There are many reasons why someone would prefer to lease a commercial property versus buying. However, a lease can be just as complex as a purchase and it’s important to know what a commercial real estate lease agreement entails. Here are a few differences to consider when deciding between leasing or buying.
Leasing
- More liquidity
- Leasing commercial real estate requires less money upfront. Common items you may need to cover when leasing are security deposits, attorney fees, and inspections. This is significantly lower than the amount you would need for a purchase thus less of your liquid capital is being utilized in acquiring the property.
- Potential tax benefits
- Purchases and leases both have potential tax benefits so be sure to consult your tax professional for more detailed information. Some benefits to discuss are deducting lease payments, utilities, maintenance, property insurance, and property taxes.
- Higher flexibility
- Businesses ebb and flow and a benefit to leasing is the flexibility you have to move into another space that better fits your needs. The length of a commercial lease can have a large range so be sure to consider how much time you’d like to spend there when beginning your search. If your goal is to purchase but you can’t find the right space or need more funds, leasing also allows you the ability to continue your day to day business while you save and wait for a property you’d like to purchase.
- Cheaper and easier to get into an existing development
- If you are hoping to move into a specific building, location or area of town and there aren’t any spaces available for purchase leasing may be your only option.
- No investment potential
- When owning a building you are able to build equity and benefit from the appreciation if it sells. As a renter you don’t receive these benefits which can hurt your income potential.
- Higher monthly payments
- Mortgages can be spread out up to 30 years so your monthly lease payment could be higher than your payment if you owned. Also, some lease agreements require a tenant to pay more than just rent. For example, a triple net lease requires tenants to pay monthly property taxes, utilities, maintenance costs, and retail insurance. These can increase the cost of a lease compared to a mortgage.
- No property control
- A landlord has the control to make vital decisions about the property that can affect your business. Also, there are such things as clauses in your lease agreement that can trigger a termination or increases in rent based on certain criteria should be well understood and thought through prior to signing. These things add a level of uncertainty then an outright purchase would.
- Renewals can lead to cost increases
- The end of the lease comes with a high level of uncertainty. A landlord could decide to significantly increase the monthly payments or decide not to renew your lease at all which could leave you hurrying to find a new space.
Buying
- Earning equity in the property
- There are a few ways to earn equity after purchasing a property. If you took out a loan the property will earn equity as you repay the loan. You can also increase the value of your property with improvements such as renovations or expansions.
- Asset appreciation
- Over time the property can increase in value by general appreciation. An increase can occur for a multitude of reasons including low supply, increased demand, or as a result of changes in inflation or interest rates.
- Rental potential
- If you do not plan to occupy the entire property you could choose to rent out the vacant space to a tenant. This will bring in rental income but you’ll also be responsible for the tenants in a landlord capacity unless you decide to hire a property management company.
- Potential tax benefits
- Consult with your tax professional for more detailed information but potential benefits could include deductions for interest expense, depreciation expense, and other non-mortgage related expenses.
- Higher upfront costs
- When purchasing real estate you’ll come across many things that will add up to higher upfront costs than you would see if leasing. Things like your downpayment, closing costs, inspections, and due diligence can add up quickly requiring .
- Increased liability
- As an owner you’re responsible for the safety of those who utilize the space. You’re responsible for any maintenance or repairs on the property as well. If you are renting out space there are additional insurance policies you’ll need to have in place for your protection.
- Risk of property depreciation
- You are at the will of the real estate market so there is always a risk of your property losing value just based on those conditions. Your property can depreciate regardless of what condition you’ve kept it in.
- Lack of flexibility to move your business
- If you find the property you are in doesn’t fit your needs anymore you can’t just leave at the end of your lease. You will need to either sell or rent the space which could be difficult depending on various circumstances. A lease of a few years provides a much greater flexibility than a 15-30 year mortgage.
Common Types of Commercial Leases
The simplest type of commercial lease is a full-service gross lease, or gross lease. It is structured so a tenant is charged a gross lump sum each month. This rate includes all the operating costs related to running the property such as property taxes, insurance, maintenance, and common area maintenance fees or CAMs. Since all of these fees are included in the rate a gross lease option will be higher than comparable properties that are using a different structure.
Gross leases can be adjusted to exclude certain expenses like utilities a tenant can pay on their own which would then be called a modified gross lease. Often times to avoid unlimited expenses an expense cap will be written into a gross lease which means the landlord will pay for a certain amount but anything exceeding is considered the tenants responsibility.
A percentage lease is when a tenant pays a base rent plus a percentage of any revenue earned while conducting business on the property. These are most commonly seen in a retail setting like a mall. It’s a benefit for tenants that would like to keep their rental costs low as they increase revenue.
A net lease (meaning “net of” or excluding certain expenses) refers to a lease structure where the tenant pays a base rent and is also responsible for directly paying specific building-related expenses. The base rent amount is generally considerably less than that of a gross lease, since tenants then have to factor in paying their own utilities, cleaning fees, property taxes, CAMs and insurance premiums. Tenants should carefully evaluate these associated costs in addition to the base rent and consider what their total estimated expenses would be.
There are three main types of net leases: single-net leases, double-net leases and, the most common, triple-net leases. We’ll break down each type and its related expenses below.
Single-Net Lease
Single-net leases are not very common, but in this type of structure tenants pay a base rent plus their pro-rated share of the building’s property taxes. Tenants also typically pay for their own utilities and janitorial service. The landlord covers all other expenses, including insurance premiums and CAM charges.
Double-Net Lease
Often displayed as “NN” in property listings, double net leases charge the tenant a base rent plus the tenant’s share of property tax and insurance premiums. Tenants also pay for their own utilities and janitorial expenses.
What the tenant does not pay for in a double-net lease are common area maintenance fees. These may include expenses for equipment, supplies, maintenance and any necessary repairs of the lobby, restrooms, elevators, stairwells and hallways, as well as the salary of a lobby attendant or security guard. These costs are covered by the landlord.
Triple-Net Lease
The triple-net, or “NNN,” lease, charges tenants a base rent, and tenants are then responsible for paying their own utilities and janitorial expenses, in addition to their share of the property tax, insurance premiums and CAMs. The base rent for a triple-net lease is often a lower cost due to the fact that the tenant is responsible for all the associated charges of the property. Triple-net leases are one of the most common types of commercial leases. You can read a detailed explanation of the NNN lease here.
Triple-net leases are beneficial for tenants as they allow them to pay their fair share of building expenses, and depending on individual usage, some tenants can save on costs compared to a gross lease. However, this lease type also comes with risks considering the tenant bears all the responsibility for expenses. Tenants can consider negotiating a cap on expenses in a net lease structure, especially if the building is older and may need frequent repairs.
An uncommon variation known as an “absolute-net” lease or “bondable lease” holds the tenant responsible for paying rent, expenses and for all repairs to the building. The tenant is responsible for these items regardless of the building’s condition, even if it becomes condemned, and also for rebuilding it in the event of a disaster. This type of lease is mostly used by landlords who have borrowed heavily to finance the property and pledge the rent money as a security for the debt, and it puts all risk on the tenant.
(Information is from Loopnet. Click here for the full article.)
Letter of Intent
In commercial real estate a letter of intent (LOI) outlines the basic terms and conditions the tenant is prepared to offer in consideration of a lease. It’s a way to open dialogue between both parties and come together before formalizing a contract. This eliminates surprises and the need for multiple revisions on a contract. Below is a list of items you will be addressing in an LOI.
- Landlord
- Tenant
- Leased Premises
- Use of the Premises
- Parking
- Signage
- Initial Lease Term
- Option to Renew
- Tenant Improvements
- Landlord Improvements
- Rent
- Additional Charges (NNN)
- Tenant Expenses
- Landlord Expenses
- Security Deposit
- Exclusive Use
- Early Occupancy
- Additional Terms
- Brokerage
- Response Date