Navigating Commercial Real Estate Contracts: Key Clauses And Negotiation Strategies

Commercial lease agreements are among the most widely used business contracts. These essential documents are crucial to forming stable, mutually rewarding landlord-tenant relationships. At their best, commercial real estate (CRE) contracts help to create the conditions for business success for tenants, for return on investment for landlords, and even for job creation and overall economic growth for the communities in which the leased premises are located. At their worst, these same commercial leasing agreements can become a never-ending morass of confusion, contract disputes, and administrative headaches for all involved. The critical role that commercial real estate contracts have to play in business success for tenant businesses and property owners alike means that it is essential for all parties to prioritize careful negotiation strategies.

An experienced Arizona commercial real estate and business law attorney can often help to identify key clauses based on an individual client’s business and the factors in play at a specific property. Harrison Law, PLLC advises both tenants and property owners throughout Arizona on key contract clauses and negotiation strategies for commercial leasing arrangements, so call our Phoenix-area office at (480) 320-2310 today to set up a consultation to discuss your commercial real estate contract needs.

What Are the Main Types of Commercial Real Estate Contracts?

Most commercial real estate is developed by investors or speculators and then rented, with or without the assistance of a third-party property management company, to tenants who sign long-term commercial lease agreements. Unlike most residential leasing, in which the typical pattern consists of prospective tenants filling out rental applications and landlords approving or denying them, for commercial tenants and CRE developers negotiating the terms of their commercial real estate contracts is an essential part of establishing a business relationship that in many cases is expected to last many years, if not decades. Whether you are a business owner looking to sign your first long-term lease or a real estate developer looking to hone your approach to contract negotiations for commercial leases, a brief refresher of the main types of commercial real estate contracts can help to set in place a context for considering key clauses and the circumstances in which they are most likely to apply.

Gross Lease

The advantage of a gross lease is its simplicity. In a “gross” lease, the tenant pays a single flat fee that covers all expenses associated with their occupancy of the premises, and the landlord (the property owner, or in some cases a property management company on the owner’s behalf) pays all other expenses, such as premises liability insurance and the taxes required by the Arizona Department of Revenue, out of that fee. Some commercial real estate contracts may be negotiated to allow for a “modified” gross, in which the tenant pays a flat fee that covers almost all expenses, while a few key incidentals are explicitly excluded by specific contract clauses. A business law attorney from Harrison Law, PLLC with experience in drafting and negotiating commercial real estate contracts may be able to help you understand whether a modified gross lease is a useful option in your situation.

Net Lease

Net lease agreements are among the most popular forms of commercial real estate contracts. These contracts are called “net” leases because the tenant covers at least some of the incidental expenses associated with property maintenance and operations in addition to their fixed rental fee (making the rental fee a “net” expense for maintaining their tenancy on the premises, rather than the total “gross” monthly or quarterly cost).

The incidental costs associated with commercial leases are traditionally sorted into three expense categories: taxes, maintenance, and insurance. Leases that follow the “net” structure may be classified as single-net, double-net, or triple-net, according to the number of expense categories for which the tenant is responsible.

Percentage Lease

The rates paid by tenants in percentage leases will vary over time in tandem with their business fortunes. A percentage lease is recalculated periodically to combine a base rate, which the tenant pays in each pay period, with a percentage of their profits. While this pay structure may pose some risks for landlords in terms of the potentially lower base fee a percentage lease may command, it also has the potential to result in substantial revenue creases if the tenant’s business does well. Percentage leases therefore often appeal to tenants who might otherwise be nervous about their chances for business success at a specific location: The percentage structure ensures that the landlord will have a vested interest in the tenant’s ultimate success on the premises.

Variable Lease

Like a percentage lease, a variable lease is recalculated at regular intervals. However, the changes in rent due are determined not by the tenant’s profits per se but depend instead on external factors.

Variable leases come in two broad subcategories: graduated and index. In an “indexed” variable lease, the periodic adjustment in rent is calculated relative to a predefined measure of economic trends, such as the Consumer Price Index provided by the United States Bureau of Labor Statistics. In a graduated variable lease, the adjustments are made on a regular schedule, irrespective of economic trends; often graduated leases will make seasonal adjustments to account for variations in business revenue for “peak” vs. “off” season in particular industries.

How To Negotiate a Commercial Real Estate Contract?

Negotiating a commercial real estate contract can be a daunting undertaking. In addition to choosing among the various leasing structures, it will be essential to identify key contract clauses to include in the lease agreement. Landlords and tenants are likely to have substantial common ground, but on some level they are also apt to have competing interests, so advanced negotiation strategies may be called for.

Clauses of Special Interest to Tenants

Generally speaking, the desirability of a contract clause is going to depend heavily on the perspective of the party examining the contract. What works well for the buyer is often a detraction from the point of view of the purchaser – and the same is true for landlord-tenant negotiations. A few key clauses that tenants often prioritize (and may compromise on other contract terms to achieve) include:

• Exclusive use: Exclusive use clauses are commonly sought by tenants operating in the retail sector. The specific terms involved will depend on the parties negotiating the contract, but in general an exclusive use clause is designed to limit the competition a business is likely to face in the spot they are leasing, usually by specifying that the property owner will not lease nearby or adjacent property to another retail business with similar offerings, price points, and clientele.
• Subleasing: A subleasing agreement specifies terms under which the tenant has the right to contract with a third party to use some or all of the premises covered in their lease agreement during the term of their lease. This type of agreement can be helpful for seasonal businesses that sharply expand or curtail their operations during certain times of the year, as well as for those that are testing expansions into a new market and are anxious to secure a means of recovering the costs associated with a long-term commercial rental if the revenue yield from the venture proves disappointing.
• Co-tenancy: Smaller businesses sometimes choose their locations based on the proximity of larger businesses they know are popular with their target market. Particularly for small retail startups, the presence nearby of a much larger retailer or even a restaurant that can be expected to generate high volumes of consistent foot traffic may prove a decisive factor in selecting a location to rent. Because all of these advantages evaporate if the “anchor” business departs the premises, prospective tenants who consider this kind of “co-tenancy” to be important to their business outlook will often negotiate aggressively for a contract clause that secures their right to early release from their rental agreement if the specified business closes its doors.

Clauses of Special Interest to Landlords

While tenants tend to prioritize clauses in commercial real estate contracts that either limit their competition within the premises (for instance, in a strip mall or other multi-tenant retail development context) or guarantee that the property owner will have an ongoing interest in the tenant’s business success, landlords generally prize contract terms that secure stable rent revenues from each tenant without restricting their flexibility in developing, leasing, or otherwise disposing of other units within the premises. Clauses commonly used to achieve these goals include:

• Rent escalation: Landlords have an obvious interest in securing the right to increase tenants’ rental fees in light of changes in the commercial real estate market. For gross leases or single- or double-net leases, as well, contract clauses that specify “triggers” that will authorize an escalation in rental fees can be crucial to a property owner’s bottom line.
• Security deposit: Security deposits are important in most forms of leasing. In commercial real estate contracts, landlords may sometimes tie security deposit negotiations to lease renewal dates, providing incentives for solvent tenants to remain on the premises.
• Relocation: Relocation clauses provide landlords with enhanced flexibility but can be unpopular with tenants, due primarily to the inconveniences they can cause when activated. Essentially, a relocation clause allows a landlord to move a tenant to a different unit within the same premises – for instance, by shifting an accounting business to a different suite of offices within the same complex – either at-will or when certain conditions, outlined in the contract, have been met.

Key Clauses To Negotiate in Commercial Leases

There are a number of common clauses in CRE contracts that both parties may wish to negotiate. Examples of these include:

• Alterations: Alterations clauses specify the extent of alterations a CRE developer is willing to make to accommodate a tenant, or the extent of alterations to the premises the tenant is permitted to make. These clauses will also need to specify who is responsible for the costs associated with any such alterations, as well as how any assessments related to structural integrity of the premises (a potential factor if more than cosmetic changes are under consideration) will be handled.
• Maintenance: In many “net” leases, responsibility for costs associated with property maintenance will be clear from the expense categories excluded from the tenant’s rental fee. In an unmodified gross lease, the default assumption will typically be that the landlord will pay for these costs out of the rent revenue. For other lease types, however, specifying who will pay for which types of maintenance becomes crucially important for each party to develop a sound understanding of their overall ongoing expenses associated with the rental agreement.

Are You Preparing To Negotiate a Commercial Real Estate Contract?

Whether you are an entrepreneur seeking a new location for your startup business or a commercial real estate developer looking for a tenant whose business will be a good fit for a long-term lease, knowing which contract clauses have the greatest impact on your priorities is essential to making wise decisions as you negotiate the terms of your agreement. Consider scheduling a consultation with Harrison Law, PLLC. Our business law attorneys are experienced in negotiating a wide variety of commercial real estate contracts and may be well-positioned to advise you as you weigh your options. Call (480) 320-2310 today to set your appointment.

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This website and article have been prepared by Harrison Law, PLLC for informational purposes only and does not, and is not intended to, constitute legal or financial advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.