years, leasing would probably be preferable, since it allows businesses to move more easily.
- Capital supply and capital needs—leasing frees up a greater percentage of a small business's capital for other operating needs (advertising, production, equipment, payroll, etc.). If the business does not have a lot of extra cash on hand (and few small businesses do), then leasing may be the more sensible choice. This is probably the biggest reason why small companies lease.
- Financing and payment flexibility—It is generally easier to secure financing to lease rather than purchase a property. In addition, leases can be spread out over longer periods than loans and can be structured to compensate for cash flow variations (the latter can be an important factor for seasonal businesses).
- Resale value—Is the value of the property likely to increase? If so, how much? Many small business owners choose to purchase rather than lease—even if they have to accrue significant debt—if they decide that the asset is a worthwhile long-term investment.
- Equipment—Many lease agreements include stipulations that provide lessees with increased flexibility in terms of upgrading and/or maintaining equipment.
- Taxes—Property owners enjoy tax benefits such as depreciation and investment tax credits that are not open to tenants.
OTHER LEASE TERMS
In addition, there are other elements of a lease agreement that can weigh heavily on a contract's overall acceptability. Details of lease contracts can vary enormously. "In theory," noted Steingold, "all terms of a lease are negotiable. Just how far you can negotiate, however, depends on economic conditions. If desirable properties are close to full occupancy in your city, landlords may not be willing to negotiate with you over price or other major lease terms. On the other hand, in many parts of the country where commercial space has been over-built, landlords are eager to bargain with small businesses to fill empty units."
Leases typically cover any remodeling that needs to be done to the property and specify who will pay for it. Most such work falls under the category of "leasehold improvements": carpeting, insulation, plumbing and electrical wiring, lighting, windows, ceiling tiles, sprinkler and security systems, and heating and air conditioning systems. The lease should specify each improvement and when they will be made—ideally before move-in. A landlord will be more willing to make such improvements if the lease duration is long and/or the space taken is substantial, and the improvements are general in nature. However, as Steingold noted, "if you [the small business owner] have specialized needs—for example, you're running a photo lab or a dance studio—and your darkroom or hardwood floor would be of limited value to most future tenants, don't expect the landlord to willingly pick up the costs of the improvements. The landlord may even want to charge you something to cover the cost of remodeling the space after you leave." Some leases provide tenants with the option of making improvements themselves provided that they adhere to certain guidelines and restrictions.
Length of Lease
Negotiations between tenants and landlords often snag on the question of lease length unless the small business owner has a clear picture of the future. Lessors normally want long leases, lessees short leases with rights of renewal. Generally, small business owners try to secure leases with mid-range lengths. Leases of less than a year can leave them more vulnerable than they would like, but multi-year terms can be dangerous as well, especially if the business is new and unproven. A common compromise is to include an "option clause" in the contract so that the lessee can stay if he or she wishes at the conclusion of the original lease period.
Many small business owners quite reasonably insist that any lease agreement they sign contain what is commonly known as an "exclusivity clause." This clause provides the tenant with an exclusive right to sell his or her product or service on the property, obliging the lessor to prevent such sales by other tenants.
Landlords often ask lessees to secure insurance in the event that 1) the tenant damages the leased property, or 2) customers or others suffer injuries on the premises. Such clauses may be absent if the space rented is strictly for office use. When insurance is required by the tenant, the landlord frequently sets the amount.
Use of Premises
Shopping center/strip mall landlords typically include language in the lease contract providing specific details on approved uses of the premises that are being rented. Such stipulations often serve to protect the businesses of other tenants. For example, the owner of a cafe in a strip mall may be quite unhappy if his neighbor, who formerly ran a quiet sports memorabilia shop, decides to change gears and launch a tattoo parlor.
In addition, lease contracts provide stipulations and regulations on many other issues of interest to both lessors and lessees. These include:
- Signage (regulates the size, style, and brightness of tenant advertising signs)
- Compliance with various zoning laws, permits, and restrictions on use of space
- Compliance with other local, state, and federal laws
- Subletting or assigning the lease
- Definition of the space being leased
- Security deposit
- Landlord's right to enter leased space
- Relocation (wherein the landlord relocates a tenant to another space because of remodeling or expansion by a neighboring tenant)
- Default provisions
- Hours of operation
- Incidents of damage or destruction from natural causes
- Indemnification provisions
- Abandonment (by the tenant, either through outright abandonment, diminished hours of operation, etc.)
- Condemnation (cases where all or part of the property is taken by city, county, state, or federal government for other use, such as road, right-of-way, or utility easement)
- Bailout clauses (in the event of catastrophic developments—tornadoes, riots, wars, floods, droughts, etc.)
- Cotenancy clauses (allows the business owner to break the lease if an anchor store closes or moves)
- Recapture clauses (also known as a cancellation clause, this allows landlords to evict tenants for breach of contract if the tenant is unable to meet minimum rent requirements)
CHOOSING BETWEEN EXISTING AND PLANNED BUILDINGS
Most start-up businesses move into already existing facilities. Many small business owners with the means to do so choose new facilities for the features or the prestige and take out leases while the facility is still in its planning stages. The savvy small business owner will consider the potential benefits and drawbacks of both choices before deciding. "Leasing in an existing building provides the Lessee … with more [knowledge about the place] at the time new space is occupied than any other facility option," said Wadman Daly in Relocating Your Workplace. "More so than in any other circumstances, the [lessee] is in a position to closely inspect both the facility and the terms of proposed leases in a number of competing locations. However, the nature of the lease in an existing building signifies minimum tenant control over the potential variables in either lease or facility. Rental rates, maintenance and escalation costs, utilities and building features are fixed or relatively non-negotiable. Landlords may vary in their abatements and finish-to-suit clauses, however their basic price structure, like that of the building and mechanical systems, remains unchanged. Of course, there are no investor implications with this option."
But Daly cautions that leasing in a planned building contains its own mix of attractive features and uncertainties: "Building features [in a planned building] will be new, up-to-date and, to a certain minimal extent, capable of adjustment to tenant need. If your lease is important enough to the developer, you may receive some attention when it comes to special requests for identification, parking, security, a prime location in the building, etc." Nonetheless, small business owners should be cautious when approaching such leases, for both the final appearance and utility of the building—as well as its costs—remain unseen and untested when the building is in its planning stages. "Proposed rental rates must be examined in the light of comparable projects with similar advantages," Daly wrote. "Descriptions of less obvious features like parking, air handling systems, security, maintenance, etc., should be clear and complete. The track record of the developer making the offer should be inspected carefully. Is there a history of quality construction at the rental rate asked, or one of build for quick re-sale? Is there a reputation for good maintenance or benign neglect? Regardless [of] the size of the lease or the duration of the proposed tenancy, these and related questions should be probed."
PROPERTY LEASING AS A BUSINESS
Buying, holding, and leasing property is also a common small business practice. It may begin modestly when a couple has difficulty selling a residence and chooses instead to rent it out. Then, with experience gained, they expand the activity business by buying, restoring, and leasing other properties. The small business owner, now a lessor, will be guided by those principles which favor the lessor, already indicated above. Leasing commercial property is sometimes the start and sometimes the culmination of such ventures. While most of the fundamentals of leasing are well-established and traditional, innovation is still possible in marketing such properties. An example is reported by Brandice Armstrong, writing in the Journal Record (Oklahoma City). Armstrong writes about the success of an Oklahoma City couple engaged in home and commercial leasing in leasing a commercial building. The owners hit upon the idea to hold an "open house," virtually unknown in the commercial field. They offered refreshments and door prizes. They immediately garnered 14 meaningful leads.
Armstrong, Brandice J. "Couple Takes Unique Approach to Commercial Property Leasing." Journal Record. 18 January 2006.
Daly, Wadman. Relocating Your Workplace: A User's Guide to Acquiring & Preparing Business Facilities. Crisp Publications, 1994.
"Free Kit Offers Help to Commercial Tenants." Business First-Columbus. 26 May 2000.
Kahn, Jeremy. "Disownership is Everything." Fortune. 30 March 1998.
Sivaraman, Aarthi. "Leasing Requires Care at Several Key Phases." Los Angeles Business Journal. 13 June 2005.
Steingold, Fred S. Legal Guide for Starting & Running a Small Business. Nolo Press, 1997.
Hillstrom, Northern Lights
updated by Magee, ECDI