Loss to lease is kind of like a mythical creature. It’s not an actual loss of revenue but a loss of potential revenue that a property owner or manager may not even recognize because the bottom line adds up each month. There is no impact on cash flow since it’s not expected income. There’s also no benefit from this mythical beast at tax time because it doesn’t really exist. So, how can something be called a loss if you aren’t actually losing out?

Loss to lease basics

First, let’s look at a few essential facts about loss to lease:

1. It’s the difference between the market value of a rental unit and the rent charged.
2. Its number changes as market value changes.
3. It can be a good thing or a bad thing.
4. It is almost impossible to eliminate it perfectly.

1. The difference between the market value and rent

The fact that there is often a difference between the market value of a unit and the rent charged for that same unit seems ludicrous. How can property owners make money if they aren’t charging market value? There are several reasons for this (which we’ll get into later), but the most common is that the market value increased during the lease period. Meaning, while a property owner is making $8,000 per month on a rental unit, if the market value is $8,300 on that unit, they could be making an additional $3,600 over the course of a 12-month lease. The extra $3,600? That’s the loss to lease. That is, the dollar amount a property owner could be making above the lease amount.

2. The loss to lease amount changes with market value

Not only can a property owner experience this potential loss each month, but the amount of that potential loss could also vary month-to-month or quarter-to-quarter. In a given year, when there are drastic fluctuations in property values—such as during a global pandemic—a unit could have a loss to lease that swings equally as drastically.

3. It can be a good thing or a bad thing

This is more than just a case of glass half-full or half-empty. It absolutely depends on your role in the property. If you’re an owner, it’s not such a good thing; you could be getting a greater ROI—but aren’t—or you may need to revisit your property management.

On the other hand, if you’re an investor looking to buy the property, there is the potential for rent escalation, increasing profitability with little-to-no financial outlay. For example, consider a case where the existing owner isn’t aware that the rates are well below market value. In that case, the building is also underpriced based on the CAP rate—a win for the investor. As a result, the rent rates can be escalated when the lease term expires—making the loss to lease doubly attractive.

4. It is almost impossible to eliminate it perfectly

While this doesn’t sound like great news, it’s not terrible news either since you’re losing imagined profit. But the reality is that, for many landlords, the market value increases faster than their leases accommodate for. But wait, the rent can be increased at lease renegotiation, right? Great! It all worked out. Not so fast—three months later, the market value rises (for example, due to low availability and resultant trending higher lease rates), putting your newly agreed lease out of sync again. Taking this a step further, not every unit will be on the same cycle, so while you may get one or two units up to market value (for a while anyway), the remaining units fall further behind.

How can some of it be eliminated?

One way to minimize the loss is to use leases that can be adjusted based on a specified consumer price index (CPI adjustment). In theory, this completely eliminates loss to lease since any time the market changes appreciably, the lease rate can be adjusted to match. Practically, however, this proves to be very difficult to manage. It requires someone to monitor the CPI, make the calculations, notify the tenant in advance and then set new rental rates in the system used to calculate and process the monthly rent invoices. The small gains often just aren’t worth the time spent on this. A common workaround is to factor an average CPI into the lease rate annually or utilize shorter lease terms, which allow for more frequent adjustments than a longer lease term.

On the other hand, knowledgeable landlords can buffer this by implementing backloaded leases. Back-loading provides a lower front-end rate, which tenants appreciate during their expensive move-in period, and includes an extension term for higher rental rates aligned with market rate expectations. In addition, a no-reduction clause prevents losing rent to market down-turns at extension time. CRESSblue’s extreme automation makes all of this easy to manage, and our expert team is ready to share their best practices knowledge with you.

Other factors causing loss to lease

While the main reason a property is not making its optimal income is the disparity between market value and actual rent charged, it’s not the only reason. Sometimes, it’s pretty clear what the issue is, and other times it requires an owner to dig a little deeper.

Properties that are run-down or lack amenities are not as desirable and don’t attract high-quality tenants willing to pay higher rent. That’s a clear example. A not-so-clear example is a property manager who may not be looking out for an owner’s best interests, either intentionally or unintentionally. Does your property manager have the right connections to attract tenants willing to pay higher rates? Are they staying on top of regular building maintenance while looking at cost reductions? As an owner, it’s your job to monitor your property manager and make sure you are getting the right service for your property.

Another problematic factor is assessing the property owner/landlord. Sometimes with the best of intentions, they can wreak the most havoc on the bottom line.

Are you causing your loss to lease?

Loss to lease isn’t always caused by charging less than market value. Some property owners are the cause of their own loss to lease without even knowing it. Take the case of David, a landlord we spoke with recently. He was incredibly proud that his tenants really liked him and that he cared about each and every one of them. This may seem like a fantastic approach, but he treated his property as a hobby and not an investment. He needed to formalize his business processes because his informal management style was limiting his wealth creation.

David would adjust rent based on how his tenants were doing. So you can imagine what his rents looked like during the global pandemic. Giving his tenants rent concessions ensures they stay and continue to pay rent. But at what cost? He was so focused on keeping his tenants happy and in his units, he forgot his property was supposed to make him money, not just break even at every lease cycle.

Why on earth would a landlord or property manager charge less than market value or provide regular rent concessions?

What do rent concessions have to do with loss to lease?

David thinks he’s doing the right thing by offering his tenants rent concessions. He didn’t believe using property management software like CRESSblue would be right for him. How could a software that calculates and tracks rent accurately work for him when he provides rent concessions based on how his tenants are doing?

Rent concessions are any form of reducing what a tenant will pay in rent. There are many reasons to do this, but they should be used as the exception and not the norm. When a landlord gives tenants a break on the rent, they lose out on real income, not the mythical potential income. But that real income loss is much more important. And that’s what David is facing. Let’s take a closer look at some examples of rent concessions.

Rent abatement

Giving some type of discount, be it rent concession, a percentage off or an early payment discount, is called rent abatement. It provides a financial break for the tenant and ensures the landlord gets early payments or keeps units occupied. To keep tenants in his units, David offered one month free during each one-year lease period. The remaining 11 months’ rent is paid in full, which is already lower than market value. By charging $8,000 for 11 months, David is only making $88,000 over 12 months instead of $96,000. Factor in the loss to lease of $3,600, and David is losing almost $12,000 a year through kindness and poor management.

Market rates aren’t the only factor in loss to lease analysis. If the data reveals a significant difference between the current lease and market rates, the opportunity costs of a new tenant must be factored in. Vacancy, free rent, fixturing periods costs, realtor commissions and legal expenses will offset the gains in the lease rate. Often these factors result in the landlord accepting a market rate loss to lease when negotiating with existing savvy tenants who are aware of these factors and consider them in their lease term extension proposal. This shows up in lease term extension options with wording such as “Base rent to be 90% of the market rate.”

Tenant Inducements

An extremely common tenant inducement is improvement allowances. Often a tenant will require improvements or upgrades to the physical space before moving in. These improvements are a condition of the lease. By agreeing to them, the landlord hopes these upgrades will be equally valuable to another tenant. The risk, then, is that the ROI on the tenant improvement allowance will not equal the cost of the allowance.

An alternative to tenant improvement allowances is the landlord-tenant loan. While there is some default risk here, it is far less risky than essentially giving away money in the form of free rent or improvements that may never be fully recouped through future rent. In addition, for tenants looking for an inducement to sign a lease, a loan from the landlord that is secured by the premises is attractive since moving a business is expensive. Securing additional financing from a traditional bank for moving expenses and leasehold improvements is much harder for a tenant to obtain, so a landlord loan can free up the tenant’s cash for other expenses.

Both improvement allowances and landlord-tenant loans allow a better chance for the landlord to recoup losses. But David prefers his way. Another way he accommodates his tenants is by offering a choice of upgrades or free amenities when their lease is coming up for renewal. David wants to make sure his tenants renegotiate their lease, so these small—to him—offerings provide great returns. Not quite. David fails to see that recouping the cost of the improvements or losing the income from additional storage and CAM fees will not be easy without rent escalations. Never mind that his rent is already below market value.

So, what can David do instead?

Making loss to lease work for you

Track market value and loss to lease as part of your regular accounting. This is the single most important step to making this phantom number work for you and not against you. If you know how much a unit could be worth, you will be able to make informed decisions about it, such as whether to proceed with leasehold improvements to a unit or rent escalation to full market value or a portion of it.

And when leases come up for renewal, there may be no way for you to escalate rent to market value and keep your existing tenants. That’s where your tracking can help. For example, suppose you know that the building is outdated and needs upgrades. In that case, you can leverage that information to decide which improvements will give you the most bang for your buck and bring in the highest-quality tenants possible at the highest rent they are willing to pay.

Your research may show that the market value far outstrips your property, and you need to invest in more creative ways to attract different tenants or keep the ones you have. Added amenities to the building? Rent increase is worth it. Should you renovate to an almost-new state? What does your data tell you about the area, the market, the tenants and their customers? Over-improvement may not allow you to recoup those costs.

Get creative with your concessions

If, like David, you feel strongly about giving rent concessions, there are ways to recoup the losses so that neither you nor the tenant feels the pain. For example, backloading the lease allows you to offer a break while ensuring you end up close to market rate expectations. Or, instead of offering free rent for one month and keeping the rest of the lease amount the same, increase the monthly lease amount to absorb the loss. In David’s case, the monthly rent would increase by less than $700 a month to spread the cost of that free rent month across the remaining 11 months. Or offer a landlord-tenant loan to bridge high expense periods for tenants.

Your research and data will tell you what you need to know to make decisions based on the bottom line and not your heart.

Getting more out of your data

Using loss to lease as a tool can also help identify issues when they happen and even before they happen. In addition, it can be a gauge of your property manager’s performance. Reviewing loss to lease regularly helps property owners set performance goals and reach new targets.

David didn’t want to hear that he was losing money. But once he started tracking his concessions and his potential income, he realized that he should be focused more on ROI and less on making the next leasing cycle. David finally understands that accurate financial reporting can only help his business grow. In a few short months, David has found numerous instances of loss to lease that he himself caused. And now, he has a plan in place to eliminate as much as possible at every lease cycle.

Loss to lease is an invisible number. It’s not real. It is a potential. Reaching that potential may not fully be possible, but you can use loss to lease to your advantage. By tracking it and understanding which factors you can affect and which are out of your control, you can lessen the gap between what you are making and what you should be making. It’s the only way to tame this invisible beast.

Disclaimer

This article is for informational purposes only and is not intended as professional advice; please consult a competent professional for advice specific to you. This blog is written to stimulate thinking on concepts related to commercial leasing. Please join the discussion with your experiences.

Martin Sommer, CEO, CRESS Inc.

Follow me on LinkedIn

Martin is a founder and the CEO of CRESS Inc., a Canadian SaaS company that automates lease administration and asset management. Martin also manages Karanda Properties Limited industrial portfolio as Director of Operations in all areas of commercial property management, including new development, asset management, capital expenditures, operations, leasing and lease administration of the industrial portfolio. Martin writes about property management workflow and issues. Book Martin to speak at your industry event.

This article is part three of our three-part series on commercial lease compliance:
Lease Compliance Part 1: Understanding Lease Terms
Lease Compliance Part 2: The Tenant Audit
Lease Compliance Part 3: Audit-proof Your Portfolio

In this third article, we talk about preparing your commercial property operations for potential audit scenarios. Interestingly, always being prepared leads to several habits that essentially audit-proof your portfolio against future claims.

In Part One, we looked at setting up your documentation to have accurate lease information readily available. Then, we covered how to set up your workflows to make the best practices your default. We also talked about building your team of experts to complement the skills you bring to your leadership. Putting knowledge and information into practice leads to success.

Preparation leads to confidence. Knowing what you are required to do to maintain lease compliance is empowering.

In Part Two, we reviewed best practices of accurate calculations for expense allocations on your commercial net leases. Then, we covered area gross-ups, variable expense gross-ups and how to account for discontinuities in lease periods. In addition, we highlighted the importance of recordkeeping in controlling slippage. Finally, we touched on all the steps required to comply with net lease additional rent terms.

Accounting accuracy leads to confidence. Having the correct numbers and allocations and knowing you are compliant with the leases removes doubt. And there’s no fear of inquiries uncovering deficiencies and errors in your work.

In Part Three, we will uncover the final steps to audit-proof your portfolio. Part one was knowing and part two was doing. Part three is all about sharing information.

What is an audit?

Investopedia defines a financial audit as “an objective examination and evaluation of the financial statements of an organization to make sure that the financial records are a fair and accurate representation of the transactions they claim to represent.”

An audit isn’t something to fear. Think of it as a report of financial transactions. An audit should be smooth sailing if your business practices and documents are accurate and consistent. However, knowing what to do, doing it and then sharing the information transparently means there isn’t any need for an audit.

How can transparency help you audit-proof your portfolio?

Often an audit is requested because of a lack of information. A tenant or a property owner may want an accounting of past transactions to determine whether their loss to lease is at an acceptable level. Or, they may be looking for discrepancies caused by poor workflows or outdated business systems. Either way, there is an information problem.

By ensuring a transparent business process, you open communication with tenants and owners. When stakeholders can see accurate reporting and lease terms, they are less likely to question costs. Transparency removes the need for an audit.

Let’s look at the information areas we need to share and how to distribute them to have transparent communication with both tenants and property owners.

Lease Documentation

The first step in achieving an audit-proof portfolio is making it easy for tenants to access and understand the lease terms.

Just as property managers and lease administrators need to know and understand the lease terms, so do the tenants. While the responsibility of understanding the lease resides with the tenant and their lawyer, we can make it easier by providing essential information to the tenant through a lease abstract.

A lease abstract is typically a one- or two-page reference document that includes a short description of the key terms and shows tenants where to find the full text in the lease.

CRESSblue has built-in lease abstracting capabilities to allow the data to be easily compiled. When a lease is executed in CRESSblue, the lease abstract PDF report is automatically generated. The abstract is automatically distributed to the appropriate tenant and owner portals, as well as to any internal leasing managers. This is just one example of how CRESSblue automates best practices into its standard workflows, allowing you to achieve optimal efficiency with minimum effort.

Property Budgeting

Preparing and using property maintenance and operating budgets is the best way to ensure your expenses are well-planned and executed. A budget does more than facilitate the property manager’s job, though. It is an excellent tool that allows you to charge accurate additional rent installment amounts with the rent during the financial period. Then you aren’t left with a large discrepancy at reconciliation. Advance notice goes a long way in smoothing PM/tenant relationships. No one likes costly surprises. Controlling this source of stress is paramount for peaceful business operations.

CRESSblue has budget functions that automatically add all existing expense accounts to the property budgets. This dramatically simplifies making a budget for those with little or no prior budgeting experience. As always, there isn’t any need for spreadsheets or calculators. We believe that computers should do the math for you.

Rent Documentation

Most tenant accountants and bookkeepers are not involved in the lease negotiation process. Neither are the accountants and bookkeepers at the property and asset management companies. As a result, property managers need to transmit the lease rent information to them simply and clearly.

Base rent is reasonably straightforward in most cases, but periodic scheduled rent increases still need to be communicated. In addition, the budgeted additional rent and any other rental charges, amortized cost recoveries and tenant loan installments also need to be shared. Finally, a Rental Advisory Notice (RAN) summarizes these amounts into a monthly payment schedule.

CRESSblue automatically creates, updates and distributes a new RAN with every new lease, lease addendum and every new or revised property budget. This ensures that tenants always know in advance what payments are required and when they are due.

Transaction Documentation

For net leases, the operating expenses, maintenance and service charges and, in some cases, the capital cost allowance is charged back to the tenants. These are collectively known as additional rent. Tenants can be charged either by direct invoice for immediate cost recovery or through additional rent installments and a reconciliation. For costs recovered from multiple tenants, special attention must be paid so that the calculations correctly allocate the costs to each tenant in accordance with the lease agreement terms.

Each transaction recorded to the additional rent will need to detail the cost allocation to each tenant and the basis for this amount. This transaction breakdown record must be available for the tenant to audit its proportionate share of the costs.

CRESSblue does this automatically for every additional rent-related transaction. In addition, a PDF breakdown report accompanies each transaction and can be distributed to each tenant (and owner) portal automatically when the transaction is posted.

If the tenant’s expense bill is immediately recoverable, CRESSblue can automatically generate a corresponding invoice for the tenant, including applicable management and administration fees. This workflow makes sure no allowable expenses are ever missed. And when it comes to an audit-proof portfolio, this is critical.

Reconciliation Documentation

The last part of the net lease journey is the period reconciliation. This is typically done annually, where the installment payments are reconciled with the actual allowable cost recoveries. A statement is produced specifically for each tenant that reflects their lease terms and where they are in the lease cycle. After the accounts are checked, and the additional rent reconciliation is approved, an invoice is generated for each account where the installment payments are less than the actual recoverable expenses and fees. In the case of overpayment, a credit memo is issued to each tenant that overpaid.

CRESSblue has a simple account approval process where all the calculations are done for you. Any non-recoverable amounts are indicated, and a drill-down report can be instantly pulled up to detail the reasons for any legitimate slippage. The entire reconciliation can be approved upon approval of all the expense account amounts. All tenant accounts are reconciled, all invoices and credit memos are created and posted to the accounting system, and all tenant reports are posted to the associated portals.

Distributing the information

Another important step to audit-proof your business is communication. CRESSblue has extensive automation for document creation and distribution internally between users and externally to property owners and tenants. Standard documents and reports can be generated based on event triggers linked to user actions, scheduled intervals or can be run manually at any time.

Secure portals are used to distribute documents to external owners and tenant users. Free tenant portals support both accounting and administration as segregated roles so that confidential negotiations can be kept separate from daily operations if desired. Owner portals are also free and allow owners to securely receive their property activity and financial reports.

CRESSblue portals are available for past, current and future tenants, allowing for confidentiality between occupants of the same spaces while documentation is opened and closed out between leases. Reports are automatically routed to the correct portals and recipients.

Audit-proof your portfolio

An audit is a request for information, not necessarily a challenge to correctness. There may still be tenant challenges about whether specific work needed to be done, a significant repair was capital in nature or whether it was simply maintenance that could be expensed. Those are different types of management and accounting issues that can still arise.

If a property manager feels threatened by an audit, they do not have the necessary confidence in the quality of their work. That is a clear indicator that business systems and workflow processes should be improved. There is logic to using CRESSblue to audit-proof your commercial net lease portfolio:

• If the work is done using CRESSblue, reporting accuracy is guaranteed in accordance with the entered lease terms
• Accurate data means there are no barriers to being transparent
• If transparency is easy, you can conveniently do it all the time
• Consistent transparency removes the need for an audit

Lease compliance gives everyone peace of mind. There’s no need for issues to escalate or result in audits with automated business systems that elevate your workflows and consistently provide accurate financial reporting. Because everyone is on the same page.

This article is part three of our three-part series on commercial lease compliance:
Lease Compliance Part 1: Understanding Lease Terms
Lease Compliance Part 2: The Tenant Audit
Lease Compliance Part 3: Audit-proof Your Portfolio

Disclaimer

This article is for informational purposes only and is not intended as professional advice; please consult a competent professional for advice specific to you. This blog is written to stimulate thinking on concepts related to commercial leasing. Please join the discussion with your experiences.

Martin Sommer, CEO, CRESS Inc.

Follow me on LinkedIn

Martin is a founder and the CEO of CRESS Inc., a Canadian SaaS company that automates lease administration and asset management. Martin also manages Karanda Properties Limited industrial portfolio as Director of Operations in all areas of commercial property management, including new development, asset management, capital expenditures, operations, leasing and lease administration of the industrial portfolio. Martin writes about property management workflow and issues. Book Martin to speak at your industry event.

This article is part one of our three-part series on commercial lease compliance:
Lease Compliance Part 1: Understanding Lease Terms
Lease Compliance Part 2: The Tenant Audit
Lease Compliance Part 3: Audit-proof Your Portfolio

Lease compliance covers many things. For instance, tenant compliance with their lease obligations for rent and upkeep. Not to mention landlord compliance with the building maintenance obligations and general accounting compliance in record keeping and reporting. This series will focus on three main topics: understanding lease terms, what you need to know about tenant audits, and how to audit-proof your portfolio. We are explicitly addressing lease compliance for landlords in commercial property management. You will dig into the lease clauses that cause the most confusion, stress and even fear for tenants and landlords.

Lease terms are about more than just objectives

The simplest approach to writing an agreement is to state the objectives for each party. While that is great for setting the stage, it is useless on its own. The overriding principle you want to encompass in your lease agreement is to set the boundary conditions for acceptable behaviour and performance. Define what constitutes a default and how to remedy that default in a specified period. If you use a lease agreement short form supplied for free by your realtor, it almost certainly just states the objectives and has virtually none of the boundary-setting terms and remedies you will need to resolve issues. You are unlikely to have much luck with that if anything goes wrong.

The basics of lease compliance

Before we get into the technical aspects of commercial leases, let’s review some of the most basic activities you must undertake to offer your services as a property manager to anyone, including yourself.

Be the boss, but use the team

We have covered this before in other articles, but it bears repeating. You don’t have to be the expert in everything. Instead, you need to bring in at least four classes of professionals: your lawyer, accountant, realtor and insurance agent. You may have one of these professional designations, but you need all of them on your team. Your limited experience in the other areas isn’t enough to provide professional services to yourself or others. Just don’t do it!

We see this countless times when onboarding new clients. The team has one or more professionals on it, but other key positions are missing. Often, landlords completely ignore entire business areas. This leads to significant problems that could have been avoided. For example, leases without legal reviews and agreements full of errors and inconsistencies could result in litigation. Contracts missing essential information such as the property address, the premises area and the rental rate mean unenforceable lease clauses and unrecoverable future expenses. Leases that a landlord never reads after signing or lease accounting that’s not done for a decade equal voluntary slippage. Not to mention, poorly negotiated leases result in huge liabilities years down the road. You can avoid all of these problems by ensuring that you have the right people with the right credentials on your team.

Consider a scenario in which a metal fastener supplier applies to be a warehouse tenant. The warehouse use doesn’t seem like an obvious fire hazard. However, the fasteners are coated with a film of oil, placed in plastic baggies in cardboard boxes, inside more cardboard boxes and shipped on plastic pallets. The supplier then stores the packed boxes on open mesh shelving. A lease-use review by fire inspection safety personnel could immediately identify the risk and point out the storage limitations for that combination of packaging with the existing sprinkler fire suppression system.

You are still in charge

Although you need to rely on the expertise of others, remember that your team needs direction and guidance. Do not delegate everything to others without being the boss yourself. You are the glue. You are in charge. Each of your professional team members reports to you—they do not take your place at the helm.

The professionals on your team are valuable. However, it is essential to realize that their perspective is transactional, whereas yours is relational. Your realtor is brokering a deal for you. Once they’ve closed the deal, they won’t be back until close to the lease expiry date. Your relationship with the tenant is just beginning and will continue throughout the lease term. Therefore it is essential to see the difference in perspective. Your team members complement you, but they do not replace you.

Your job is to know enough about each profession to understand the value and services they provide and understand their language. A company without anyone in charge is still chaos. If you don’t know enough about the services they provide, ask them to explain them to you. They will. It’s your job to be a leader, so use your professionals to further your expertise and career.

Use a lease template

A lease template should be the starting point for your commercial leases. This means a professional one, not just the free form your realtor used to submit the lease proposal. Pay your lawyer to provide you with a customized template suited to your business.

Your lease template should include the standard lease fields and terms in the initial section of the lease on the first couple of pages, from the names of all parties to the lease terms and indemnifiers. Together with who gets lease notifications and where they must go. The lease dates and rates. The fixturing and free rent dates and definitions. The deposits. The parking. Anything and everything that you need to fill in and review for every single lease. The rest of the document should then reference the data only by the field name. This creates a record where you can find all essential information, and it will prevent errors throughout the rest of the document.

Stay away from generic forms

Never use a form that requires you to fill in the same data in more than one place or in the middle of a paragraph buried in the document. The information will invariably be missed when you update the form during the lease negotiations or subsequently use the template. Our CRESSblue implementation team comes across these errors often. Instead, use a lease template that includes all the clauses you would expect to need for your entire portfolio of properties. Again, you want to use a cohesive, consistent and complete document.

Use your team to review

Have your insurance agent review the insurance requirements and responsibilities sections. Equally important, have your accountant review the cost allocations to understand the implications of various accounting practices noted or implied in the document. Do you know how to account for the additional rent cap the tenant wants? For example, do you know what it will cost over the lifetime of the lease and its extensions? Bring your team’s expertise into the document template to enhance your lawyer’s work. Going through this process will also increase your ability to negotiate well.

Use document formatting

Your lease agreement describes your ongoing business relationship with your tenant. Make sure it is a well-written, clearly assembled, accurate document that you can use to guide your activity. Write it so that you can be in lease compliance in a practical way without math or accounting gymnastics. The use of document formatting can go a long way to enhancing your lease agreements. To clarify, formatting here means using headers, lists and built-in document formatting available in Microsoft Word.

While there is other document editing software, stick with the industry-dominating Microsoft Office for the simple reason that you won’t be the only one editing the document. Repeatedly transitioning from one format to another rarely turns out well. Niche software products won’t make your leases better if the other party can’t use the output you provide. While on this subject, do everyone a favour and Track Changes so that changes are apparent and it is clear who made them. Digitally provide both a marked-up (changes tracked) and a clean copy (changes accepted) to the other negotiating party. It saves legal reviewing time and prevents a lot of silly mistakes from slipping through.

Cross-referencing will save you from costly mistakes

Use cross-references to link the parts of your document to the appropriate sections, not direct number references or words like “previous” or “next.” Those do not survive insertions and deletions without manual editing with a sharp eye. A cross-referenced article will update its linking automatically, making sure you are still referring to the correct section. If you delete a linked paragraph, you will have a broken link indicating you still need that section or have more editing work to do.

That covers the basics of your documents and formatting. This workflow alone will put you in an excellent position to have accurate records. And onboarding to CRESSblue will be so much quicker if you have your data readily accessible, complete, clear and consistently accurate. Make best practices your default workflow, and your work product will improve substantially as a result.

Lease agreement sections

On to the good stuff! Let’s review the key sections your standard commercial multi-tenant leases should cover and what they mean.

Basic terms and definitions

As stated in the lease template section (see what we did there? We referenced a section title, not a paragraph number or relative placement), all lease terms and definitions should be in the first section of your lease. You need them front and centre so that you do not miss any and so that you review them all for accuracy every single time you use your template.

Review the template for completeness and accuracy. Have you defined all the terms and filled in all the fields? Do they all make sense in the context of this lease?

Put your schedule of base rent payments and deposit information in this section. In addition, if you have any tenant leasehold improvement allowances or other incentives, include them in the definitions and capture all of the variable data.

Demise and term

Key things to include here are a description of the demised premises and the rentable area, what is included and which measurement standard will be applied. Be sure to include language such as “or its replacement” since standards are updated and changed over time. A typical industrial standard area reference is “in accordance with ANSI/BOMA Z65.1 – 2010 Method A (or a subsequent replacement or amended standard).”

Include a plan of the premises and site in the lease schedules with the demised areas and common areas marked out. It’s great to use colour, but remember the document might be printed and sent in black and white. It can be hard to see the area of the premises outlined in red on a black and white copy. So, using patterned fillers to identify different areas in the plan drawings can help define the spaces more clearly.

Other topics you will want to include in this section are:

• Overholding: This is when a tenant stays in the premises after the lease expires and becomes a month-to-month tenancy. This impacts your ability to obtain financing since the tenant isn’t bound to a rent term, and lenders view this as unreliable revenue. As a result, overholding rates are typically set higher to encourage the tenant to sign a lease term extension agreement.
• Delay in Possession: This describes what happens when, if for some reason, the lease commencement date is missed. How do the other dates adjust? Is the fixturing or free rent period guaranteed?
• Fixturing Period: This period allows the tenant to complete outfitting the space for their own purposes. With this in mind, define which costs are their responsibility.
• Free Rent Period: If there is a free rent period to allow the new tenant to ramp up operations, it will be defined here. Like the fixturing period, you must specify which costs are the tenant’s responsibility. Is it base rent-free, additional rent-free or some other combination?

Rent

If the base rent amount was already recorded in the definitions, what goes in this section?

• Lease Type: A covenant to pay, and a description of the lease type: a gross, net or partial net lease.
• Payment Methods: Describe what payment methods you accept.
• Deposits: What the landlord can do with them, and how they need to be replenished, increased, decreased and finally returned to the tenant.
• Rent Past Due: Interest rates and penalties.
• Partial Periods: How to account for partial rent periods.

Basic rent

This section provides straightforward information on commercial net leases. The basic rent refers to rent payments only. All other expenses and costs recoveries are classed as additional rent. Note that basic rent is paid in exchange for an interest in real property, whereas additional rent is paid under the terms of a contract. Therefore, they are treated differently in law. If you want to learn more about this, you can read it here.

Additional rent

There is an overwhelming temptation to try and cover every situation with one long run-on sentence. Resist that urge. Save the definition of capital cost and operating expense for a lease schedule. For this purpose, those terms are too indefinite to use broadly on a practical level.

However, what should be defined is how a landlord will handle operating costs and what administrative or management fees will apply. Remember that adding complexity such as multiple fee rates and lots of categories means more record-keeping and accounting, so choose your level of complexity wisely. Keep it as simple as you can. Landlords often have difficulty complying with the very complicated schemes they invent.

Property taxes are often the most significant component of additional rent. Therefore, make sure to include clauses that cover property tax increases and re-evaluations that may come up mid-term or mid-budget.

Additional rent caps may also come up in this section. They are poor tools to control additional rent, as discussed in-depth in this article. If there is a cap, make sure you capture the initial starting rate. Moreover, clearly define what is capped and how the actual formula works. Remember math class and word problems? Write the formula out with words that describe it. Someone is going to have to understand this to be in lease compliance.

Calculating the additional rent

Multi-tenant properties typically allocate expenses proportionally based on the leased area of the premises. Define the formula, not the number. For multi-building sites, specify for each expense type whether the proportion is based on just that building’s area or the entire site. Leasehold improvements, alterations, appropriation and re-measurements all have the potential to alter the proportionate share numbers. So again, you need to know how to resolve problems that arise when the original number is no longer valid.

Don’t forget to define how gross-ups will work. These are two separate calculations: one for the premises area gross-up to account for the common areas spaces, and another to account for different usage patterns on shared expenses. Usage patterns can vary due to the tenant’s use of the facilities, vacancies and hours of operation. This can cover services as well as utilities.

The most critical point in negotiating the additional rent and operating costs is to make sure it is reasonably possible to make the determinations you agree to. The required data tracking and calculations need to be practical. For example, don’t negotiate a position that requires $1,500 of an accountant’s time to recover $150 worth of additional rent. On the other hand, you could use CRESSblue and have all the math done automatically for you. That’s a reasonable and practical decision.

Utilities and HVAC

This section describes who pays for the utilities on the premises and how to calculate common area cost allocations. We’ll also describe gross-up factors for above-normal utilization here. If there is a high probability of above-normal usage compared to the other expected uses at the property, consider having individual service meters installed for those utilities.

Control and operation by the landlord

Lay out the common areas in addition to broadly defined property operation and repair responsibilities here. Use a repair and maintenance schedule to detail specific types of repairs, responsibilities and who pays for them.

Use of premises

A description of the tenant’s broadly defined permitted use of premises. This covers uses permitted by law, environmental covenants, permits and zoning requirements. Include a list of specific permitted uses and restrictions in the definitions section. Also include any provisions for waste handling and storage, nuisance, noise, discharge or overloading concerns.

Maintenance, repairs and alterations of premises

Record the process and requirements for a tenant to make repairs and alterations to the premises. Don’t include specific work for the leasehold improvements. Instead, that information should go in the lease schedule. This is for ongoing maintenance and future work requests. Items you will want to include are:

• Engineering and architectural drawings and specifications
• Required permits and regulatory approvals
• Inspections and quality control on materials
• Qualified trades
• Certifications
• Liability and responsibilities
• Access control and site security
• Final inspections, reviews and approvals
• Financial clearances for trades, contractors, liens, materials and fees payments

Typically, landlords need to arrange for annual or more frequent inspections of fire and life safety equipment. Include the procedures for tenant notifications and landlord access to have these inspections done. While the landlord can make it the tenant’s responsibility to carry these out, the practicality of getting all tenants to do the required work at or near the same time can be nigh impossible, leaving the landlord responsible to government authorities for the delinquent tenants. It’s often easier to add an inspection contract to the additional rent and have a qualified third party complete the work in one visit.

At the end of the lease term, the tenant will need to leave the premises neat and clean. The departing tenant usually takes trade fixtures, but what about removing improvements and other fixtures on the surrender of the premises? It is hard to determine what condition and desirability some of those improvements may have in the future. Likewise, a tenant will want to know what removal costs they need to budget for. Blanket statements for future work aren’t a reasonable approach; it is much better to deal only with the fixturing included in the tenant’s work now. The future removals condition should be left as part of the negotiation of the landlord’s approval for anything to be done later in the lease term.

Insurance and indemnity

There are five main areas to cover here. They are:

1. Insurance for Tenants: Minimum insurance coverage limits for the various classes and the minimum required insurer’s rating.
2. Insurance for Landlords: Minimum insurance coverage limits for the various classes and the minimum required insurer’s rating.
3. Increase in Premiums: This relates to the tenant’s use of the premises, causing an increase in the landlord’s insurance.
4. Tenant Indemnity: This releases the landlord’s responsibility for the tenant’s activities on the site and within the premises.
5. Mutual Release: Defines that each party is to carry their own insurance.

Those unfamiliar with the industry may find insurance complicated and unintuitive. If you change or edit this section, get a professional broker or agent to review both the wording and the liability you are assuming. Nothing you write in a lease agreement is going to change the effect of your insurance policy. However, you may find out that your edits have left you with an uninsured liability.

A quick word about tenant’s insurance here: if they need extra insurance coverage, don’t take it out for them for three reasons. One, they need to build their own relationship with their insurance broker. Two, it will cost them the premium plus your management and admin fees and possibly an additional nuisance charge as well. Three, as a landlord, you are disinclined to file a claim on your insurance for their property as it will affect your premiums on the entire portfolio. With this in mind, make them get their own insurance.

Assignment and subletting

Pretty straightforward here. When is subletting permitted? Landlords rarely prevent subletting. However, it is usually dependant on their approval of the new tenant, which cannot be unreasonably withheld or delayed. Key practical points are: under which conditions the original tenant is released or held to their initial obligations, defaults of the sub-tenant and what happens when a sub-tenant pays more rent than the original tenant.

Quiet enjoyment

For the direct and straight-to-the-point people, this is for you! If the tenant pays rent and agrees to everything in the lease, it says right here the landlord agrees to leave them alone in peace and quiet to mind their own business.

Damage and destruction

Contrary to what you might expect, this isn’t about the tenants wrecking the place. Instead, this section is about the significant destruction or appropriation of the property that materially affects the tenant’s ability to use it for its intended uses. The section also covers insurance proceeds. Additionally, details and conditions of lease termination by a tenant or landlord may be included.

Default

This is the first article that tenants refer to when there is a heated tenant-landlord dispute. The first section defines what events constitute a default on the part of the tenant in carrying out its duties as specified by law or in this lease.

The second section details the rights and remedies of the landlord for various defaults. Re-entry, repossession and lease termination are all available. One cautious word here—make sure your remedies are proportionate to the losses and costs as punitive damages are generally unenforceable in court. Furthermore, your lease agreement will not supersede any legal rights your tenant may have.

General

This is the fundamental legal boilerplate. For example, entry to the premises to exhibit them to a prospective new tenant, force majeure, waivers and forbearance, required notices, confidentiality provisions and the like are listed here.

Schedules

Leases should include schedules that are specific to the property and tenant relationship. At a minimum include:

• Plan of Premises: Outlines the location on the site and premises layout.
• Legal Description: Describes the property.
• Rules and Regulations: Applies to general site operations for all the tenants.
• Landlord and Tenant Work: Specific to the lease.
• Indemnity Agreement: Outlines whether the lease has an indemnifier or guarantor. Include in the agreement whether an assignment or transfer includes or releases the indemnifier. Also, consider if the guarantee covers lease term extensions.
• Extension Rights: If the tenant has any lease extension options, include the conditions for the exercise and timelines for those options.
• Tenant Environmental Covenants: These should be site-specific and, if necessary for the tenant’s permitted use, tenant-specific as well.
• Maintenance Schedule: This is an important schedule for commercial net leases.

Maintenance schedule

This schedule is gaining in popularity due to the increase in transparency and clarity it can provide.

For each of the classifications, detail all of the following:

• Description of the asset type
• Type of work: replacement, repairs, maintenance or supply
• Responsibility for the work: who looks after getting it done
• Level of service: how often it will be checked or done
• Chargeback: who pays for it
  • It can be the landlord’s responsibility
  • The landlord can pass it on to the tenant as additional rent
  • The landlord can bill it to the tenant
  • It can also be billed to the tenant directly
  • Amortized cost recovery only
    • Amortization period

This schedule is far more comprehensive than a statement about the landlord paying capital cost and the tenant paying for operational expenses.

As you can see, commercial lease compliance can be fairly complex, but using a template, schedules, and standard lease terms and clauses can help make the job easier. And don’t forget to lean on your trusted partners—lawyers, accountants, realtors and insurance agents. As a result, your team will ensure you have the most comprehensive and well-negotiated leases.

This article is part one of our three-part series on commercial lease compliance:
Lease Compliance Part 1: Understanding Lease Terms
Lease Compliance Part 2: The Tenant Audit
Lease Compliance Part 3: Audit-proof Your Portfolio

Disclaimer

This article is for informational purposes only and is not intended as professional advice; please consult a competent professional for advice specific to you. This blog is written to stimulate thinking on concepts related to commercial leasing. Please join the discussion with your experiences.

Martin Sommer, CEO, CRESS Inc.

Follow me on LinkedIn

Martin is a founder and the CEO of CRESS Inc., a Canadian SaaS company that automates lease administration and asset management. Martin also manages Karanda Properties Limited industrial portfolio as Director of Operations in all areas of commercial property management, including new development, asset management, capital expenditures, operations, leasing and lease administration of the industrial portfolio. Martin writes about property management workflow and issues. Book Martin to speak at your industry event.

As a landlord, it is important to understand commercial tenant rights as well as your rights and obligations. Commercial tenancy regulations are far less restrictive than residential landlord-tenant acts and tend to favour the landlords. This is because commercial lease agreements are viewed as contracts between knowledgeable business people. Therefore, the assumption is that they are capable of negotiating lease terms that benefit both parties. As a result, commercial lease parties tend to use more of their negotiating ability than those of a residential lease.

While every country, state and province has its own regulations to oversee these agreements, all tend to lean heavily on the wording of the lease agreements as “law” that guides the relationship.

It is essential to make sure the lease language is as straightforward as possible and clearly outlines the tenant’s responsibilities. But a word of caution. Veering away from industry language is not recommended. Inexperienced parties tend to write their agreements only in terms of intent (rights). While this seems helpful, most of the lease language is used to delineate boundary conditions of expected behaviour (responsibilities) and contains terms and remedies to describe the processes that will be used if a breach occurs. Industry terms have been tested for interpretation in the courts, and insurance companies rely on those definitions to underwrite their insurance risks.

Lease terms have meaning in a legal context, and the lease is a legal agreement. If it is not possible to write the lease in easy-to-understand terms, provide a summary of rights and obligations in clear language to outline your expectations. Commercial tenants need time to review and receive legal counsel on the lease agreement language, terms and clauses. Both parties should understand the lease terms and be aware of rights and responsibilities.

Prior to signing the lease

The best way to make sure both parties are aware of their responsibilities is to communicate openly. Clear lines of communication will ensure fewer misunderstandings and help build a stronger relationship and a level of trust. A good relationship foundation helps when questions or complex issues need to be discussed.

Before you enter into a commercial lease agreement, it’s essential to seek legal advice. Doing so will help you determine which specific policies apply to your situation. While there are laws and regulations in each jurisdiction, a signed lease agreement can waive rights granted in the acts. A good lease will outline each party’s obligations, including those relating to leasehold agreements, operating and maintenance costs, and rent, among others.

What should a commercial lease include?

A lease is a contract that outlines the rental rights and responsibilities of both the landlord and tenant. This document is intended to provide clear guidelines to both parties to minimize any potential misunderstandings.

While every lease is different, and there is no one-size-fits-all template, it should include certain items:

• Names of lessor and lessee (landlord and tenant)
• Rent amounts and rent frequency
• Insurance requirements
• The length of the lease and type of tenancy (fixed-term or month-to-month)
• Conditions for terminating or extending the lease
• Ownership of any leasehold improvements
• Responsibilities for repairs and maintenance
• Shared space and amenity cost allocations
• Consequences of non-payment of rent and other expenses
• Specifics of when/how a security/damage deposit is considered forfeited or partially refunded
• Permitted uses of premises
• Ownership of fixtures
• Liabilities and force majeure
• Any other details that have been negotiated between the landlord and the tenant

The lease terms should clearly outline whether it is a gross lease, net lease, triple net lease or percentage net lease.

If the tenant needs to alter the space before moving in, get the leasehold improvement details in writing first. The lease should outline who pays for what and whether there are any restrictions on what they can do. This will help avoid any disputes over financing and the scope of the project. The lease should also outline who is responsible for obtaining regulatory approvals and permits. Also, the lease should detail what the landlord requires from the tenant to approve the tenant’s scope of work. For example, details could include engineered drawings, work reviews and the conditions for releasing the tenant improvement allowance.

Remember, a commercial lease is a binding contract between the landlord and tenant, so the terms should be agreeable to both parties. Both the landlord and the tenant must sign the lease to formalize the business relationship. Doing so will protect not only commercial tenant rights but also the landlord’s rights as well.

During the lease term

Damages and breakdowns

Though not common in commercial leasing, you and your tenant may wish to complete an inspection report before taking possession of the property. This form contains a description of the property to detail the unit’s condition at the time of move-in. This document can support claims for the repair of damages as they occur. More commonly, the premises come “as is.” The tenant makes their leasehold improvements before occupancy, which the landlord inspects before releasing the Tenant Improvement Allowance (TIA). These improvements usually negate the usefulness of an inspection report completed at the time of possession.

Savvy tenants ask the landlord to guarantee the existing building systems (i.e. doors, dock systems, electrical services and HVAC units) for three months or, for HVAC units, three months into the first season of use.

Leasehold improvements

Tenants may require changes to the unit to make it functional for their specific purposes. These requirements should be worked into the lease in advance and clearly state which party will retain ownership of the improvements. Most commercial net leases assign ownership of the leasehold improvements to the landlord, but the tenant must still insure and maintain them. There are several ways that payment can be handled for these improvements. Further details on leasehold improvements can be found here.

Rent increases

The lease agreement should detail any increases to the rent. The landlord must include specific policies regarding rent increases to ensure that tenants know the terms and conditions. The lease alone serves as the full and final notice of all rents due. Leases almost always specifically exempt the landlord from any requirement to provide prior notice of any rental amounts being due.

Paying property taxes

This is a provision that must be outlined in the lease before tenancy. If the landlord expects the tenant to pay property-related taxes in part or in full, this must be included in the lease agreement. The clauses must be worded so that the tenant is not on the hook for future taxes once they have terminated their tenancy.

Entry to the rental unit

The lease terms determine the landlord’s rights to premises access. For example, the lease can specify access to both keys and access codes and entry without any notice or lessor rights.

Settling disputes

If the landlord is not fulfilling their obligations, the tenant has the right to take the landlord to court to force them to comply with the conditions of the lease agreement. Additionally, the tenant can ask for compensation for any losses related to the landlord’s negligence.

When a tenant has breached the lease, the landlord must notify them in writing and provide a reasonable amount of time—usually 10 days—for them to begin to comply. If the tenant has failed to fulfill their obligations, the landlord has the right to terminate the tenancy. They can also take the tenant to court to reclaim any rental income owed as a result.

Expansion rights

If a unit opens up in the commercial property, an existing tenant within the building may have the right to lease it before anyone else. This is the Right of First Opportunity, or ROFO. If a tenant is looking to expand their presence within that building, this can give them an advantage in a competitive market. This does guarantee that the tenant will secure the space, however. The ROFO usually specifies the rent terms, often 90% to 100% of the market rate.

The Right of First Refusal (ROFR) works a little differently. The landlord is entitled to lease the available space to a third party, but first, the existing tenant has the right to match the third-party’s offer on the unit. In this case, the tenant does not have the opportunity to negotiate the lease terms with the landlord; they must accept or decline the terms presented.

In either case, the ROFO or ROFR details should be very clearly spelled out in the lease agreement ahead of time so that both parties know their rights. You can find more information on ROFO and ROFR clauses here.

Eviction

Landlords can evict tenants for not following the lease terms. That’s why it’s critical to be aware of all the obligations set out in the lease to maintain compliance.

If tenants do not pay their rent on time, the landlord has two primary courses of action.

The first is to terminate the lease and evict the tenant. This typically happens after a set amount of time without rent payments. The landlord changes the rental unit’s locks. Ideally, this occurs after giving the tenant reasonable time and access to remove property from inside the unit. However, this ends the landlord’s right to use other options he has under the lease. Typically, this isn’t the first choice as commercial leases are valuable, and the recovery rights are significant.

The second is known as the right to distrain the tenant’s chattels. Typically the tenant’s chattels are the lifeblood of their operations, and their business is finished without them. This provides significant motivation for the tenant to redeem the lease. The landlord seizes the tenant’s property on the premises. The landlord must give the tenant notice of the seizure and hold the property for five days before disposal. If the back rent is still unpaid, the landlord is free to sell the seized property to recoup some of their losses. If the value of the tenant’s property exceeds the back rent, the excess must be paid back to the tenant.

The landlord has various rights outlined in the lease, which can be jointly or severally applied. For example, the landlord can apply a three-month rent penalty in addition to seizing the tenant’s property. On the other hand, the right to distrain can be specifically excluded in the lease terms. This is more common for tenants with a patented or restricted product.

At the end of the lease term

Ending a tenancy

Most regulatory bodies have rules about how a lease can be ended. In a month-to-month tenancy, either the tenant or the landlord must give written notice at least one month in advance of termination. For a fixed-term lease, there is no requirement to provide notice to terminate by the end date. If both parties wish to continue the lease agreement, a lease extension agreement should be made before the due date. Without an amended lease agreement, the tenant becomes a month-to-month tenancy in an overholding position and no longer has the right to occupy the unit once the term is up. Overholding usually comes with a rental rate increase to compensate the landlord for the term insecurity.

Restoration of space

If the tenant has made significant changes to the unit through leasehold improvements, the landlord may require them to restore the premises to the original condition. Landlords may wait until close to the end of the lease term to make that decision, as some alterations may enhance the space and increase the property’s value. However, tenants need to know whether they need to outlay a considerable expense at the end of their lease and budget accordingly. Optimally, if the landlord granted approvals before the leasehold improvements, they should add the restoration clauses to the lease in advance to avoid last-minute panic.

Extension rights

When continuing a tenancy, there can be two options: renewal or extension. A renewal of a lease agreement constitutes a wholly new agreement, potentially with new terms and obligations. An extension, however, continues the existing lease agreement with the landlord with an extended end date. The renewal represents a short break (and potential change) in the relationship between the two parties. The extension perpetuates the original lease without a gap. An extension is preferred when both the landlord and the tenant are happy with the existing conditions and wish to continue the relationship as is.

Security deposit returns

At the end of the tenancy, the landlord must return the initial security deposit, less any charges for damages incurred. The landlord will often require the tenant to vacate the premises first to inspect the unit. If any damages are found, the landlord should provide documentation as proof of the damage and itemize any deductions taken from the security deposit. The tenant may negotiate these deductions if they can show evidence that the damage was pre-existing or occurred due to normal wear and tear. If no significant damage occurred during the lease term, the deposit should be refunded. Tenants who have proved themselves to be reliable and trustworthy may be able to negotiate the early return of the deposit, but that would be on a case-by-case basis.

Final reconciliations

Both parties should agree upon any further reconciliations as outlined in the lease. Any reconciliations that occur outside of the parameters of the lease should be negotiated by the two. In the event of a disagreement, the parties can settle the issues in court.

These are just some of the general commercial tenant rights and landlord rights that you may come across. Some of this information may vary from country to country, state to state and province to province. As usual, always consult a commercial property lawyer before entering into a lease agreement, and seek legal advice to ascertain your specific rights in the event of a dispute.

Disclaimer

This article is for informational purposes only and is not intended as professional advice; please consult a competent professional for advice specific to you. This blog is written to stimulate thinking on concepts related to commercial leasing. Please join the discussion with your experiences.

Martin Sommer, CEO, CRESS Inc.

Follow me on LinkedIn

Martin is a founder and the CEO of CRESS Inc., a Canadian SaaS company that automates lease administration and asset management. Martin also manages Karanda Properties Limited industrial portfolio as Director of Operations in all areas of commercial property management, including new development, asset management, capital expenditures, operations, leasing and lease administration of the industrial portfolio. Martin writes about property management workflow and issues. Book Martin to speak at your industry event.