How to Negotiate a Commercial Lease

Have you found a retail space for your business and are ready to sign a lease? Here are three things you need to know

 

Groucho Marx: All right. It says the first part of the party of the first part shall be known in this contract as the first part of the party of the first part, shall be known in this contract – look, why should we quarrel about a thing like this, we’ll take it right out, eh?

  Comedy is rooted in truth, which is what makes the Marx Brothers’ “Contract Skit” so hilarious. We can all relate to the frustration of negotiating formal contracts and commercial leases are no exception. But with a little preparation you can make your next lease negotiation as easy as possible. 

  Here are some tips and tricks that will help you to better understand your lease and hopefully to realize the best deal possible.

  When negotiating a lease for commercial property, there are three primary moving parts called “concessions” that tenants will use to achieve the best deal possible. Which of the three you push hardest for depends a lot on your business plan, but even more so on your initial capitalization:

• The Lease Rate

This is self-explanatory – everyone knows what a lease rate is: The “price” per month that you will pay to occupy the space. From the landlord’s perspective, they obviously have a vested interest in keeping the lease rate as high as possible, but they have another hidden motivation for doing so. See, commercial investment properties are valued for sale and refinance purposes based on their capacity for generating revenue. What’s more is that revenue is “capitalized” on the investment market which means $100,000 of income is worth $1.4M. The multiplier in this case is seven percent, which is what we call a “CAP Rate,” or the ratio of the income to the value of that income stream.

 Point is, asking for a monthly rent reduction of $1,000 for example, equates to a loss of sale/refinance value of $171,429 for the landlord. This is why it is extremely difficult to get landlords to budge on their rates: it hits them twice – once each month and again at a sale/refinance of their loan. Tenants will be able to get better “gross” concession by being more aggressive on one the other two concessions.

• Free Rent

This is my personal favorite negotiating point right here. As an inducement for signing a longer term lease, many landlords will agree to allow a tenant to occupy their space without paying rent for a period of time. This can be crucial for a tenant, particularly new businesses without existing revenue sources. A couple months rent free can give tenants the time to get set up in their new location, advertise to their customers, and start generating income before they ever have to make a single rent payment. It is also a much easier pill for a landlord to swallow, and again that ties into the CAP rate valuation of their building. Take the $1,000 rent reduction from the point above on a three-year lease for example. Total concession equals $36,000, but it also reduces the property’s capitalized value by $171,000.

 If instead you asked for four months of free rent (at $10,000/mo.), you have received a higher gross concession ($40,000), but the landlord suffers no reduction to the capitalized value of his building, so he’s going to be much more willing to grant you that larger concession.

• Tenant Improvements

Also called “TI’s”, this is the cost to build out or “improve” a space to make it functional for a particular business. Very common in restaurants and medical properties, this concession asks the landlord to participate in the cost to remodel or finish the space to a tenant’s specifications. This concession is usually given as a one-time credit and is often negotiated in “dollars per square foot.” This one is frequently a win-win for both sides because it reduces a tenant’s up-front out-of-pocket expenses as their business ramps up; and for the landlord they are actually investing that money back into their building. Many tenant improvements remain the property of the building owner when a tenant vacates.

Of course, when leasing a space literally everything is negotiable. These are just the three primary means of maximizing the concessions from landlords. Every deal should ideally involve a combination of all three, just keep in mind that sometimes you can gain the most by taking into account the person’s motivations on the other side of the table. Good Luck!

Cameron Wilson is director of brokerage and business development at Bradley Scott. He can be reached at (360) 479-6900 ext. 219.