Founder and CEO, Visual Lease.
Real estate leases can serve as key strategic assets for companies, presenting opportunities to improve the execution of a business strategy while also creating operational efficiencies. But leases also present risks. Without close attention to them, you can lose the situs of your business, cause disruptions in operations and lose money by overpaying your operating, tax and other rent charges. In addition, new accounting rules (ASC 842, IFRS 16 and GASB 87) that require leases to be listed as liabilities on balance sheets create added risks and opportunities across all industries.
To receive the benefits of a well-managed portfolio of leases and also reduce the risks, you’ll need to have a firm understanding of what is in your leases. Here are 10 key financial commercial lease clauses that you should keep a close eye on throughout your lease term.
1. Rent And Default
Missing a rent payment can carry heavy consequences. If you go into default, the landlord can terminate the lease and you could be evicted, face lawsuits to recover back rent and have your property subject to seizure to cover any balances due. If the lease is terminated by default or otherwise, if you do not completely vacate the premises, you can be charged 150% to 200% of the regular monthly rent each month until you comply.
2. Rent Increase Steps/Percentages
Rent can increase by a set amount at set intervals — by percentages to account for inflation, as a pass-through to cover increased operating expenses or in step with the Consumer Price Index (CPI). Some increases will occur annually, while others might activate at irregular intervals, making it critical to keep track of what the increase is and when it takes effect. These increases have to be factored into your ASC 842, IFRS 16 and GASB 87 lease accounting calculations, as well — and subsequent changes in rents require remeasurement of those calculations.
3. Profit-Sharing Or Revenue-Based Rent
Common in retail leases, percentage rent or turnover rent calculation requires you to share a percentage of your gross sales with your landlord, who often has the right to audit your books to validate the numbers. Tracking the details of sales, breakpoints and other metrics is crucial to complying with this clause and paying the proper amounts to your landlord.
If you had enough leverage to pre-negotiate an option to renew, expand, contract or terminate your lease early, be mindful of the terms and the date by which you must give notice to your landlord. If you miss an option notification date, your landlord will likely not keep the option open. If you pre-negotiated a set renewal rental rate and you miss the option notice date, your landlord will have the leverage to increase the rent back to market or even to above-market rates.
5. Operating Expenses
Most leases require you to pay your ratable share of operating expenses, property taxes, insurance and common area maintenance (CAM) charges in addition to your base rent. Although these clauses are heavily negotiated with tenants securing exclusions of the items for which they have to pay, most landlords do not tailor the billings to their individual tenant leases, nor are the numbers verified by landlords’ auditors.
This is particularly important after a year like 2020 when occupancy rates changed and operating expenses didn’t conform to expectations. For tenants with 2020 or 2021 base years, the base year expenses can be wildly underestimated, leading to significant expense overcharges throughout the lease term. These charges should be checked by experienced tenant lease auditors.
6. Rent Incentives And Reimbursements
Landlords will frequently offer incentives to tenants to move into their buildings, such as free rent, reduced rent and tenant improvement (TI) allowances. The nature of the incentives and conditions for receiving them vary from lease to lease. You must be very careful to track them and comply with the instructions to ensure you receive what you’re owed.
7. Janitorial Services
Janitorial services are typically provided by your landlord along with other maintenance services. In office buildings, the cost of basic cleaning is included in operating expenses (see above). However, in many cases, you might require extra cleaning for kitchen space, executive conference space or other nonstandard areas. Be sure you understand your rights and requirements under your lease so that you don’t pay twice for the same services.
In some leases, the tenant pays the utility company directly based on a separate meter that measures consumption in the space. In others, the landlord purchases electricity for the building and then charges each tenant based on the landlord’s method of measuring consumption, which can be through a private submeter or an electrical survey. In these cases, landlords can add administrative charges that can range from 1% to 12%. It’s on you to understand what you owe and be on guard for potential application errors and other miscalculations.
9. Overtime Services
Overtime services, from after-hours HVAC to freight elevators and beyond, are often charged at set hourly rates and can be charged in increments as short as 15 minutes. Some tenants will need these services regularly, some intermittently, some on short notice, and multiple tenants might share the same services. You need to closely track overtime services rates and their basis, any increases in cost and your usage of these services to ensure that you’re paying for only what you require.
Are you responsible for insuring the building? Will you have to pay rent even if the space is damaged? Are you obligated to pay for repairs? Understand your responsibilities and obligations in terms of insurance.
In future articles, we’ll review a series of other critical considerations and best practices for proactive lease management.
The information provided here is not legal advice and does not purport to be a substitute for advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation.