How a lease agreement can make or break your business

I was recently listening to a podcast interview with a blogger who specializes in social media. She stressed the importance of sometimes writing for a mass audience as opposed to your professional inner-circle. It inspired me to write this column on a topic most people who work within my industry understand. But among the public, including many landlords and tenants, it remains the single most confusing topic in commercial real estate: triple net and modified gross leases and how they differ.

First, it's important to understand and recognize that a lease is a legally binding document. The days of handshakes and napkin deals are, for the most part, over. Furthermore, real estate expense is often one of the highest budget items for a company. So the impact these documents have on your bottom line cannot be underestimated. A poorly written or overly expensive lease can bankrupt your business. And, from the landlord's perspective, a binding lease effectively limits your rights to certain portions of your real estate. As a result, this inhibits your ability to redevelop or even sell the property. So, for all parties, it's vital to know what you're signing up for.

In Maine, we typically work with two forms of commercial real estate leases. A triple net lease and a modified gross lease. Landlords, for the most part, choose which form is used. In theory, both types can be used for all commercial real estate market sectors, including office, retail and industrial. But there are benefits for using one versus the other depending on the type of property and number of tenants in the building.

The triple net lease is when a landlord charges the tenant a base rent. For the purpose of illustration, let's say that base rent is $10 per square foot. As an important aside, all prices in Maine commercial real estate are quoted on an annual basis per square foot; so $10/SF on 5,000 SF is equal to $50,000/year.

Beyond the base rent, in a triple net lease, the tenant pays a pro rata share of three net expenses: real estate taxes, property insurance and common area maintenance charges. Those charges are where you'll see expenses for landscaping, snow plowing and removal, property management, accounting/legal expenses, repairs and maintenance, security, common area janitorial, etc. Triple net expenses vary building to building but, on average, range from $3-5/SF; industrial buildings can be as low as $1/SF and Class-A office buildings can be as high as $6/SF.

Triple net leases are most common in stand-alone buildings where it is easy to account for the expenses. But, again, it's at the landlord's discretion to use triple net leases. The plus side for the landlord is knowing that if the building expenses increase, they'll be protected as the tenant has to absorb those costs. The downside is additional accounting (especially in multi-tenanted buildings) and some tenants are not comfortable with triple net leases.

The modified gross lease is simply when the rent includes the base and triple net fees. So a triple net lease for $10/SF at a building where the expenses are $3/SF is equal to a modified gross lease rate of $13/SF. Most larger, multi-tenanted office buildings use some form of a modified gross lease to simplify rent schedules. Modified gross leases can still protect landlords from increasing taxes or insurance by including a provision that says the tenant shall be responsible for any increases over the first-lease-year operating costs.

But, as always, exceptions abound.

It is important to note that, regardless of lease form, most tenants will be responsible for paying janitorial, phone/data and a pro rata share of utilities. In Maine, utilities are especially important to understand. They can include electricity, water and/or sewer if on a public system, and heat (usually oil, propane or natural gas).

When going over your lease, ask important questions like: Is the space separately metered for electricity? What's the heat source? How is it zoned? Do you have any historical records? I've heard too many horror stories, especially in older multi-tenanted buildings, of one tenant unknowingly paying for another tenant's heating, venting and cooling use.

I believe a lease is one of the most important documents any business can sign, regardless of size or location. By fully understanding your lease, you ensure that you only sign what protects your long-term interests (whether tenant or landlord).

Of course, every tenant, building and transaction is different from the last. So it's best to consult a real estate attorney or local commercial real estate broker when dealing with these matters.

Article originally published in Mainebiz on October 29, 2012. 
http://www.mainebiz.biz/article/20121029/CURRENTEDITION/310259992/how-a-lease-agreement-can-make-or-break-your-business