How to Negotiate a Lease
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This year may be the best time ever to rent space to start your own business: The nation’s 102,000 shopping centers are dotted with vacancies that landlords are desperate to fill. “I’ve never seen better deals,” says Paul G.W. Fetscher, president of Great American Brokerage in Long Beach, N.Y. “Everything is negotiable.”
But knowing what to negotiate is surprisingly complicated. Landlords may be anxious to fill empty spaces, but they’re also eager to make up for the money they’ve lost during the recession, and, unless you’re careful, that bargain lease you sign today can be filled with hidden charges, escalating fees and clauses that kick in when you’d least expect it.
Nick Rizzi, a former New York banker, thought he knew a lot about leases when he rented space for his tax preparation business, Smart Tax, in Brooklyn five years ago.
“It was February of my first tax season,” Rizzi says, “and the roof started leaking. I called the landlord and he said, ‘Didn’t you read the lease? I’m not responsible for the roof.'”
Commercial leases often run to hundreds of pages, and it’s easy to miss something crucial–such as who’s responsible for roof repairs or who foots the bill when snowplowing costs triple or the parking lot trees need to be replaced. And in the excitement of starting a business, it’s easy to forget what can go wrong. What if the Starbucks or Safeway you were counting on to bring customers your way suddenly closes down? Or the shopping center loses half its tenants? A properly negotiated lease contains contingency plans for those scenarios and many others.
We’ve asked real estate brokers, attorneys, small-business owners, franchisors and franchisees to walk through a typical commercial lease with us, to point out the items open to negotiation and to highlight the traps so that you can open your business in a perfectly maintained location–not an overpriced storefront with puddles on the floor–at a low monthly rent.
And speaking of Rizzi, he opened three more Smart Taxes after that first location. Each time, he took much more care before signing a lease: “If I find a vacant space I like, I spend a couple of days in the neighborhood, talking to proprietors of nearby businesses. I’ll go into a deli, buy a Snapple, and before long the owner is telling me how business is and what he’s paying for rent. I watch the foot traffic going past. Do they look like my customers?”
Find a Location
Basically, you want to be near complementary businesses that are making money. A tax preparation business does best when it’s near a bank and an insurance office; a children’s clothing store draws customers from a nearby toy store or Build-A-Bear Workshop. The International Council of Shopping Centers in New York lists 10 types of shopping centers on its website, icsc.org, and cites the types of stores found in each. For deeper research, order the council’s book, Dollars & Cents of Shopping Centers/The SCORE 2008, for about $200 from Amazon.
Or just get in your car and drive around. John Namey, director of real estate for the 380-unit Firehouse Subs in Jacksonville, Fla., says he goes into likely new trade areas and “drives the major and minor roads, looking where restaurant concentrations are. Where are our competitors located? We end up identifying a ground zero anchor point, then we tell prospective franchisees to look for sites within that point.”
Check out the traffic patterns of logical shopping centers, says Vas Lahanas, senior vice president of business development for Salsarita’s Fresh Cantina, a franchise chain based in Charlotte, N.C. Is it easy to get in and out of the parking lot? Contact the department of transportation and ask whether major construction is planned for nearby roads.
And don’t make the mistake of going for the cheapest rent rather than the right location. Says Fetscher, “When I reviewed leases for a franchised restaurant chain, the franchisees paying $8,000 a month in rent were happier than those paying $3,000.”
Hire a Broker
You’ll need a commercial real estate broker to show you viable vacancies, but finding the right broker is tricky. Namey suggests asking owners of recently opened businesses who they used, then interview several candidates and ask them the hard questions: Do they understand your business? How many similar deals have they done? What landlords have they worked with?
Don’t use anyone who also represents a competitor or someone looking for the same type of space, Namey says. And never use a broker who is also representing your potential landlord, because it’s the landlords who pay broker commissions. Typically, that’s 7 percent of the first two years’ net rent, 4 percent for years 3 through 10 and 3 percent after that, Fetscher says.
“Will he work with the guy looking to rent 1,200 square feet or try to keep the landlord with 1 million square feet happy?” asks Kevin Hein, a partner with the Faegre & Benson law firm in Denver.
What Can You Afford?
Commercial leases are calculated by the year. So a landlord might advertise a 1,200-square-foot space for $50 per square foot per year, but that means the location rents for $60,000 a year, or $5,000 a month. Business owners calculate how much rent they can afford as a percentage of annual sales–generally, it’s less than 10 percent of projected gross revenues, Fetscher says. So you’d need revenues of $50,000 a month to afford that $5,000 rent. Your broker will assist with these calculations, providing information on what similar tenants are paying in the area. And if you’re starting a franchise, your franchisor will help, too.
The Heart of the Deal
When you’ve found the right space, your broker will send the landlord a letter of intent, a nonbinding document that spells out what space you want and what rent you’re willing to pay. The letter also includes the business terms for the lease–and these are open to negotiation. The letter of intent may go back and forth for weeks before you and the landlord reach agreement, so be careful not to become emotionally attached to a property. “If a landlord realizes a tenant is hopelessly committed, he’s unlikely to negotiate lease changes,” says Abe Schear, a real estate partner with the Atlanta law firm Arnall Golden Gregory. Here are the crucial points:
Term of the lease Commercial leases run for five to 20 years, with options to renew, but lease terms too are open to negotiation. If you’re spending a lot to improve the property, you’ll probably want a longer lease; if you’re worried about changes in the neighborhood, you may want a shorter span. If you’re starting a franchise, your lease should last as long as your franchise agreement. Renewal terms should be clearly stated.
Beginning date of the lease If the space requires major construction, you don’t want to start paying rent until it’s finished. Kristen and Miguel Pagano thought their Greene Turtle Sports Bar and Grille franchise in the Greenbrier Mall in Chesapeake, Va., would be open in February. “Everything takes longer than you expect,” says Kristen Pagano. “Luckily, we negotiated to not pay rent until we opened, because now we’re aiming for May.”
Percentage rent clause Herb Weitzman, CEO of Weitzman Group and Cencor Realty Services in Dallas, says tenants agree to pay higher rent when their sales exceed a certain threshold. The International Council of Shopping Centers publishes rent guidelines–a supermarket can pay 2 percent of gross sales to its landlord and make a profit, a pizza parlor can pay 10 percent and so on. Your broker will negotiate an initial rent below that; then, once you start making money, it will go up. Be careful. As Hein says, “Retail sales can have big swings. We negotiate that percentage rent doesn’t start until our tenants have hit their sales figures for 12 months in a row.”
Kickout clauses What if you make less money than projected? A kickout clause lets you out of the lease after a certain time period–usually three or four years–if your revenues don’t reach expectations. Landlords of new shopping centers are more likely to agree to a kickout clause than ones with established malls.
Co-tenancy agreements Say you’re leasing space in a shopping center because of another tenant, perhaps a supermarket or a Macy’s. What if that tenant closes or moves away? You can negotiate that if an important tenant leaves, you can pay lower rent or leave yourself.
Tenant improvements In some areas, desperate landlords are offering huge concessions to attract new tenants, even building out their spaces for free. To persuade Pat and Alisa Akers to open a Firehouse Subs franchise in her shopping center, a Virginia Beach, Va., landlord made more than $300,000 in improvements, including upgrading the exterior, repaving the parking lot, installing two restrooms, a patio and a new heating and air-conditioning system. Pat Akers says the couple also negotiated a 10-year fixed-rate lease.
An experienced broker will know what incentives landlords are giving in your area–they’re often calculated in dollars per square foot of leased space–and will ask for them in your letter of intent. If you don’t need major improvements, you may want to ask for several months of “free” rent instead.
Common Area Maintenance (CAM) fees In addition to rent, a commercial tenant pays a share of a shopping center’s maintenance–landscaping, snowplowing, cleaning and so on. It’s calculated according to how much space is leased. You can prevent CAM charges from soaring by negotiating:
- A fixed CAM rate. Without this, your landlord can increase your share should other tenants leave the center.
- A cap on CAM increases, set at somewhere between 3 percent and 7 percent a year.
- A refusal to pay CAM administrative charges. These fees can be highly profitable for landlords.
Radius clause In exchange for all those concessions, a landlord will ask you not to open another business within a certain radius, usually 5 miles, of your store. This clause could pose problems if you become so successful that you can’t handle all your customers in your present facility. Try to negotiate a time limit–after five years for a 10-year lease, for example.
Exclusivity clause This protects you by asking the landlord to agree to not place a competing business in his center, or, if it’s a large mall, within so many feet of your business. Critical, of course.
Personal guarantee If your business fails, your landlord will want you to continue to pay the rent out of your personal funds and resources. As a new tenant, you probably can’t eliminate a personal guarantee, but you might be able to limit it to your first few years in business.
Hire an Attorney
When you and your landlord reach an agreement, the terms will be drafted into a formal lease and you’ll need an attorney to review it and negotiate with the landlord’s attorney. “Choose that attorney carefully,” says New York restaurateur Josh Fröm. “When I was negotiating a lease for a restaurant space, I used an attorney who was referred by another restaurant operator, but he did not have the experience I needed and the negotiations fell through.” To vet a new attorney, Fröm asked for references and talked to people who had signed leases that the attorney had negotiated.
Experienced real estate attorneys, Hein says, charge from $3,500 to more than $10,000 for their services, depending on the complexity of the lease. Before you hire counsel, says Schear, the attorney and real estate partner in Atlanta, “ask what the cost will be and what you are going to receive.”
And while you might save money by asking your personal attorney to read through your lease, that might be the biggest mistake of all. “This document will control the next 10 to 20 years of your life,” says Lahanas of Salsarita. “It’s vital that you invest in a qualified real estate attorney to review it.”
Julie Bennett is a freelance writer specializing in small business and franchising.