on March 5, 2016
Each commercial lease provision is important in its own right. Nevertheless, clients, real estate brokers and real estate attorneys instinctively look for what is commonly considered the most important provision to both the landlord and tenant: the rent. Although seemingly straightforward, calculating rent in a particular commercial lease lease can be cumbersome and often varies depending on whether the space is used as office, retail, restaurant, laboratory or industrial.
Base Rent and Triple Net Provisions
Rent is typically set at a price per square foot per year (commonly referred to as “base rent”), which is usually based upon rentable square feet (“RSF”) instead of usable square feet (“USF”). For example, if a lease base rent is $10 per square foot for 4,500 RSF, the tenant will pay $45,000 in base rent per year, or $3,750 per month. In oversimplified terms, RSF is the entire area of the interior space of premises and may include certain “unusable” portions of the premises like utility closets, building columns and the like. USF contains the entire area of the interior space of premises, but subtracting out certain portions that cannot be used by the tenant (i.e. utility closets, building columns, etc).
Lease rental provisions are usually one of two forms: rent is either “gross” or “net.” A “gross” lease means that the tenant’s base rent covers all of the costs associated with the tenant’s occupancy, with some exceptions like separately-metered utilities. A “net” lease (also known as a “triple net lease”) means the tenant’s base rent covers only a portion of the costs associated with the tenant’s occupancy. Other costs, such as taxes, insurance and building maintenance costs, are billed separately to a tenant. Because the tenant covers the additional costs under a “net” lease, the base rent charged is typically lower for a “net” lease than a “gross” lease.
Percentage Rent — Natural vs. Artificial Breakpoints
Regardless of whether a lease is “gross” or “net,” some commercial leases contain a “percentage rent” provision. “Percentage rent” is rent paid in addition to base rent and is based upon a percentage of the tenant’s sales. This type of structure is common for restaurants, multi-tenant commercial spaces and shopping center kiosks. Landlords request percentage rent on the theory that certain commercial enterprises, like shopping centers, are a natural draw for customers. Under this analysis, because the landlord’s rental income will increase if the tenant meets certain sales goals, the landlord is incentivized to increase traffic to the tenant’s business. If the tenant fails to obtain the applicable sales goals, however, the tenant will not owe any additional percentage rent.
The point at which percentage rent is paid is call a “breakpoint,” which can be a “natural” or “artificial breakpoint.” Artificial breakpoints are created based on a predetermined dollar amount of gross sales. Continuing with the above example, assume the parties agree that if the tenant’s gross sales exceed $1,000,000, the landlord is entitled to 5% of the amount over that breakpoint. Under this scenario, if the tenant generates $1,200,000 in gross sales, the tenant would pay the landlord $10,000, or 5% of the $200,000 over the $1,000,000 breakpoint. Natural breakpoints are calculated based on dividing the base rent by the percentage to be paid to the landlord. Using the same example, if the parties agreed to a natural breakpoint, the annual rent, $45,000, would be divided by the agreed upon percentage, 5%, which equals a natural breakpoint at $900,000 in gross sales. The justification for a natural breakpoint is that the tenant should only pay the percentage rent on sales over and above what is required under base rent. Meaning, the landlord only receives a percentage of the tenant’s gross sales after the base rental amount is covered.
Deciding between an artificial breakpoint and natural breakpoint can be difficult, particularly when a tenant does not have past sales to analyze. In general terms, a tenant may prefer a higher base rent with a higher breakpoint, which would enable the tenant to profit at a lower sales level before having to pay the percentage rent. Conversely, a landlord may be interested in accepting a lower base rent with a lower breakpoint if the landlord is confident that the tenant’s business will be particularly popular in the space.
Rent Increases – Extensions
At the end of the term of a lease, the landlord and tenant may agree to extend the term of for an additional period of time (e.g. five additional years). Upon such extension, most leases state that rent will have a fixed increase for that extension. A fixed increase is simple: the rent increases annually based on a previously agreed upon amount or percentage. More common, however is a provision that rent will be adjusted to the then fair-market-value (“FMV”). Rent adjusted for FMV is generally based on comparable leases of comparable space.
Whether a lease or space is “comparable” is generally determined using factors listed in the lease. A “comparable space” involves a number of criteria, including the location and size of the space; the use of the space; prominence within the area; and the age of the building and its amenities. Determining the FMV, of course, can be subjective. It is not uncommon for any three real estate appraisers to come up with three substantially different FMV valuations. As such, it is critical to draft lease extension provisions with as much detail as possible for the determination of FMV.
The above is a simplified summary of different approaches to rent for a commercial space. Each situation is different, and often different locations will have differing “standards” for how leases are structured. For example, in the Boston area, the standard provisions for commercial leases in Cambridge often differ from those in Boston. In fact, the standards in different neighborhoods in Cambridge (e.g. Kendall Square) often deviate from other neighborhoods (e.g. Harvard Square). As such, it is critical that both landlords and tenants speak with a Boston commercial real estate attorney before executing a commercial lease.