Your Commercial Property Purchase: Lease Basics
By Cathy Humphrey
You did it! You’ve bought a commercial property and now you are wondering what to do next. Whether you are trying to fill vacant space or inheriting an existing tenant, it is important to know what you’re getting into, as a commercial lease is very different from a residential lease. Many business terms are negotiable, so if it works for both you and your tenant, you can likely make it happen.
Not all commercial leases are the same and the type of lease you use depends on the type of property you have. For now, I will assume that you are leasing out commercial space of less than 10,000 square feet within an office, retail or industrial development, as opposed to a shopping mall, large industrial site, freestanding building or a land lease.
Rent During Fixturing Periods
If your space is vacant when you take possession you will need to factor in a cushion for covering the carrying costs until the tenant has moved in and is paying rent. The Fixturing Period is the period of time between when a tenant takes possession of the space and when it opens for business and starts paying rent. Regardless of who is paying for the Tenant Improvements, or TIs, tenants are not usually willing to pay rent during the Fixturing Period, although they will often pay for utilities.
If you are going to manage the unit yourself, it is important to have a thorough understanding of what you can charge your tenant, what costs you may be carrying, and how to manage your cash flow.
Before the start of your fiscal year, you need to create your annual budget so you can let your tenant know what their estimated share of operating costs will be, known as the rent notice. Depending on the property, operating costs could include landscaping, garbage, snow removal, paving, insurance, and general repairs and maintenance. Property taxes are also included in this budget. It doesn’t need to be complicated, but you do want to make sure that you aren’t omitting anything that could be charged to the tenant.
At the end of the year, you will need to send your tenant a reconciliation of what your actual expenses were versus your budgeted expenses. If you over-budgeted, you will need to refund that amount to your tenant (or you could let them apply it to their next month’s rent). If you under-budgeted you will need to invoice your tenant for the difference.
Managing Cash Flow
If you’re just getting started, these tips to manage your cash flow could help you sleep better at night.
- Prepare your budget in plenty of time so you can get your rent notices out a month before the end of your fiscal year. If you follow the calendar year and you send your rent notices out in February or March, you will have to cover any shortfalls until your tenant has their new rent schedule in hand and can make the adjustments.
- Property taxes can be a big cost; where possible, get set up with the City’s Tax Installment Payment (TIP) program. That way the money will come out of your account each month instead of all at once. If the municipality sends you an updated TIP amount notice part way through the year, you can often adjust that portion of the rent for the remainder of the year so you aren’t out of pocket.
- Capital expenditures need to be included in your budget. Even though they are eventually paid for by the tenant, you are still responsible for paying that amount up front and then amortizing it over the life of the item and collecting a portion of it each year. For example, if you’ve gotten quotes from industrial roofing companies and a new roof will cost you $25,000. It should last 20 years so you can charge back $1,250 per year to your tenants.
- You can’t charge a tenant for expenses that you didn’t incur, so you will want to put aside a portion of the income from your minimum rent, just as you would with a residential property.
- Where possible, include an administration fee in the lease. This could range from 5% to 15% of operating costs. Tenants may resist paying this fee on property taxes, insurance and utilities. Surprisingly, this cost is often charged in addition to property management.
As you can see, it is important to try to make your budget as accurate as possible so you aren’t carrying costs unnecessarily. If a large unexpected expense does show up part way through the year, for example a record year of snowfall, most tenants would tolerate an increase spread out over the remainder of the year rather than one large bill with the year-end reconciliation.
If you have a single tenant building or a strata unit, this process will be simpler, but a solid understanding will still help you succeed as an investor. You could structure the lease so that the tenant pays property taxes, utilities, garbage removal, etc. directly, as long as you are comfortable that they will pay it on time. You don’t want to find out the hard way that the taxes aren’t paid, the garbage is piling up, and the parking lot has large potholes in it.
As with residential investments, you can hire a property manager to take care of things or you can manage the building yourself, it all depends on how hands-on you want to be. If you decide to hire a property manager, make sure you hire a commercial property manager who has experience with your type of property. If you want to manage it yourself, be sure to pay yourself, just as you would to manage a residential property.
I have to be honest, my eyes still glaze over every time I read an insurance clause in a commercial lease. It is important to get advice from an insurance broker who is familiar with commercial insurance and you need to ensure that the lease clearly sets out the insurance you require your tenant to purchase. Always make sure that your tenant provides you with a copy of their insurance certificate each year.
Your insurance broker can also help you determine what kind of insurance you need to purchase yourself, including commercial liability, building replacement, business interruption, loss of income, and the myriad of other types of commercial insurance available.
Many leases include a rent abatement clause that allows the tenant to reduce the rent that is paid in the case of a fire or other damage in proportion to the amount of the space that was damaged and the time it was unusable. Make sure that the wording takes into account the type of tenant you have. For example, an industrial tenant that has a fire in one corner may be able to operate, but a restaurant that loses its kitchen won’t reopen until repairs can be made. Going back to the insurance clause, you also need to make sure that you have the appropriate rental income insurance to make up the difference.
Chattels vs. Fixtures
When a tenant moves out, they can take their chattels with them, but they must leave fixtures behind. Improvements to the building are fixtures and become your property when the tenant leaves. As a guideline, chattels can be easily removed or are proprietary to the tenant, fixtures are attached. Examples of chattels could include freestanding shelving or equipment; while fixtures could include retail sales counters and built in shelving. You also want to make sure your lease gives you the option to require the tenant to remove everything when they vacate, in case your new tenant has significantly different requirements.
If you are helping pay for TIs, there are a few different ways you can recoup these costs. You can amortize the cost of the improvements over the term of the lease and then bump up the base rent to recover those costs, or you could have the tenant repay those costs as a separate line item under operating costs. Rolling the amount into the base rent can sometimes let you keep the rents a bit higher on renewal, although a savvy tenant will baulk at this. Keeping the calculation separate can change the way it is accounted for (e.g. long term debt repayment as opposed to base rent). This is not an exhaustive list; I am sure you can come up with other creative strategies. As with everything, there are advantages and disadvantages to each strategy; always check with your Accountant to see which works best for you.
Renewing the Lease
If your tenant has an option to renew their lease, there is a specific time frame within which they can exercise that right. It can vary, but 6-12 months is common. Even if you are confident they are going to stay, have a conversation with your tenant a few months before the notice deadline. If they are planning to leave, you want to make sure you have some time to find another tenant and minimize the time that the space is vacant.
If they do want to renew the lease, it is to your advantage to negotiate the new rental rate after they have given notice that they want to renew: it gives you a bit more negotiating power if they are already committed. Your broker will be able to give you some comparables to help with your negotiations. Most leases contain an arbitration clause that defines how rents will be determined if the parties can’t agree. In my experience, it is best if you can negotiate a deal. Arbitration can be quite costly and time consuming, and it can damage your relationship.
Registering the Lease
Many tenants will want to register their lease against your title. This does not usually cause any problems, but make sure you have your lawyer review the documents. The actual document that is registered varies by province. Alberta and Ontario both require fairly simple documents: in Alberta it is a caveat and in Ontario a Notice of Lease. In BC it is a little bit more complicated, but as long as you make sure your lease states that the costs of preparing documents and registration fall to the tenant it shouldn’t be too onerous. Always make sure that your lease requires the tenant to discharge the charge from title, at their cost, when they vacate.
As you can see, it is important to familiarize yourself with the many different aspects of the commercial lease. It may seem a bit daunting, but your professional team and the REIN community can help you work through it. It won’t be long before you are as comfortable with commercial leases as you are with your residential ones.
Cathy Humphrey is a real estate investor who has over 25 years of experience in various aspects of managing commercial property and is currently the Real Estate Manager for a Canadian restaurant chain. Reach Cathy at firstname.lastname@example.org