Commercial Real Estate Basics for Business Owners

Commercial real estate is one of the biggest financial decisions a start-up or established business will make, regardless of whether they need their first office or they're moving to a new location. Business leases are quite different from an apartment lease, can be negotiated, and can last for years. It's costly to get it wrong. You can have your growth for 10 years on one right.

Whether you are a landlord or a tenant, this guide covers the basics, so you can enter into any business real estate transaction with confidence, knowing exactly what to expect.

So what is commercial real estate?

Commercial real estate (CRE) is defined as any piece of real estate that is not used as a home. It can be a small retail storefront, a multi-story office tower, or a massive distribution warehouse.

It is important to know which business category your enterprise belongs to, not only for space availability, but because each business category has different market dynamics, lease terms, and cost structures.

Understanding Lease Types

Most business owners are caught off-guard at the lease. Commercial leases bear little resemblance to residential leases, and the financing is quite different. The most usual are:

Gross Lease

A flat monthly rent is charged, and this rent covers the majority of operating expenses - taxes, insurance, maintenance, etc. More straightforward to budget, with generally higher base rent to make up for that.

Net lease (Single, Double, Triple)

Base rent plus some/all operating expenses of the property are paid. Triple Net (NNN) leases (found in retail) require the tenant to cover base rent, property taxes, building insurance, and maintenance expenses. The amount you are required to pay each month may vary.

Modified Gross Lease

A compromise. Landlords and tenants share operating costs as outlined in the lease. Widely found in multi-tenant office buildings.

Smart business owners also look at the base rent as only a fraction of the real picture when it comes to renting space - they also take into account taxes, utilities, insurance, and CAM.

Before you negotiate, use these key terms to know.

There's a jargon to commercial leases. These are the terms that will make up your deal:

Rentable square footage - You'll be charged for rentable space, which includes shared spaces (bathrooms, hallways, lobbies). The usable space is the actual space your business uses. The difference is known as the load factor, and is usually around 10-20%.

Common Area Maintenance (CAM) Charges - Funding to pay for the upkeep of shared areas. These can constitute 15-30% of base rent in retail and/or office properties.

Tenant Improvement Allowance (TIA) - Funds that the landlord provides to make certain that the space is customized for your needs. One of the key points to negotiate in longer leases.

Lease Term & Renewal Options - Typical commercial leases are 3 to 10 years long. Lock in renewal terms at fixed rents to guard against rent increases.

Personal Guarantee - Sometimes, the landlord requires the business owner to include his or her personal guarantee on the lease, and may hold the business owner liable even if the business fails.

Exclusivity Clause - This clause will help the landlord ensure that they do not allow commercial space to be rented out in the immediate vicinity of the tenant's business that will be competing with the tenant.

The question here is, which is more practical, leasing or buying?

For most early-stage businesses, leasing is usually the ideal solution for most of these reasons, because it allows you to keep your capital free, it allows for flexibility, and it doesn't tie up your cash in liquid assets. However, when your business becomes more mature, it begins to make sense to have an owner.

Consider leasing when: You have a need to grow quickly, and your space requirements fluctuate, you are in a high-cost primary market, or you require capital flexibility in your business and stock.

Purchase when: occupancy requirements are consistent and predictable, prices are reasonable in a secondary/ suburban market, or real estate is integral to your business (hospitality, manufacturing).

The advantages of buying include that it leads to equity, may appreciate, and potentially generate rental income on the spaces not being used. However, it's accompanied by the property administration obligation, capital pledge, and less agility.

The following are signs that could be red flags to watch in any deal.

The transaction of commercial real estate can be fast, and landlords are seasoned negotiators. Be alert for these danger signals:

Uncapped CAM charges - Negotiate a cap on an annual increase of CAM - this is usually 3-5%.

No exit clause - When a lease does not provide for the right to sublet or assign the lease, then it is an end-all lease. Discuss the right to sublet.

Vague definition of operating expenses - Obtain precise definitions of operating expenses.

Short notice for renewal - Some leases will have a 12–18 month notice period for renewal. If you miss the window, you will not get a second chance.

How to Approach the Market

Do research before dealing with the landlords. Check out the market vacancy rates in the area you are interested in; the more vacancies, the better your negotiating hand. Know if rents are increasing or decreasing. Meet with the landowner and other businesses around the premises to see their experience with the building and the landowner.

Do not work with any commercial agent, but a tenant's broker. A tenant's broker must work for your best interests, not the landlord's, and they may not work for you unless the landlord pays them!

The Bottom Line

One of the most negotiable deals in business can be commercial real estate transactions - if you know how to play the game. Understand your lease type, your total cost of occupancy, negotiate all the important clauses, and don't overlook the legal review.

The right space, on the right terms, is a competitive advantage. The incorrect lease is an annual drain on cash flow and accumulates over a number of years. Do the work in advance, and your space will work for you, not against you.