This article is part of a larger series on Business Financing.
A commercial real estate lease is an agreement that allows a business to rent commercial property from a landlord. Commercial leases come in three main forms: full-service leases, net leases, and modified gross leases. The process of identifying, negotiating, and signing a commercial lease is a long one. Knowledge of the necessary steps, which are discussed in detail in this article, will help business owners make a more informed decision.
1. Commercial Real Estate: Leasing vs Buying
First, it makes sense to decide whether to buy or lease commercial real estate. There are occasions when purchasing commercial real estate is advantageous. Specifically, the benefits of buying over leasing commercial real estate include:
- Building equity: You can use this equity as collateral for additional expansions.
- Owning an appreciating asset: Commercial real estate properties can increase in value over time, perhaps yielding a profit should you sell. However, assets can also lose value, making it an investment with risk that you need to consider.
- Depreciation of the building: You can claim the annual depreciation on your tax returns.
- Cash flow: Commercial spaces typically require owner-occupied businesses to occupy 51% of the building. However, you can rent out the remaining space and receive rental income.
It’s not uncommon for commercial buildings to be sold, which can leave lessees in the lurch. If you’re leasing a space that’s sold to another landlord, it’s possible that you might get kicked out of your space―this will be highlighted in the termination clause within the lease. If you own your own space, you’ll never get kicked out.
With leasing, tenants avoid down payments on a commercial loan, which can range between 10% and 25% of the property’s purchase price. Instead, they pay a refundable deposit that can equal up to six months of rent. Furthermore, lease payments can be deducted, reducing the tax burden.
By contrast, property owners can only depreciate the asset over its useful life. Owners can also deduct interest payments and origination fees if a commercial real estate property is financed.
Owning can be more stable than leasing. If you’re interested in buying a commercial property, read our article on the best commercial real estate loans.
2. Set Your Commercial Real Estate Parameters
Should you decide to lease, the next step is to set your property parameters as there is a wide range of commercial property available for businesses of all types. These parameters will help you limit your search to commercial spaces that suit your needs. Specifically, you’ll want to understand the following:
- Ideal customer or employee pool
- Commercial property zoning
- Desired size
- Maximum budget
Let’s look at each of these in more detail:
Ideal Customer or Employee Pool
Understanding your ideal customer is the most important property parameter if you’re a business looking to attract physical visitors to your location. Restaurants, retail locations, and similar types of businesses are good examples. These businesses should know where their ideal customers are located. A fast-casual restaurant may lease a commercial space in an area accessible to people who like fast-casual dining. Alternatively, a Michelin Star restaurant might want to choose another location in a more affluent area.
If you’re looking for office space, you’ll want to find a commercial space that’s convenient for your employees. You can conduct a similar analysis and find an area that’s highly populated by or easily accessible to your ideal employee pool.
Commercial Property Zoning
Commercial real estate properties are zoned for specific uses. For example, a warehouse is a commercial property zoned for industrial use. Other commercial zoning includes leisure, office, retail, and restaurant. The type of zoning dictates the type of business that can operate out of the commercial building. Make sure that you understand your local zoning laws as well as the type of zoning your business needs.
To do this, you can check with your local chamber of commerce or Google either your ZIP code plus zoning regulations or your city plus zoning regulations. We give you an example of commercial property zoning when we discuss the commercial requirements and best practices for storefront sign zoning.
The commercial lease options available are largely dependent on the size and layout of the space you need. To calculate the size, determine the number of customers or the size of your workforce to derive the necessary square footage.
For example, restaurants and retail locations typically require 15 square feet per customer on average. Meanwhile, offices typically require between 100 to 150 square feet of usable workspace per employee. Multiply the desired number of customers or employees by the appropriate square footage to yield the commercial space size that you need.
Another thing you’ll want to determine is your monthly budget. This will help you limit your searches to those spaces that are affordable. Your budget is largely dependent on your business’s size and performance.
Start by determining the average price per square foot for your area. Price per square foot is typically derived from the annual lease amount divided by the total rentable square feet of the space. You can find the average price for your area by typing your ZIP code into LoopNet’s directory of commercial properties available for lease.
Once you find the average price per square foot, multiply that by the square footage you need for your business. This should give you your expected annual budget for your commercial lease. Divide that by 12 to find your expected monthly lease payment.
Next, you’ll want to add up your expected utilities and common area maintenance fees (CAM) and include them in your max budget calculations. A good rule of thumb is that utilities average around $2 per square foot annually and CAM fees will cost between 20% and 30% of your annual lease payment.
You’ll also want to include expenses for any expected build-outs or annual rent increases. Examples of build-outs would include kitchen equipment in a restaurant or fixed shelves and walls in a retail establishment. The cost of build-outs is largely dependent on the type of business, but it’s possible to get the landlord to cover some of the costs. For rent increases, expect that your lease payment might increase 3% annually.
If you can keep your lease budget under 10% of your expected annual gross income, you should be able to manage the monthly lease payments and associated fees.
Accessibility is also a major parameter for retail businesses and restaurants. These businesses will want to have adequate parking for their customers. Furthermore, they’ll want to choose a location with a high amount of foot traffic and vehicle traffic and be compliant with the Americans with Disabilities Act (ADA).
3. Find a Commercial Real Estate Broker
Most commercial real estate leases are facilitated by brokers. Typically, there are two types of commercial real estate brokers involved: listing agents and tenant brokers.
Listing agents are hired by a landlord to list their commercial property. Listing agents earn a commission, typically paid by the landlord, of between 3% and 6% of the total lease. A listing agent has a duty to act in the best interest of the landlord.
Tenant brokers represent tenant interests. However, tenant brokers also typically earn a percentage of the overall commission paid by the landlord, known as the tenant broker’s fee. The tenant broker, while representing the tenant, doesn’t always have a duty to act in the best interest of the tenant. Depending on the arrangement, the tenant broker may act more as an objective third party.
When To Use a Tenant Broker
It’s not mandatory that a tenant use a broker. However, tenant brokers can typically help a tenant with the following:
- Lists of available real estate
- Accurate market pricing and comparables data
- Knowledge of local market conditions
- Access to financing options
This service is usually free to the tenant since the landlord typically covers the tenant broker’s fee. As a result, it’s a good idea to engage a tenant broker and have them help you find suitable locations to lease.
How to Find a Commercial Broker
Tenant brokers can be found online or through a personal network. One example website is The Broker List, which has an index of searchable broker profiles. You can search by name, company, or ZIP code. Alternatively, you can find a broker by asking your professional network.
Here are some questions to ask when considering a commercial broker:
- What is the broker’s experience with your specific commercial needs?
- What is the size of the broker’s real estate practice?
- How is the broker being compensated?
- What is the broker’s fiduciary duty?
- Is the broker knowledgeable about the local market?
Specifically, you’ll want to find a broker who has the right mix of experience and attention. Once you’ve identified a broker you trust, you will likely sign a written contract. This contract usually stipulates that the working relationship is either exclusive or nonexclusive.
Exclusive Arrangement With Commercial Broker
An exclusive arrangement is where the tenant works exclusively with one broker for a period of up to one year. During this time, the tenant can’t work with another broker. A commission, equal to a small portion of the expected tenant broker fee, is negotiated between the tenant and broker and paid only if there are no tenant broker fees paid out by the landlord.
Nonexclusive Arrangement With Commercial Broker
A nonexclusive arrangement comes in two forms:
- Right to represent: A right to represent nonexclusive arrangement is similar to an exclusive arrangement except that a tenant is allowed to speak with other brokers. The tenant still pays a commission as they would with an exclusive agreement.
- Not for compensation: This arrangement is nonbinding and no commissions are negotiated. It gives the broker the right to speak on your behalf and schedule listings for you to see. While it provides flexibility, the arrangement gives the tenant broker less of a fiduciary duty.
How To Work Without a Broker
Remember that signing an agreement with a tenant broker isn’t mandatory. While a tenant broker is helpful, there’s always a small chance that you’ll end up having to pay a commission.
If you choose to look for yourself, you’ll have to find new listings, set up walkthroughs, and negotiate the lease without the help of an experienced broker. The only benefit of not using a broker is that there’s no chance of paying a commission. Otherwise, it’s probably best to use a tenant broker.
4. Understand the Different Types of Commercial Leases
There are three dominant types of commercial leases, with costs and fees assessed differently based on the type of lease.
A full-service lease is the most common type of commercial lease for office buildings. The landlord is responsible for paying the expenses associated with the property, including property taxes and insurance, repairs and maintenance, and utilities and janitorial services. In this scenario, the landlord takes on the responsibility of maintaining the property. There are also no hidden costs, and businesses can forecast their monthly and annual lease payments.
A net lease agreement is where the landlord charges a lower annual rent when compared to a full-service lease. However, landlords can also include monthly “usual costs,” which include such things as property taxes, property insurance, and common area maintenance items (CAMS). Net leases can be either a single, double, or triple net lease.
- Single net lease: A tenant pays rent plus a pro-rata share of the building’s property taxes.
- Double net lease: A tenant pays a portion of the property insurance in addition to rent and property taxes.
- Triple net lease: A tenant pays the pro-rata share of property taxes, property insurance, and CAMS. Triple net leases are the most landlord-friendly and are most common with restaurants and retail locations.
While the base rent is lower for the tenant with a net lease, the tenant is also responsible for the monthly costs associated with property maintenance. These expenses are typically added to the base rent monthly.
Modified Gross Lease
A modified gross lease is a compromise of the full-service lease and the net lease. A tenant might pay for their portion of their property taxes, property insurance, and CAMS, but they pay it as a lump sum payment along with their rent.
The rent on a modified gross lease is therefore fixed, and there are no hidden costs or unexpected charges. If any of the taxes, insurance, or CAMS increases, the rent remains the same. Utilities and janitorial services are covered by the landlord with a modified gross lease.
5. Find the Right Commercial Property
When considering different commercial property listings, make sure you assess the following in addition to your property parameters:
- Location: Make sure that the property is either around your ideal customer or ideal workforce. You’ll want to find a space that has adequate foot traffic and vehicle traffic as well as adequate parking for customers or employees.
- Amenities and services: You’ll want to understand the full range of amenities offered by the commercial space. These amenities and services may include such things as communal rooms, free Wi-Fi, loading bays and docks, dining options, outdoor space, sewage and utilities, on-site security, and more. The zoning of your business will often dictate the type of amenities and services you require.
- Landlord history: This is important to understand since commercial leases are typically multiyear agreements. The landlord you choose will most likely dictate the lease agreement, changes to the agreement, rental increases, and more.
- Anchor tenants: Some multiunit commercial properties have an anchor tenant, such as Wal-Mart, Target, or other large chain retailers. If the anchor tenant leaves, the landlord might be able to get out of the property’s other leases legally. Make sure you know about any anchor tenants before you sign a lease.
Conduct Multiple Walkthroughs
You and your broker should identify multiple commercial spaces to view. This helps you get a better understanding of the average price and gives you a leg up during the negotiation process. During your search, you’ll also want to compare rents to ensure you’re staying on budget. A rule of thumb is that you should consider at least four commercial properties prior to signing a lease.
Walk-throughs are conducted with your broker and sometimes the landlord’s broker. With commercial spaces that require lease build-outs, bringing a licensed contractor along is a good idea as well. Build-outs may be fully or partially covered by the landlord. It’s important in this scenario that you get an accurate renovation estimate and negotiate a build-out into your lease.
Also, keep in mind that a creative broker may be able to develop other options that might offer advantages such as co-tenancy and lease term flexibility.
6. Negotiate Commercial Lease Terms
Once you’ve considered your commercial property options and their associated leases, it’s time to choose one or more commercial spaces and negotiate the leases. When formally entering into a commercial lease negotiation process, you’ll want to start by requesting the terms in writing. This request can come from you or your broker, and the terms are supplied by the landlord’s broker.
From there, you’ll want to write a business letter of intent (LOI) that represents your offer or counteroffer. The LOI is a chance for you to sell the landlord on why you would make a great tenant and is beneficial in a commercial real estate market with high demand.
Your LOI should include:
- Statement with your intent to lease
- Description of your business
- Number of years in business
- List of products and services, including pricing
- Your proposed terms
The terms can be either the same as the terms proposed by the landlord’s broker or a counteroffer by you or your broker. The terms include the rental price and type of lease, but they also include more nuanced terms. You can counter any of these lease terms. If it’s a counteroffer, the negotiation process begins.
Common Commercial Lease Terms
Commercial leases often have similar lease terms. While the payment structure might differ, all leases include such things as the required deposit and lease length. Specifically, you’ll want to understand the following terms of your lease:
This determines the type of business that can use the space. For example, some spaces are zoned for retail while others are zoned for office spaces.
Commercial leases typically range from 3 to 10 years. A short lease can be advantageous because it gives a business flexibility and reduces any future financial burdens.
If a lease is assignable, it means you can sublease the property or sell the business with the lease included at a future date.
This details who is responsible for repairs, maintenance, and other costs associated with the property. Net leases will place this on the tenant; a full-service lease will place this on the landlord.
Rent & Escalation
Leases will stipulate the monthly and annual rent, along with any future escalations or increases in rent. Most rent escalations average 3% annually.
Typically up to 6 months of rent, the deposit protects the landlord from a delinquent tenant or a tenant that causes excessive damage to property.
These represent the ability for a tenant to make leasehold improvements in their commercial space at the landlord’s expense. Build-out credits typically reduce the rent, reimburse the tenants, or have the landlord pay out of pocket.
This allows either party to terminate the agreement under specific conditions.
If the commercial property is damaged, the tenant will pay a reduced amount of rent until the damage is fixed.
If a building has a significant vacancy, the landlord can estimate what the variable operating expense would have been if the building had been fully occupied and charge tenants the pro-rata share of that cost.
A commercial real estate lease is a long-term rental agreement between the landlord of a commercial space and a business. Doing research on where you want to lease space, finding the right broker to assist you, and negotiating the best terms will go a long way to helping you get the best possible lease for your business.