Commercial Leases

Leasing of Real Property

There are different types of ownership for land but, in common law states, the most common form is the fee simple absolute, where the legal term fee has the old meaning of real property, i.e. real estate. An owner of the fee simple holds all the rights and privileges to that property and, subject to the laws, codes, rules and regulations of the local law, can sell or by contract or grant, permit another to have possession and control of the property through a lease or tenancy agreement. For this purpose, the owner is called the lessor or landlord, and the other person is called the lessee or tenant, and the rights to possess and control the land are exchanged for some payment (called consideration in legal English), usually a monthly rent. The acceptance of rent by the landowner from a tenant creates (or extends) most of the rights of tenancy even without a written lease (or beyond the time limit of an expiring lease). Although leases can be oral agreements that are periodic, i.e. extended indefinitely and automatically, written leases should always define the period of time covered by the lease. In the 1930s, the British government introduced infinite leases, only to remove the power to create these in the early 1990s. A lease may be:

1. a fixed-term agreement, in other words one of these two:
   • for a specified period of time (the "term"), and end when the term expires;
   • conditional, i.e. last until some specified event occurs, such as the death of a specified individual; or
2. a periodic agreement, in other words renewed automatically, usually on a monthly or weekly basis
3. at will, i.e. last only as long as the parties wish it to, and be terminated without penalty by either party.

Because ownership is retained by the lessor, he or she always has the better right to enforce all the contractual terms and conditions affecting the use of the land. Normally, the contract will be express (i.e. set out in full and, hopefully, plain language), but where a contract is silent or ambiguous, terms can be implied by a court where this would make commercial sense of the transaction between the parties. One important right that may or may not be allowed the lessee, is the ability to create a sublease or to assign the lease, i.e. to transfer control to a third party. Hence, the builder of an office block may create a lease of the whole in favour of a management company that then finds tenants for the individual units and gives them control.

Leasing of Tangible Personal Property

An owner can allow another the use of a vehicle (such as vehicle leasing of a car, a truck or an airliner) or a computer either for a fixed period of time or at will. This can be a simple leasing transaction, or it can be a transaction intended to allow the user the right to buy the item at some future time.

In a simple lease (rental) of a car, P pays O a rental for the use of the car during the agreed period which may be a few days (e.g. for a holiday trip) or longer where it is more economic to pay for use rather than pay for the ownership of an asset of depreciating value. Normally, only P will be allowed to use the vehicle and, in such a case, P has possession and control. But, P could be an employer who allows C the use of the car to visit clients, and thereby gives C control.

In a lease with the possibility of purchase, O could allow P to lease the car for a specified period of time. If all the rental payments are made in full, P will then be allowed to buy the car at the contractual purchase option price. In a consumer lease subject to the federal Consumer Leasing Act and the Truth in Lending Act, the purchase option price can not be a "bargain" purchase, that is, it cannot less than the originally estimated fair market value. A "bargain" purchase creates an installment sale, to which the Truth in Lending Act (TILA) applies including the standardized disclosures, most importantly the Annual Percentage Rate (APR). Typically, the vehicle dealer or other personal property seller offers the leasing terms and contract of a third party finance company. Hence, O leases the vehicle to P, and upon execution of the contract simultaneously sells ownership of the car to F and assigns the lease contract to F. It is standard for the contractual terms to prohibit P from parting with possession or control of the car to another (if P does part with possession, this can be a theft of the car from F).

There are two principal types of leasing, depending upon the party taking the risk of the value of the vehicle (or other leased property) at lease end. In the U.S. this is called Closed-end leasing. In other jurisdictions, it is called hire purchase, lease purchase or finance leasing. These transactions are complicated. The most common problem arises when O makes specific representations as to the quality and reliability of the car to P during the initial negotiations. If what is said induces P to buy the car from O, those representations would usually be enforceable against O. But, in this transaction, O first sells the car to F who makes no representations to P. The laws vary from state to state on the extent to which P might be allowed a remedy if the car proves to be of poor quality.

To clarify the concept, the owner of tangible movables has the power to keep possession and only to transfer control. This may be for:

1. short- or long-term storage (e.g. leaving a passport with hotel staff or depositing valuable property in a bank vault — a hotel or bank holding property is a bailee); or
2. for delivery purposes (e.g. using a carrier to transport goods to a specific destination); or
3. it may be a form of mortgage — a pawnshop holds a pledge over the goods deposited until the money lent is repaid.

Leasing is a common method by which airlines acquire their aircraft, usually from companies specialised in the field of Commercial Aircraft Sales and Leasing. Aircraft leasing transactions are typically divided into finance leasing and operating leasing.

Businesses often choose to lease rather than buy office equipment, including computers. Since office equipment depreciates rapidly, leasing can be more cost-efficient than ownership.

Commercial Leasholds

Benefits

For businesses, leasing property may have significant financial benefits:

1. Leasing is less capital-intensive than purchasing, so if a business has constraints on its capital, it can grow more rapidly by leasing property than it could by purchasing the property outright.
2. Capital assets may fluctuate in value. Leasing shifts risks to the lessor, but if the property market has shown steady growth over time, a business that depends on leased property is sacrificing capital gains.
3. Leasing may provide more flexibility to a business which expects to grow or move in the relatively short term, because a lessee is not usually obliged to renew a lease at the end of its term.
4. Depreciation of capital assets has different tax and financial reporting treatment from ordinary business expenses. Lease payments are considered expenses, which can be set off against revenue when calculating taxable profit at the end of the relevant tax accounting period.

Disadvantages

There are some significant drawbacks:

1. A net lease may shift some or all of the maintenance costs onto the tenant.
2. If circumstances dictate that a business must change its operations significantly, it may be expensive or otherwise difficult to terminate a lease before the end of the term. In some cases, a business may be able to sublet property no longer required, but this may not recoup the costs of the original lease, and, in any event, usually requires the consent of the original lessor. Tactical legal considerations usually make it expedient for lessees to default on their leases. The loss of book value is small and any litigation can usually be settled on advantageous terms. This is an improvement on the position for those companies owning their own property. Although it can be easier for a business to sell property if it has the time, forced sales frequently realise lower prices and can seriously affect book value.
3. If the business is successful, lessors may demand higher rental payments when leases come up for renewal. If the value of the business is tied to the use of that particular property, the lessor has a significant advantage over the lessee in negotiations.

Net Leases

The net lease requires the tenant to pay, in addition to the fixed rent, some or all all of the property expenses which normally would be paid by the property owner (known as the "landlord" or "lessor"). These include expenses such as real estate taxes, insurance, maintenance, repairs, utilities and other items.

The precise items that are to be paid by the tenant are usually specified in a written lease. For properties that are leased by more than one tenant, such as a shopping center, the expenses that are "passed through" to the tenants are usually prorated among the tenants based on the size (square footage) of the area occupied by each tenant. The term "Net Lease" is distinguished from the term "Gross Lease". In a net lease, the property owner receives the rent "net" after the expenses that are to be passed through to tenants are paid. In a gross lease, the tenant pays a gross amount of rent, which the landlord can use to pay expenses or in any other way as the landlord sees fit.

Types of Net Leases

There are standard names in the commercial real estate industry for different sets of costs passed on to the tenant in a net lease.

Single Net Lease

In a single net lease (sometimes shortened to Net or N), the lessee or tenant is responsible for paying property taxes as well as the base rent. Double- and triple-net leases are more common forms of net leases.

Double Net Lease

In a double net lease (Net-Net or NN) the lessee or tenant is responsible for real estate taxes and building insurance. The lessor or landlord is responsible for any expenses incurred for structural repairs and common area maintenance. "Roof and structure" is sometimes calculated as a reserve, the most common amount is equal to $ .15 per square foot. Double net leases are rarely used in the industry.

Triple Net Lease

A triple net lease (Net-Net-Net or NNN) is a lease agreement on a property where the tenant or lessee agrees to pay all real estate taxes, building insurance, and maintenance (the three 'Nets') on the property in addition to any normal fees that are expected under the agreement (rent, etc.). In such a lease, the tenant or lessee is responsible for all costs associated with repairs or replacement of the structural building elements of the property.  Use of a triple net lease may be a prerequisite for credit tenant lease financing, and may permit a lender to lend to the landlord on nonrecourse terms.  This form is frequently used for freestanding buildings, such as outparcel developments or single-tenant "big box" sites.

Although rents are usually lower in triple net leases than other forms of lease agreements, this form of lease agreement is desirable for real estate investors since the expenses incurred on the investor are dramatically decreased due to the transfer of financial responsibilities on the property from the investor/lessor to the lessee. But they may also have certain tax disadvantages for the lessor. Among other effects, if the lease produces losses, these could be disallowed for their tax benefit due to the passive loss limitations of the Internal Revenue Code Section 469 or the at-risk rules of IRC §465, and significant income from them could cause a closely held C corporation to become a Personal Holding Company per IRC §542 (subject to a special tax), or an S corporation to lose this status per IRC §1362(d)(3). 

Bondable Lease

A bondable lease (also called an absolute triple net lease or a "hell-or-high-water lease") is the most extreme variation of a triple net lease, where the tenant carries every imaginable real estate risk related to the property. Notably, these additional risks include the obligations to rebuild after a casualty, regardless of the adequacy of insurance proceeds, and to pay rent after partial or full condemnation. These leases are not terminable by the tenant, nor are rent abatements permissible. The concept is to make the rent absolutely net under all circumstances, equivalent to the obligations of a bond: hence the "hell-or-high water" moniker. An example of this type of lease would be a leaseback arrangement in which a retailer leases back the building it formerly owned and continues to run the store.

Bondable leases are typically used in so-called "credit tenant lease" deals, where the main driver of value is not so much the real estate, but the uninterrupted cash flow from the usually investment-grade rated "credit" tenant.

Accounting For Leases

A lease is defined as a contractual agreement between a lessor and lessee that gives the lessee the right to use specific property, either owned by or in the possession of the lessor, for a specified period of time in return for stipulated, and generally periodic, cash payment.

The accounting profession recognizes leases as either an operating lease or a capital lease (finance lease). An operating lease records no asset or liability on the financial statements, the amount paid is expensed as incurred. On the other hand, a capital lease is recorded as both an asset and a liability on the financial statements, generally at the present value of the rental payments (but never greater than the asset's fair market value). To distinguish the two, the Financial Accounting Standards Board (FASB) provided criteria for when a lease should be capitalized, and if any one of the criteria for capitalization is met, the lease is treated as a capital lease and recorded on the financial statements. The primary standard for lease accounting is Statement of Financial Accounting Standards No. 13 (FAS 13), which has been amended several times. In July 2006, the FASB and the International Accounting Standards Board (IASB) announced the commencement of a joint project to comprehensively reconsider lease accounting, with the intention to release a new standard in 2009.

The basic criteria for capitalization of a lease by lessee are as follows:

1. The lessor transfers ownership of the asset to the lessee.
2. A bargain purchase option is given to the lessee. This is an option that allows the lessee, upon termination of the lease, to purchase the leased asset at a price significantly lower than the expected fair market value of the asset. (Intermediate acct. 11th ed, Kieso Weygandt Warfield)
3. The life of the lease is greater than 75% of the economic life of the asset.
4. The present value of the minimum lease payments (MLP) is equal to or greater than 90% of the fair market value of leased property. To understand and apply this criterion, you need familiarize yourself with what is included in the minimum lease payments and how the present value is calculated. The minimum lease payments include the minimum rental payments minus any executory cost, the guaranteed residual value, the bargain purchase option, and any penalty for failure to renew or extend the lease. The amount calculated is then discounted using the lessee’s incremental borrowing rate. However, if the lessee knows the implicit rate used by the lessor and the rate is less than the lessee’s rate, the lessee should use the lessor’s rate to discount the minimum lease payment.
5. If any of these criteria for capitalization are met, the lease should be capitalized and reported on the financial statements by the lessee. If none of the criteria is met, the lease is considered operating and is generally reported (aside from the rent expense) only in the footnotes to the financial statements. For a more in depth explanation, see the accounting textbook Intermediate Accounting, 11th ed, Kieso Weygandt Warfield.

Lessee Accounting

Under an operating lease, the lessee records rent expense (debit) over the lease term, usually on a straight-line basis and a credit to either cash or rent payable.

Under a capital lease, the lessee does not record rent as an expense. Instead, the rent is reclassified as interest and obligation payments, similarly to a mortgage (with the interest calculated each rental period on the outstanding obligation balance). At the same time, the asset is depreciated. If the lease has an ownership transfer or bargain purchase option, the depreciable life is the asset's economic life; otherwise, the depreciable life is the lease term. Over the life of the lease, the interest and depreciation combined will be equal to the rent payments.

Other Lessee Financial Accounting Issues

Leasehold Improvements: Improvements made by the lessee. These are permanently affixed to the property, and revert back to the lessor at the termination of the lease. The value of the leasehold improvements should be capitalized and depreciated over the lesser of the lease life or the leasehold improvements life.

Lease Bonus: Prepayment for future expenses. Classified as an asset; amortized using the straight-line method over the life of the lease.

Rent Kicker, or Percentage Rent: Common in retail store leases. This is a premium rent payment that the lessor requires and is treated as a period expense. For example, it may be stated in the contract that if sales are over $1,000,000, any excess over this amount will have 2% taken out as a rent kicker.

Lessor Accounting

Under an operating lease, the lessor records rent revenue (credit) and a corresponding debit to either cash/rent receivable. The asset remains on the lessor's books as an owned asset, and the lessor records depreciation expense over the life of the asset.

Under a capital lease, the lessor credits owned assets and debits a lease receivable account for the present value of the rents (an asset, which is broken out between current and long-term, the latter being the present value of rents due more than 12 months in the future). With each payment, cash is debited, the receivable is credited, and unearned (interest) income is credited.

Other Issues

Usually, when a lease is entered into, a security deposit is required. There are two types of security deposits:

Nonrefundable security deposits: Deferred by the lessor as unearned revenue; Capitalized by the lessee as a prepaid rent expense until the lessor considers the deposit earned.
Refundable security deposits: Treated as a receivable by the lessee; Treated as a liability by the lessor until the deposit is refunded to the lessee.

Commercial Leasing Guide 

Leasing a commercial space instead of committing yourself to owning commercial real estate can be an excellent move, but there are fewer tenant-friendly laws and no standard lease agreements. You'll need a lawyer’s help to negotiate the best deal on a commercial lease.

Every commercial lease should be in writing and should include the following details:

1. How much rent is due, including any increases (called escalations). You’ll want to know the going rate for space in the neighborhood before you begin negotiating. It also helps to let the landlord make the first offer, and ask for a lower rent than you think you can initially get. Escalations should be for specific dollar amounts or tied to a known method of calculation, such as cost of living indexes.
2. How long the lease runs, when it begins, and under what conditions you can renew the lease. A shorter lease means less commitment, but less predictability for the long run. If location is very important — for example, if you have a retail store — you may want to opt for a longer lease. You can always attempt to renegotiate lower rents or improvements as time goes on. If you have a month-to-month lease, you’ll want to make sure the landlord gives you as much time as possible when terminating the lease.
3. Whether your rent includes utilities, such as phone, electricity, and water, or whether you’ll be charged for these items separately.
4. Whether you’ll be responsible for paying any of the landlord’s maintenance expenses, property taxes, or insurance costs, and if so, how they’ll be calculated.
5. Any required deposit and whether you can use a letter of credit instead of cash.
6. A description of the space you’re renting, square footage, available parking, and other amenities.
7. A detailed listing of any improvements the landlord will make to the space before you move in. Your landlord may be more willing to make lots of expensive improvements if you’re signing a longer lease.
8. Any representations made to you by the landlord or leasing agent, such as amount of foot traffic, average utility costs, restrictions on the landlord renting to competitors (such as in a shopping mall), compliance with Americans With Disabilities Act requirements, and so forth. These may come in handy later when you want to renegotiate your lease.
9. Assurances that the space is zoned appropriately for your type of business. Of course, you’ll also want to check out this information with local zoning authorities.
10. Whether you’ll be able to sublease or assign the lease to someone else, and if so, under what conditions. You’ll want to negotiate the ability to sublease so that you can move with as little financial pain as possible.
11. How either you or the landlord can terminate the lease and the consequences.

When it comes time to renegotiate your commercial lease, you’ll want to document your reasons for a lower rent or more space improvements with hard facts regarding lower foot traffic than represented, a downturn in your industry, and so forth. Some landlords will even be willing to take a percentage of your sales instead of a flat rental fee when economic times are slow.

As a tenant, you have far more leeway when negotiating a commercial lease rather than with a residential lease, which is one reason why having your own lawyer to represent you in negotiations is so important. A lawyer can also research zoning laws and local ordinances and fill you in on the local real estate market conditions and customs.

Leasing Checklist

In many states, commercial leases are not covered under consumer protection laws that normally safeguard tenant rights. It is assumed that commercial leases are contracts between knowledgeable business people, and therefore less government regulation is needed than in residential leases. Thus it is essential to scrutinize every aspect of the lease and renegotiate unfavorable terms before signing.

Non-Compete Clause

If you run a retail establishment, insist upon a provision that prohibits the landlord from renting space in or near the same retail center to a competitor.

Dispute Resolution

If there is a dispute involving you and the leaser, by what method will it be resolved? Negotiating for mediation or arbitration rather than regular court is usually advantageous.

Spatial Specifications

Exactly how much space is being rented, and which areas are included? It is wise to take a tape measure and confirm the leaser's measurements, as they are often exaggerated. Finding a discrepancy in reported space and actual space is a valuable bargaining tool. Do you have the right to move to another space in the complex if you need more room to expand?

Default & Termination

Under what conditions can either party free themselves from the lease and what notice requirements are needed?

Pets

In an effort to attract skilled employees, more employers are allowing pets in the workplace. Will the leaser permit pets in the space?

Rent

Prices are always negotiable in commercial leases, and may depend greatly on concessions made with regard to other aspects of the lease as well as general market conditions. If options to renew are considered, what rent increases are allowable, and how are they calculated?

Additional Costs

The cost of utilities, taxes, and maintenance are often passed on to the tenant. If you agree to pay them, make certain that your portion is in line with the percentage of the building that you occupy.

Buildouts

Improvements, modifications, and fixtures added to a rental space are called buildouts. Negotiation should include whether these are allowed, which party will pay for them, and who owns them after the lease ends.

Sublease

The term "sublease" refers to a transfer of less than the entire term of the lease. Under a sublease, the subtenant is not directly responsible to the leaser, whose recourse against the subtenant is only through the original tenant. If your business fails or the location doesn't match your needs, do you have the leaser's permission to sublet the space to another party?

Term Options

Many new businesses negotiate a short initial lease with one or more options to renew. Options give you the right to stay by notifying your landlord in writing a certain number of days or months before the lease expires. Landlords may want a higher rent for the renewal period as well as an extra fee in exchange for the option.

Leasing Pitfalls

The following factors may adversely affect the tax status of your leases:

1. rental payments that establish equity or lead to a property title,
2. rental payments that exceed the fair rental value of the property by a wide margin,
3. rental payments that are actually the equivalent of interest on a purchase, and
4. when, subsequent to the end of the lease, the option to purchase is exercised at a rate that is quite low in comparison to the actual property value.