Commercial Leases: Matching Financial Terms with the Business Deal

By Michelle A. Neumann

If you are about to embark on a new lease for commercial office space, fine tuning your understanding of common lease terminology can help expedite the process and ensure that the legal provisions of the lease match your business needs. Your first exposure to the unique terms related to a commercial lease may come in the form of a "letter of intent" or "term sheet", usually prepared by a broker, outlining the key terms of the lease. Once the letter of intent is executed by the landlord and the tenant, an attorney (usually the landlord's attorney) prepares a draft of the lease based on the letter of intent. Most landlords have a standard lease form that serves as a starting point. Any lease terms not supplied by the letter of intent will be as set forth in the landlord's form. Therefore, it is important to make sure that the letter of intent is accurate and includes all of the deal points between the landlord and tenant.

One of the most important terms in the letter of intent is the rent. You may see the rent obligation described as "gross", "triple net" or "percentage", among other terms. (Often times the lease itself may be referred to as "gross lease" or "triple net lease". A gross lease is sometimes called "full service" lease.) Gross rent means that the amount quoted for rent payments includes the base rent for the space as well as an amount to cover the tenant's share of utilities, insurance and the other expenses related to the ownership and maintenance of the building. Triple net rent (sometimes called "NNN"), by contrast, means that the amount quoted for rent payments is the amount of base rent, net of taxes, operating expenses and insurance expense. A triple net lease will require the tenant to pay its pro-rata share of those expenses, usually by paying a monthly estimate and reconciling annually to the actual expenses. Larger tenants may have the leverage to negotiate a cap on annual increases for some or all of these expenses. It doesn't hurt to ask. At the very least, ask for documentation of the expenses for the building for the past few years.

Percentage rent, which is used in a retail lease context, simply means that the tenant pays rent based on a certain percentage of its sales. Percentage rent leases include provisions requiring the tenant to periodically report on its sales so that the landlord can confirm the amount of rent due. Usually there is some amount of base rent payable in addition to the percentage rent, and percentage rent may not apply until a certain dollar amount of sales is achieved. Items that are to be excluded from the definition of gross sales can be heavily negotiated.

The tenant's obligation to pay operating expenses is a key financial component of the lease. Operating expenses can also be referred to as "CAM charges" or common area maintenance charges. Generally, the term "CAM charges" connotes a somewhat narrower range of expenses than the term "operating expenses." For leases in which the tenant pays its pro-rata share of operating expenses, there will generally be a very broad definition of the term "operating expenses", along the lines of "all expenses necessary to own, maintain and operate the building". Some leases will then include specific list of items excluded from operating expenses. The landlord and tenant can spend quite a bit of time negotiating items that will be excluded. Given that the definition of operating expenses can encompass a wide range of costs, it is important to have a thorough understanding of exactly which costs are being passed on to the tenant.

In connection with the term "operating expenses" you may also see the term "base year" used. For leases using a base year, only the increases in operating expenses over the base year are passed on to the tenant.

While the above provides a short summary of common meanings for certain lease terms, there are no universally-accepted or mandated definitions. As each building is unique, so is each lease. For that reason don't hesitate to ask for a detailed explanation of terms you don't understand, including numerical examples if necessary. It is very important to analyze the exact language of each lease, and to confirm that the lease matches the terms of the letter of intent. An experienced real estate attorney will be able to assist in you in this process.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should consult with competent counsel with regard to specific situations.

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