The Commercial Lease

By Keith Lord
Far too often in our business, we see landlords making terrible mistakes in leasing their commercial space. Many landlords are highly skilled in residential leasing, but don’t fully understand the commercial lease. This is unfortunate, since commercial leases can make up the majority of a building’s income, expenses (usually taxes) and, subsequently, the building’s value.

Though the residential and commercial markets are quite different, the notions behind the industry are the same, and therefore residential Realtors can learn from commercial successes and mistakes.

In the recent past, many landlords lost buildings because of poor commercial leases, so it’s important to review some commercial leasing basics. In a sense, this is similar to the way residential deals fall through when agents don’t pay attention to the clients’ clues.

Basic Commercial Theory
The goal with the commercial lease is basic: “make the other guy take the risk.” In long term leases (over 2 years) there is a tenancy risk. Your goal is to make the other party responsible for as much of the risk as possible. These risks include tax increases, rent increases, inflation, maintenance, repair, tenant business risk, renewal risk and more. The landlord’s ideal goal is to put these risks on the tenant, while the tenant’s goal is to make the landlord absorb as many of these risks as possible. Any smart tenant or tenant broker should know this game.

An example of this can be seen from a well-known Chicago restaurateur, who usually offers a landlord the following “deal.” If the landlord will discount their rent, pay for all the tenant build out, offer the tenant a 20 percent free rent concession and a fixed-rent, 10-year gross lease with a kick out after the first year, then the landlord can have the privilege of leasing to this “big name” tenant. No prudent landlord should accept this type of deal structure because it places too much risk on the landlord, but more than 25 landlords in Chicago have followed this path. When this tenant is successful, then the landlord will do well. When the tenant fails — the tenant has closed five sites ­— the landlord’s losses are huge.

The Good Tenant
After you hang a “For Lease” sign on your property and Fred of Fred’s Video and Coffee Extravaganza calls to lease the space, how do you determine whether Fred is a good tenant or the next coffee shop to fall under Starbuck’s rule?

The first thing to understand is that all types and sizes of tenants can default. National and regional tenants default as often as small local merchants. Remember McDonald’s on Clybourn, Brown’s Chicken on Division and West Coast Video almost anywhere? These tenants, for whatever reason, are not there anymore. Don’t equate size or a national name with lower landlord risk.

Another landlord mistake is assuming that tenants’ brokers have screened their tenants. Usually they have not, and many times the brokers are surprised by their tenant’s potentially weak financial position.

When landlords represent themselves, they should use the following criteria to screen tenants:

1. How long have the tenants been in business? Obviously, the longer the better. Is the business they have been conducting the same type as the one they are currently proposing to open? If not, this increases your risk.

2. Do they currently own or manage the existing business? It is common in Chicago for a good chef to want to open his or her own restaurant, but a great chef may be a poor business manager.

3. Does the tenant’s current business make money? Make the tenant prove this with audited tax returns. Don’t accept a home-computer-generated financial statement; you need financials from an outside source.

4. What does the tenant’s credit look like? Run a credit check on the tenant, the business principals and the business.

5. Get tenant references and call them. Call the tenant’s banks, suppliers and attorney if possible.

6. What is the success history of the tenant? Is this the first venture or has he/she started a successful business in the past? Has he/she failed in business in the past? Is there any past history of bad debt or a terminated lease? Call previous landlords.

7. Where is the tenant’s start-up money coming from — debt, equity, a partner or personal funds? Find out the status of these funds. Everybody has the money to start a business until it’s time to cut a check. Don’t waste your time and legal fees on tenants without verifying their liquid funds.

8. How much is the tenant placing at risk personally? You want as much tenant personal risk as possible because corporations are fairly easy to bankrupt. When you lease to a tenant, you place your building’s income flow at risk. The tenant should also place his or her assets at risk.

9. Are the tenant’s business pro formas available? If they are, get a copy and review them. If none exist, look out. A tenant without a business plan usually fails.

10. Use your gut feelings. Does the tenant seem like a good risk? Always meet with the principals or managers of the business and trust your opinion of their potential success.

Back to Fred’s Video and Coffee Extravaganza, if Fred is experienced, has good credit, is well capitalized, comes recommended and personally guaranteed, and if the lease and your gut says he will pay, then he is a good risk.

The Lease Guarantee
One of the best ways for a landlord to reduce tenant risk is with a strong lease guarantee. A strong lease guarantee is one that is large, liquid or easy to perfect if the tenant defaults.

If the tenant is a national corporation, the landlord should try to get a full corporate guarantee of the term of the lease. If the tenant is a subsidiary, try to get the parent company and the subsidiary to co-guarantee the lease.

If the tenant is midsize, try and get a corporate and personal guarantee. Again, if possible, the guarantee should be for the full lease term. It is easy to take a corporation into bankruptcy, many tenants set up small corporations in anticipation of using them as lease escape hatches.

For a smaller tenant, S corporation, or partnership, is as strong a personal guarantee as they can possibly provide. Many times you can get multiple business partners and/or spouses to co-guarantee the lease.

A large security deposit is another form of guarantee. This is the most liquid form possible. The higher risk the tenant, the larger the security deposit a landlord should require. We have completed leases in which the entire first year’s rent is paid up front.

Another form of guarantee for higher risk tenants is requesting the tenant to provide a letter of credit (LC). The tenant goes to his or her bank and pledges funds to create the LC. The landlord should hold the LC, which should be convertible to cash if the tenant defaults. We usually request an LC equal in value to the cost of the lease (construction, brokerage commission, legal fees) plus six to 12 months of rent. Subsequently, if the tenant defaults, our costs are covered, and we have a cushion to release the space.

Bottom line, guarantees reduce the landlord’s risk. Get the best, largest, most liquid guarantee possible.

As outlined above, there are many things to consider when moving forward with a commercial lease. Though the details vary from residential transactions, the same instincts are required. In general, get as much information as possible from your client — or your tenant — and that will put you on the path to success, regardless of whether you are on the commercial end or the residential end of a real estate deal.

Keith Lord is president of The Lord Companies, LLC. The Lord Companies LLC principals have over 25 years experience in both retail and office brokerage in Chicago. LORD can be reached at 312.944.6270.

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