Leasing Commercial Real Estate: Before, During and After Your Search

Leasing Commercial Real Estate: Before, During and After Your Search

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Renting commercial real estate is one of the most significant activities your business will ever undertake. A small business might have just one location, so picking a good space is paramount to making your business a success. Because of its importance, picking a commercial property should be undertaken with care, based on hard facts, and not rushed. If you approach the task methodically, you have a much better chance of snatching a property that is ideally suited for your business. Leasing a good property does not guarantee a business’s success, but leasing a bad one can be the kiss of death.

Before You Start Your Search

Expect to devote a considerable amount of time to research before you begin searching for your ideal property. The process is akin to a feasibility study, in which you incorporate your goals, your requirements and any constraints that affect your search. Here are the critical factors to consider:

Population: If you are opening a retail store or restaurant, you’ll want a location that attracts enough people to support your sales targets. To put it simply, you’ll want to be near likely customers. For example, if you are opening a retail shop or casual restaurant, you might want to be in a mall or a part of town favored by folks who are likely to visit your establishment. A ritzy, high-price restaurant might do better downtown near a business or entertainment district. You can research income by ZIP code to identify pools of affluent potential customers. If you are looking to lease a business office space, you’ll want a location that is easy for employees, and recruits, to reach.

Access: Closely aligned with population requirements is accessibility. If you expect your customers or employees to drive to your location, you’ll need adequate parking space. This won’t be a problem in most malls, but parking should be a consideration if your business will be in an office building or standalone store. If you need your own parking facilities, a good rule of thumb is one spot for every three customers and one spot for every employee.

On the other hand, if foot traffic will be your primary consideration, seek out rental space in a mall or on a city street. The classic way to gauge foot traffic for a location is to commission a survey that measures this. It is possible that neighboring stores might have valuable data to share, although some might be reticent to share their information if you are perceived as a potential competitor.

Size: The common wisdom for office space is a minimum of 100 square feet of workspace per employee. You might be able to do with less if you pack your people into shared cubicles, but consider morale before proceeding. Restaurants and retail shops need about 15 square feet per simultaneous customer. That is, if you want your business to accommodate 60 shoppers or diners at any given time, you’ll need at least 900 square feet of space. If you have an elaborate kitchen or selling floor, you might need considerably more.

Zoning: Naturally, your prospective location must be zoned for commercial use, but unless the zone is mixed use, there might be restrictions on the type of business allowed in the zone. Look for the right type of zoning, whether it be office, restaurant/retail, industrial or leisure. Your local government should be able to provide the information you need. Also, check out any restrictions on storefront signs, a common zoning feature.

Budget and cost: Use realistic numbers to figure how much you can spend on a lease. Your lease shouldn’t exceed 5% to 8% of your yearly gross income. Determine the average rent per square foot in the locations you are considering and multiply by your size requirement to get your annual rent. Add $2 per square foot to the annual number for utilities, and 15% to 35% for common area maintenance fees, then divide by 12 to get the monthly cost. You should also consider rent increases—a good guess is an annual increase of 2% to 3%—and the cost of building out the space to meet your requirements.

Finding a Place

Now that you have a good idea of the ideal property’s characteristics, it’s time to come back down to earth and find a real place at a real address and get a real lease. You can try to do it on your own—we discuss how below—or use a broker, which is how most commercial leases are negotiated. Let’s start with the two types of commercial real estate brokers: leasing agents and tenant brokers.

Leasing Agents

Leasing agents work for landlords and are paid 3% to 6% of a lease’s total value for tenants signed. While leasing agents are usually very friendly, remember that they work for the landlord, not you.

Tenant Brokers

Tenant brokers represent tenants, but they are often paid a broker’s fee by the landlord. If this sounds like it can lead to ambiguous loyalties, you’re right. You can help ensure that the tenant broker is on your side by entering into an exclusive arrangement with the commercial broker for a three- to 12-month period and paying the broker a commission. However, these arrangements are unusual.

Typically, you have a nonexclusive arrangement with a commercial broker. A "nonexclusive right to represent arrangement" resembles an exclusive arrangement, except the tenant can deal with multiple brokers. In a "not-for-compensation nonexclusive arrangement," the tenant is neither bound to the broker nor pays any commission. This is a flexible arrangement, but the landlord pays the broker, so once again a conflict of interest is possible.

You can attempt to work without a broker by referencing online listings prepared by various sources like LoopNet and the Commercial Real Estate Listing Service. You will have to assume the tasks normally executed by the broker, including finding properties, booking walkthroughs and negotiating the lease contract.

Whatever broker arrangements you make, you should keep certain criteria in mind when evaluating lease spaces:

  • Location, access and safety: Ensure that the property satisfies your requirements for vehicular or foot traffic, is in a neighborhood conducive to buying your product or service, and is located in an area that can attract employees. Check crime reports for the area to see how safe the neighborhood is. You don’t want potential customers or employees feeling unsafe, and you don’t want to have to pay extra money for additional safeguards for your property.
  • Landlord or management company: Check out websites like Better Business Bureau to see if your prospective landlord or management company has a good reputation. Landlords have a lot of power, in that they set the terms of the lease agreement and control rent increases, so it makes sense to find one with a good history.
  • Amenities: Your business might require or benefit from certain amenities and services, such as on-site security, loading docks, free Wi-Fi, nearby dining and so forth. The local zoning will help determine what kind of amenities will be available in a given location.
  • Alterations: Consider the cost of building out the space, as this can significantly increase the cost of renting or delay your move-in date. Find out whether leasehold improvements or build-outs are covered by the landlord or the tenant.
  • Neighbors: If you are considering a lease in a mall, shopping center or other multiunit space, a big anchor store like Walmart or Home Depot can help attract traffic, especially if the anchor store is related to your business in some way. Check whether the landlord—or you—can break your lease if the anchor tenant leaves.

It’s best to consider multiple properties—between four and 10 as a rule of thumb—before settling on one. You’ll get an idea of average rents and amenities by participating in technical property reviews, also known as walkthroughs, with licensed contractors to see what work will be necessary to prepare a space for your business. You’ll also gain insights into the lease terms that landlords are proposing in the area.

Signing the Lease

If you’ve identified a suitable property, it’s time to negotiate a lease. You start by obtaining the lease terms in writing from the landlord or broker. You should understand the types of leases commonly used for commercial properties:

  • Full service lease: This is used most commonly when leasing office buildings. The rent includes all costs, including insurance, property tax, maintenance, repairs, cleaning and utilities. This is a desirable lease for tenants because you won’t face any hidden costs or maintenance tasks.
  • Net lease: This kind of lease charges a rent lower than you’d see in a full-service lease, but you will typically have to pay monthly expenses. In a single net lease, you’ll pay your portion of the building’s property taxes. A double net lease adds on property insurance costs, while a triple net lease also includes common area maintenance and is routinely used for retail and restaurant spaces.
  • Modified gross lease: This type of lease sits somewhere between full service and net leases, in that the tenant pays for taxes, insurance and common area maintenance in a fixed lump sum on top of the rent. There are no hidden or surprise costs, and the landlord usually picks up the tab for janitorial services and utilities.
  • Percentage lease: A percentage lease involves a base rent due every month plus a percentage of gross sales above an agreed breakpoint. For example, a lease might set the breakpoint at $100,000 of gross sales per month. If the tenant’s sales exceed the breakpoint, the landlord would collect a percentage, say 5%, of the overage. The benefit of this lease is that the tenant pays less when sales are slow, but the landlord participates in revenues when sales are brisk.

To negotiate the lease terms, you write a business letter of intent that includes your intention to lease the space, a description of your business that includes what you sell, how you price your offerings, how long you’ve been in business and your proposed terms. These terms typically include rental amount and escalation, security deposit, how the space will be used, type of lease, length of lease, special requirements and they specify responsibility for repairs and maintenance.

You should have some knowledge of what nearby tenants are paying so that you can negotiate a fair price. Nail down any hidden costs and ask for favorable clauses, as included in the following list of negotiation points to consider:

  • The terms of the lease—that is, how long the lease lasts.
  • Your right to make leasehold improvements to the property and to receive credits against rental charges for these improvements.
  • Any rent abatements in case the property is damaged.
  • A clause making the landlord responsible for improving the property before your move-in date.
  • Your right to assign the lease—that is, to sublease the property.
  • How buildouts will be paid. A buildout is the interior work a tenant needs to operate—such as putting in shopping aisles, a kitchen, etc. The landlord might be responsible for some of these costs, or they might be covered in their entirety by the tenant.
  • The signage rights of the business.
  • Exclusivity rights that prevent the landlord from renting a nearby space to a direct competitor.
  • Termination clauses.

Pay special to the termination clause. You might like to reserve the right to terminate the lease if an anchor tenant leaves. You should consider clauses that allow you fix a delinquent rent situation before eviction, and how much, if anything, you’ll be penalized for early termination. You might be facing competition for the space, so the letter of intent should point out why you’d be a good tenant for the landlord. Expect to go through a round of counteroffers as you negotiate the lease. A broker can be instrumental in helping you obtain the lease terms you desire.

Before you sign the lease, have the property inspected, identify any deficiencies, and verify that they’ve been corrected. You should also verify that the landlord has clear title to the property. Take a final walkthrough to ensure everything is as it should be. In addition, make sure all your financial arrangements are in place, such as having money set aside for the security deposit—typically six-months’ rent. If you find conditions that conflict with the lease terms and that the landlord won’t address, you might have to walk away from the lease. It’s better to avoid getting involved with a bad landlord than battling with one after you move in.

Justin is a Sr. Research Analyst at ValuePenguin, focusing on small business lending. He was a corporate strategy associate at IBM.