Commercial Leases Key Clauses and What They Mean

1 FALL 1995 PUBLICATION 1097 INSTRUCTOR S NOTEBOOKA Reprint from Tierra Grande, the real estate Center JournalCommercial LeasesKey Clauses and What They MeanAproperty s estimated net operating income(NOI) is one basis for estimating itsvalue. Because a property s estimated NOIdepends on the payments expected fromindividual tenants, real estate analysts should reviewthe economic Clauses that are part of each commer-cial property lease . From the lease -by- lease review ofthe economic Clauses , an analyst assembles thefollowing information used to estimate the annualNOI for the analysis period.

2 Expiration date of current Leases Current rental rate and rental growth rate Proportion of operating expense paid by thetenantCommercial Property LeasesAlthough Commercial property lease forms arestandardized, there is no such thing as a standardcommercial property lease . The negotiation betweenlandlord and tenant usually results in some additionto, subtraction from or a wording change in thestandard form before the parties reach a strong landlord and a national tenantnegotiate a Commercial property lease , both partiesrely on previous negotiations; both are likely to haveadvice from experienced legal advisors.

3 But in somecases, the parties may not be evenly matched. Forexample, a strong landlord may be negotiating withan inexperienced local tenant, or an inexperiencedlandlord may be negotiating with a strong nationaltenant. And if both parties are inexperienced, theoutcome may be unpredictable. Thus, the specificterms of Commercial property Leases may varysignificantly, even among tenants in the sameproperty. To correctly forecast the property s incomestream, therefore, it is essential to analyze particularclauses in each tenant s lease .

4 Because the property sestimated value is based on its estimated income,analyzing each lease is essential to the Commencement DateForecasting the property s income stream beginswith determining the remaining term of each lease is dated when it is negotiated and signed;however, the lease may begin on a later date. Forexample, if a lease is signed before construction iscompleted, there may be considerable time betweenthe date the lease is signed and the date the prop-erty is ready for identifying the lease commencementdate is important because the lease s expiration datedepends on the commencement date rather than thesigning date.

5 The information contained in the leaseagreement s economic Clauses assists in estimating aparticular tenant s contribution to NOI as long asthe lease is in lease expiration dates also indicate periodswhen vacancies may occur. The analyst must con-sider the probability that the current tenant willrenew the lease or that a replacement tenant can beobtained if the lease is not RentThe agreed fixed minimum rent is stated in thelease, usually in terms of the monthly rent to bepaid.

6 The per-square-foot rental rate is calculated bydividing the fixed minimum annual rent by thenumber of square feet Leases may have a means to enable theproperty s owner to cope with rising managementcosts and to achieve a competitive rate of increases in the monthly fixed minimumrent may be agreed to when the lease is negotiated;although these planned increases are included in thelease, they may be noted in an entirely differentsection of the lease from the statement of the initialfixed minimum increases in the fixed minimum rent alsomay depend on changes in a specific economicindicator such as the Consumer Price Index.

7 Linkingrent increases to specific economic indicators maybe used alone or in combination with specificallystated increases in the fixed minimum future rental increases are not specificallystated, forecasting future rental income is moredifficult for the analyst because the future course ofinflation must be estimated. Nevertheless, makingsuch an estimate may be easier than forecastingfuture market rental rates, which depend on thesupply and demand for a particular type of space ina specific market the minimum rent for a fully leasedproperty for the period of analysis is relativelysimple.

8 However, future rent may be more or lessthan what would be received if the property wererented at market rent RentLease agreements between retail tenants and retailcenter owners usually include a fixed minimum rentand a percentage rent provision. This provisionBy Wayne E. Etter and Rafael FigueroaInstructor's Notebook presents a lecture on a basic real estate subject. Written by an expert, Instructor's Notebook takes readersinto the classroom to hear the professor's talk.

9 This regular feature is designed as an introductory lecture on a different topiceach the tenant to pay the larger of the fixedminimum rent or a stated percentage of gross example, if the fixed minimum rent is $5,000per month ($60,000 per year) and the percentage rentis 5 percent of gross sales, the tenant will pay$60,000 per year until the store s gross sales exceed$1,200,000 (.05 $1,200,000 = $60,000). Gross salesof $1,200,000 are called break-even sales.

10 The per-centage of gross sales used to calculate the percent-age rent may vary for different levels of gross salesin excess of break-even break-even sales amount usually increaseseach year. The annual increase should at least beequal to expected inflation. In this way, the tenantis protected from paying a higher rent resulting fromsales increases caused by price inflation rather thanthe increased quantities of rent allows the owner to share inthe benefit of rising sales over time andencourages the owner to maximize thecenter s appeal to consumers.