For many entrepreneurs, the space from which they operate their businesses will be an essential factor in determining their current and future success. One of the primary reasons for this connection is that the cost of the space will form a substantial part of the overhead costs that will have a direct impact on their financial bottom lines.
While leasing space is not as permanent a commitment as purchasing property, it still represents a major commitment that will normally legally bind a business to a property for a substantial period of time. As a result, caution must be taken when entering into any leasing arrangement.
Here is an overview of some of the common pitfalls that entrepreneurs, both new and old, fall into when leasing commercial space.
Letters of Intent, Offers to Lease and Leases
Letters of Intent and Offers to Lease are the two types of documents that are most often used in lease negotiations.
A Letter of Intent is usually a non-binding document and is generally executed by the landlord and a tenant in the early stages of negotiations. However, it is important to take care in either drafting or signing such a letter, as, depending on the specific wording of the document, the potential exists for a court to find that it is in fact a binding agreement.
The purpose of a Letter of Intent is to set out the major financial and business terms of the lease as the base for negotiating final terms. Quite often, a Letter of Intent also prohibits either party from negotiating with other parties for the same lease space for a specified period of time. Normally, it would include a description of the space that will be leased, the cost of rent, whether percentage rent will also be payable, the duration of the lease and whether there will be a right of renewal.
As opposed to a Letter of Intent, an Offer to Lease, often referred to as an agreement to lease, is intended to bind the parties. It is at this stage of negotiations that the four corners of the leasing relationship are established in a legally binding fashion and, therefore, the parties should be diligent to ensure that all significant issues are not only addressed but also defined in significant detail in order to prevent future confusion or disagreements.
Similar to Letters of Intent, the Offer to Lease will contain the financial and business terms of the lease but in far greater detail. They may also contain various covenants and warranties given by one party to the other.
It is also common for Offers to Lease to contain a provision which states that by executing the offer, the tenant agrees to execute the landlord’s standard Form of Lease by a certain date. If after signing an Offer to Lease that contains such a provision, a tenant subsequently refuses to sign the landlord’s standard Form of Lease, the tenant will be exposed to a possible lawsuit and damages being awarded in favour of the landlord. In addition, even if the standard Form of Lease is not executed, a leasing relationship may still be found to have come into existence by the courts and the tenant and the landlord will be bound by the terms as set out in the Offer to Lease.
If, after signing an Offer to Lease with a standard Form of Lease provision, the tenant is not satisfied with some of the terms or definitions in the lease presented by the landlord, he or she will not have a choice and must, except in very rare circumstances, execute the lease as tabled. A tenant can, of course, still request revisions to the lease once a binding offer to lease has been executed, but most landlords will refuse to even consider them, particularly revisions to any of the financial terms of a lease. The landlord will instead simply point to the above-noted binding provision.
Net leases, Rent, and Operating Costs
The majority of commercial leases are net leases. If a lease states that it is a completely net lease to the landlord, this means that, except as otherwise expressly stated in the lease, the landlord is not responsible for any costs relating to the premises and the tenant is responsible for all such costs. Sometimes people refer to leases as being net-net leases or triple net leases.
Under net leases, one typically finds three types of rent that are charged to the tenant. The first type is the basic minimum rent, which is the yearly rent payable by the tenant for the leased space. There is also percentage rent, which normally requires the tenant to pay a percentage of its annual revenues above a certain preset amount. This largely applies to retail and/or restaurant operations. Finally, there is additional rent through which the landlord recoups its costs of operating the space, including, among other things, the costs of repairs, insurance, and taxes.
Most of the additional rent charged to a tenant will be comprised of what is often referred to in a lease as “Operating Costs”. Operating costs will normally be a defined term and its meaning should always be carefully reviewed prior to signing either a lease or an offer to lease which requires a tenant to execute a standard form of lease.
In most cases, the landlord will reject any requests for substantial changes to the definition of operating costs. Nevertheless, its definition should not be ignored simply because changes to it are likely to be difficult to obtain. A detailed review of the definition should be undertaken to ensure that all operating costs are fully understood. These types of costs can quickly grow out of control and have the effect of doubling or even tripling the amount of rent, which may ultimately bring about the failure of an otherwise successful business.
In many net leases, the definition of additional rent and/or operating costs will permit the landlord to charge the tenant for all of the operating costs for the space, even those that are not specifically set out in the lease. Not only does such a clause contribute to the possibility of operating costs spiraling out of control, but also to the likelihood of hidden costs being charged to the tenant. In almost all cases, a landlord is required to reconcile, once each year, actual operating costs with those charged to the tenant throughout the previous year.
Many tenants do not realize it, but HST is payable on all rents payable pursuant to a commercial lease, even if the lease does not specifically state that HST is payable on the rents.
Commercial leasing is a complicated matter with many pitfalls awaiting the unwary. Retaining the assistance of a qualified, experienced advisor, such as a lawyer, early in the lease negotiation process can help you avoid many of those pitfalls. By following this approach, you will be able to focus not only on where your business is but also on where it is going.
For information related to commercial leasing and Nelligan O’Brien Payne LLP’s commercial leasing team, please contact James Leal directly at 613-231-8319 (firstname.lastname@example.org) or visit our commercial leasing page.
Author: Geoff Cantello for the Ottawa Small Business Forum, © Nelligan O’Brien Payne LLP © 2011