Commercial Leases for Small and Medium-Sized Businesses: Key Legal Pitfalls & Negotiation Opportunities

Commercial leases are fundamental for any business with a brick-and-mortar presence—whether retail, warehouse, or office space—with rent often representing one of the largest, if not the largest, incurred expense.  Leasing a space is a profound step and sizeable commitment for any business, regardless of whether the business is newly established or preexisting.  Commercial spaces that are owned by large real estate companies position business owners at a disadvantage when negotiating their lease and business owners may not appreciate that most provisions in a lease can be negotiated, even with large and sophisticated landlords. 

Below we discuss several key elements of commercial leases and provide insight into negotiation opportunities and fallback positions for addressing common legal pitfalls.

1.     Personal Guarantees and Personal Liability Exposure

Landlords may require a personal guaranty from the tenant’s owners, making them personally liable for rent and other non-financial obligations if the tenant breaches the lease.  From the landlord’s perspective, personal guarantees ensure that landlords have additional recourse (or remedies) in the event the tenant fails to uphold its obligations under the lease.  For a business owner, a personal guarantee means that that owner’s personal assets may be at risk, irrespective the tenant’s business structure.  Here are a few ways to think about personal guarantees:

A.   Other Security in lieu of a personal guarantee:  Landlords may be willing to forego a personal guarantee if offered a higher security deposit, letter of credit, or other security in lieu of the guarantee.  

B.    Limit to rent and/or liability cap:  Personal liability exposure could be minimized by, non-exhaustively:  (1) limiting the guarantee to rent obligations only and until a replacement tenant is found, and / or (2) capping the amount of liability that the business owner personally guarantees.

C.    Eliminate if the lease is transferred:  Many personal guarantees attempt to bind the original tenant and require a guarantee of the obligations of any subsequent tenant(s) in an assignment or transfer scenario.  Limiting the scope of the personal guarantee only for so long as the tenant remains in the space can protect a business owner from being responsible for any breaches of the subsequent tenant’s financial or non-financial obligations under the lease.

D.   Corporate guarantee:  Owners of multiple businesses often explore whether there is ability to replace the personal guarantee with a corporate guarantee.  This may satisfy the landlord’s concerns as to additional remedies in the event of failure to pay rent or breach of other obligations under the lease, while affording the business owner an added layer of protection for their personal assets and from personal liability.  

2.     Ambiguous Common Area Maintenance (CAM) Charges

CAM or operating expenses typically include expenses and costs of the landlord related to the operation and management of the project, land, or shopping center within which leased premises lie.  These fees are in addition to rent and unless clearly addressed in the lease, they can be unpredictable and significantly increase business operating expenses year after year.

A.   Understand the costs included in CAM:  As a first step, it is important to understand what charges are included in CAM and how those are reconciled prior to signing a commercial lease.  The lease should, at a minimum, contain a description of CAM charges, and if it is unclear what certain items are, tenants may benefit from inquiring with the landlord for further details or for a written statement of CAM charges.

B.    Cap annual increases:  Considering it may not be easy to pinpoint exactly what each CAM charge may include, negotiating a percentage cap on annual increases of CAM is an efficient way to limit unpredictable expenses.  A landlord will typically provide the tenant with an estimated CAM charge amount at the beginning of the lease and for every subsequent lease term year.

C.    Costs Excluded from CAM:  Clarity about what expenses are excluded from CAM charges is critical.  For example, CAM typically does not include real estate broker fees, attorneys’ fees relating to tenants at the project (if within a shopping plaza) or at another site owned by the landlord, legal fees for the collection of rent of other tenants of the landlord, penalties imposed on the landlord for violations of any law, reserves for anticipated future expenses, personal property, or liability insurance costs.  

3.     Permitted Use, Set Hours of Operation, and Exclusivity Issues

A.   Permitted use:  The permitted use provision dictates what activities a tenant may or may not conduct at the leased property.  A broad permitted use definition will allow for flexibility in business activities beyond what may be initially anticipated.  For example, retail stores initially selling leather goods may later decide to also provide services related to leather goods.  A permitted use definition that is narrowly limited to retail activities would not allow the provision of these ancillary services from that location without amending the lease. 

B.    Set Hours of Operation:  While it is reasonable to operate at standard hours, businesses may want to retain flexibility and avoid an obligation to keep the doors open at set hours.  For example, a bagel shop may not want to stay open past noon if all their bagels are sold out for the day.  Additionally, a business owner may want to ensure that there are adequate exceptions to the set operating hours to account for scenarios where it would be impossible or overly burdensome to keep the business open.  For example, leases may often exclude major holidays and emergencies, or even pandemics.  Notwithstanding the above, commercial leases typically contain provisions stating that continuous non-operation of a business for a consecutive period of time (i.e., 30 days) is deemed a breach of the lease.

C.    Exclusivity:  If there is interest in expanding a tenant’s business, provisions that prohibit the opening of the same or similar business at another location may be burdensome.  On the flip side, if a landlord owns many properties that are geographically proximate to the tenant’s business, tenants sometimes attempt to negotiate an exclusivity clause in their favor prohibiting the landlord from leasing any of their nearby properties (usually within a specified mile radius) to a competing business, or to a business whose revenue of competing goods or services exceeds 10%, or 20% or 30% (percentage subject to negotiation) of their total gross revenue.

4.     Unclear Maintenance and Repair Obligations.  

Maintenance and repair obligations are often divided between the landlord and the tenant, although, at the end of the day, the allocation of responsibility is a creature of contract subject to negotiation between the parties.  Clearly defining each party’s maintenance and repair obligations, and ensuring there are no ambiguities about concurring responsibilities and the extent thereof, may save the tenant significant expense and headache down the road.

Take HVAC repairs, for example.  HVAC, plumbing, and structural components often represent significant expenses.  It is not uncommon for landlords to assume greater responsibility for these systems—particularly during the initial years of the lease—since repairs and maintenance benefit the property well beyond a single tenant’s term.  

By contrast, other maintenance obligations, such as upkeep of the interior of the leased premises, may be more appropriately assigned to the tenant.  Below are a few approaches to consider when negotiating maintenance provisions.

A.   Cap of responsibility on larger items.

B.    Tenants often explore building in the lease a period of time at the start of the lease where the tenant will not be responsible for maintenance and repairs of certain larger items.

C.    Representations and Warranties regarding the Condition of the Premises:  If the tenant is responsible for maintenance, it is good practice to request representations and warranties regarding the condition of the premises on the lease date and / or the move in date.  For example, the tenant may be responsible for mold prevention and maintenance related to mold exposure.  In cases like these, the tenant may ask the landlord to represent in the lease that there are no current or past known mold conditions, or conditions that could reasonably lead to mold (i.e., a leak) at the leased premises.

5.     Lease Assignment

As a small or medium-sized business owner, flexibility to relocate or reformulate business models could be important.  Tenants in this positions often consider a right to assign the lease or sublease the leased premises.  

6.     Opening Day and Rent Commencement Date

If leased space requires construction, businesses may want to look closely at when the rent payment obligations begin.  Delays in construction are more frequent than parties like to admit, and paying rent for a space from which revenue cannot yet be generated could exponentially increase capital requirements.  

Conclusion

Commercial lease agreements are often dense and landlord-favorable, making it critical for businesses to fully understand their and their landlords’ contractual obligations and negotiate terms that best align with their long-term interests.  By understanding and addressing key lease terms at the start, businesses can minimize financial exposure and create a more balanced leasing arrangement that supports a business' growth and stability.  

Although the above-discussed legal pitfalls are a useful starting point, each lease agreement is unique and may contain other instrumental provisions necessitating thoughtful review and negotiation.  Consulting a legal professional to review and negotiate the lease terms can be an invaluable investment in a business’ future.

Roumel Law PLLC regularly assists clients with reviewing and negotiating complex commercial leases.  If you are considering a commercial lease and are seeking attorney review, or have further inquiries about this article, please contact:

Katerina Roumeliotis

Roumel Law PLLC 

katerina@roumellaw.com

(202) 270-8067

www.roumellaw.com