Simply put, a lease is a legally binding contract between two parties—the owner (lessor) and the tenant (lessee)—in exchange for fixed payments (rent) for possession and stated use of real property for a specified period of time. After the marketing plan is implemented and begins attracting prospects to the site, it is necessary to develop an outline for leasing to and placing the occupants in the property. This in-house leasing plan typically includes a site plan of the property (preferably drawn to scale), unit numbers, and square footage dimensions. The rent schedule portion of the leasing plan outlines the current or desired rents for each space, lease expiration dates, and any concessions. The plan may also display anticipated parking counts for each occupant.
Real estate managers typically sign the lease as the agent of the owner, which is stated in writing on the contract. Regardless of the type of agreement, good management practices require a written lease, which offers greater protection to both parties. It also assures the owner that the tenant will occupy the space for a certain period and that the owner can anticipate a prescribed income for that period. In theory, no financial loss should occur because of a sudden vacancy. The tenant has possession of the space for the duration of the lease at a set rental rate. The lease may also outline procedures for rent increases, which is more common in commercial leases that have multiyear terms.
The lease should clearly delineate the property owner’s and tenant’s responsibilities and eliminate misunderstandings between the owner and the tenant—so both of them must understand its provisions. The real estate manager is responsible for asking new tenants whether they have read and understood the lease because any unclear provisions can be explained at that time.
Generally, a lease form that is reasonable, standardized within a property type—apartment, office space, etc., consistent with state law or any landlord and tenant acts, and suitable for all tenants—should be used. As a matter of goodwill, the lease should not contain clauses to which informed people will object or that uninformed people will ignore. When properly prepared and presented with equal emphasis on the tenant’s point of view, the lease has excellent marketing value. The leasing plan should always reflect the goals and objectives of the owner. Organizations such as the Society of Industrial and Office Realtors (SIOR), the National Apartment Association (NAA), and NATIONAL ASSOCIATION OF REALTORS® (NAR®) provide lease documents through their local affiliates that are current and contain the necessary, localized disclosures and protective clauses to keep the owner and real estate manager compliant.
Numerous leases are suited for different types of rental space, but all leases should describe the demised premises—the leased space that is conveyed from the owner to the tenant—and state the duration of the agreement, the amount of rent, and when and how payment is to be made. The following lists the principal contents of a lease:
The type of lease depends on the kind of property. The following lists four basic types of leases:
A written lease defines the rights and obligations of the office tenant and the building owner, but because of the complexity of the arrangement and a term that normally lasts more than one year, lengthy negotiations usually precede a lease signing. Real estate managers almost always participate in the negotiations. In some cases, the leasing agent may work out the details, but the real estate manager will usually administer the finalized lease agreement. As a representative of the owner, the manager will be instrumental in clarifying any of the tenant’s questions and suggesting possible compromises. It should be noted, however, that any drafting of lease clauses or significant changes in the wording of a lease should be made by the owner’s attorney as real estate managers are not typically authorized to perform these functions.
The starting point of negotiations is usually a proposal or letter of intent (LOI) from the prospective tenant, followed by the presentation of the building owner’s standard lease form, which contains clauses that apply to all of the leasable space in the property. However, negotiation of each individual lease generates a unique document that reflects the relationship between the owner and a particular tenant. Many clauses require minimal discussion, but the concerns of the prospective tenant and the owner usually center on the tenant improvements and any allowances, and those are negotiated at length. Other clauses that often prompt negotiation relate to rent increases (escalations), pass-through charges, services, term of lease and extensions, and tenant options. Insurance requirements and indemnification clauses are often highly negotiated.
In developing a standard lease form, one of the owner’s objectives is to minimize expenses associated with the rent received. On the other hand, the incoming tenant might want to maximize the rights and services it receives for that rent. To accommodate these differing desires, a number of specific clauses are common to leases for office space. Two commonly used clauses are (1) rent escalations and (2) pass-through expenses.
Escalation Clauses. Because a commercial lease is often in effect for several years, it commonly includes an escalation clause to provide for a regular increase in rent. Property owners and real estate managers write escalation clauses into a lease to recover increases in real estate taxes, property insurance, and other operating expenses over the term of the lease. Common escalation clauses follow.
Operating Expense. A lease may contain an operating expense escalation clause, under which any increases in operating costs are passed on to the tenants on a pro rata basis. For example, if operating expenses for a 150,000 sq. ft. building were $540,000 one year and $600,000 the next, the owner would pass the $60,000 ($0.40/sq. ft.) increase through to the tenants. The pro rata share of a tenant who occupies a 12,000 sq. ft. office would be eight percent or $4,800 per year above the prior year’s expenses.
Base Year. Sometimes a lease provides for rent adjustments by referring to a base year—occasionally the current calendar year, but more often the first full calendar year after move-in. The base year is also a negotiable item. Once the base year is established, the tenant pays for increases over the amount of operating expenses in the base year. For example, a tenant who moved into offices in October 2017 under a five-year lease would be responsible for increases from the base year of 2018. Escalation of the base rent would take effect in 2019, 2020, and 2021, with a partial escalation for 2022 when the lease term would expire. The base year may change when the tenant renews the lease because the renewal date then becomes the base year, which might be stated as a specific rate plus accrued escalations. The property owner, with the assistance of the real estate manager, must take the property’s cash flow into consideration when establishing the base year for escalations because it will be in effect for the full term of the lease.
If the property is new, the first full calendar year may not always contain the true or full services necessary to maintain the property. In this case, the operating costs may be passed through as a set maximum for the first few years, after which the base year would be determined as year two or three when expenses stabilize. Alternatively, a gross-up provision is included, whereby the property’s operating expenses are increased (grossed up) to an estimate of what they would be at 95 or 100% occupancy.
Expense Stop. Another strategy is to include an expense stop provision, which sets a limit on the owner’s expense escalations. For example, if the stop is set at $8.25 per square foot per year, the tenant must share in the increased expenses over that amount on a pro rata basis. The stop is often based on the amount of expenses for the previous full calendar year, and it may be stated as a total amount per year rather than on a per-square-foot basis.
Another term similar to the expense stop is a “cap” on pass-through charges. A negotiated cap in the previous example might be that the tenant would reimburse actual expenses, but no more than five percent over the previous year’s expenses. In these examples, tenants are assured that any major swings in expenses, such as a large elevator repair billed to the tenants on a pro rata basis in one year, are eliminated and replaced with a known and capped annual increase. Caps are often included for controllable expenses such as janitorial, security, and utilities but exclude non-controllable expenses, such as real estate taxes, insurance, and snow removal in the northern states.
In most situations, operating expenses are estimated for the coming year and billed to tenants’ pro rata on a monthly basis in advance. At the year’s end, when the actual costs are known, adjusted amounts are billed (or credited) to the tenants—a process called reconciliation.
Inflation Offset. An escalation clause can also serve to offset the loss in value of the rent dollar over time due to inflation. The owner and tenant can agree to determine the increase in several ways:
Fixed Annual Increase. The tenant and real estate manager may prefer to agree on a fixed annual increase for the duration of the lease or on specific rates for set intervals. Annual escalations might be stated specifically, such as $10 per sq. ft. in year one, increasing to $11 in year two and $12 in year three, or as a percentage, such as eight percent per year. A lease for a very long-term rental might be negotiated to state specific increases only every three or five years.
Pass-Through Charges. In a commercial lease, not all operating expenses of the property are necessarily collected in the rent. In a gross lease, the owner pays all the expenses of the property and must recover those costs through the rent, but that arrangement is uncommon in large office buildings. Usually the owner bills some expenses to the tenant on a prorated basis in the form of a pass-through charge. The pass-through charges are in addition to the base rent charged for the leased space. When the tenant pays any operating expenses directly, the lease is called a net lease. Three types of net leases are common, but the expenses covered under each type of net lease vary by region:
In general, the higher the level of net lease a region uses, the lower the base rent. In other words, a gross lease for office space will state a comparatively high rent because the owner will pay all operating expenses from that rent. The all-inclusive rent for that space is its base rent. A single-net lease on that same space will state a lower base rent because the tenant will pay part of a certain operating expense or expenses. In the case of a double-net lease, the base rent for the space will be even lower because the tenant will pay more operating expenses. With a triple-net lease, the base rent on the space will be lowest of all because the tenant directly pays most, if not all, of the expenses. The three types of net leases are also used for industrial and retail space, and standard definitions are available for those uses; they are explained in Chapter 13.
The lease states the specific pass-through expenses the tenant will pay and the method of computing the tenant’s pro rata share. The most common pass-through expenses are utilities and common area maintenance (CAM), in addition to real estate taxes and property insurance. Owners may pass through capital improvements in the common areas as well, particularly if the improvement reduces an operating expense (e.g., a more efficient HVAC system may lower utility costs). However, the lease must clearly state that capital improvements will be passed through and some leases may require certain capital expenses to be amortized and billed to the tenants over the life of their lease, or on the basis of the projected life of the particular improvement.
To encourage the leasing of a space or to encourage the renewal of a lease, a concession is given by the owner to a prospective tenant. The concession usually provides a monetary incentive but may not reduce the quoted rent. Concessions may be in the form of free or reduced rent for a specified period, financial assistance with moving from the former location, payment of penalties for breaking a former lease, or payment for above-standard tenant improvements. A concession can also be an advance of funds that allows the tenant to invest in certain improvements or incur other costs initially and pay the money back to the owner over the term of the lease. This permits the quoted dollar rent per square foot to stay as high as the market will bear. Concessions might be greater at certain times—for example, when the supply of available office space exceeds demand.
Prospective tenants or current tenants negotiating a lease renewal may seek other rights. In a lease, an option is the right to obtain a specific condition within a specified time; the option is often written into a lease as a formal addendum, or addition. Except for situations in which a cash payment to the owner is involved, options always benefit the tenant rather than the owner, who is understandably reluctant to grant them. However, the property owner may need to grant options so a property can be competitive and reflect market conditions. Option clauses usually require the tenant to notify the owner of their intention to exercise the option within a certain number of days of the lease expiration. Failure to provide such notification may void the tenant’s rights.
Option to Expand. A tenant that anticipates growth may bargain for an option to expand that requires the owner to offer additional space at a stated time in the future—often at the end of the lease term. Except in very soft market conditions, owners rarely grant such options because they can mean the expansion space will be vacant for some time before the option is exercised. In other cases, the anticipated expansion space might be temporarily occupied by another tenant, and that could require additional costs moving them to another space.
Right of First Refusal. As an alternative to an option to expand, the owner may offer a right of first refusal, which gives the tenant first choice to lease contiguous space or other space in the building only when it becomes available—the lease clause usually specifies the area.
Right of First Offer. Another possibility is for the property owner to grant a right of first offer, which gives the tenant the right to be the first to make an offer when and if a specific space becomes available. If the subject space is leased to an existing tenant at the time the owner grants the first-offer right to the tenant who requests it, the availability date can occur at several times:
An owner may also give a right of first offer on unleased new space; this takes place when a building is under renovation or construction, the delivery date is uncertain, and marketing has not begun. The tenant that holds the right of first offer usually has a short time after receipt of the owner’s availability notice to exercise that right.
Option to Renew. Sometimes a tenant may seek an option to renew on the same terms and conditions as the original lease. However, owners are disinclined to grant such renewal options for several reasons. First, a multiple-year lease usually does not account for all possible market changes during its term—even with escalations still in effect, the actual rent may remain below the market rate. In addition, a renewal option does not guarantee that the tenant will remain. When granted, such options usually refer to a rent adjustment to an increase to be agreed upon or to market rates current at the time of renewal.
Option to Cancel. Under some circumstances, a tenant may seek an option to cancel or a termination right, which grants the tenant the right to cancel the lease before its expiration—sometimes upon certain stated circumstances—and, if granted, usually requires a financial penalty. For example, if government regulations change and a tenant’s current use violates those regulations and it can no longer sustain its operations, the tenant’s termination right would be exercised.
Lease renewals are very important in the overall economics of property performance. Renewing the lease of an existing tenant is usually more profitable than finding a new tenant for the space for the following several reasons:
Only tenants who are satisfied with the property and the service they receive will renew their leases. In this regard, every contact with the tenant is an indirect renewal effort.
The reasons for not renewing a lease are beyond a real estate manager’s control. Market conditions usually change during the lease term, rents may go up or down, and vacancy may increase or decrease. Lease expiration usually requires negotiating new lease terms unless the lease that is expiring contains an option to renew that already has specified terms and conditions of renewal. The starting point of negotiations may be whether the parties are willing to renew the lease, and the conclusion may be whether the proposed terms are acceptable. The following lists some principal bargaining points:
Both parties usually expect the rent to increase, but the exact amount may be subject to negotiation, depending on market conditions. Renewal terms are more likely to be negotiated for commercial leases, and the negotiations may be as comprehensive as for a new lease.
To facilitate lease renewals, two basic administrative tasks will be performed: (1) generate a list of all tenants’ lease expiration dates based on the property’s rent roll, and (2) contact the residents or tenants directly when leases are about to expire. If possible, speaking to the tenant face to face is the best and most direct approach. Otherwise, contacting them via letters or e-mails is effective as well.
The timing of renewal negotiations should be adequate for tenants to make their decisions and for the manager to find replacements for those who decide to move. For residents, a notice of 60 to 90 days in advance of lease expiration is expected. For commercial tenants with long-term leases, renewal negotiations may begin a year or more in advance. Note that market conditions will often dictate how far in advance the manager should begin working on a renewal. In a soft market, tenants will be contacted much earlier than the standard notice period in an effort to minimize turnover.
Commercial building owners are increasingly responsible for installation, operation, and maintenance of telecommunication risers and cabling in their buildings. The lease document should address the risks that accompany this responsibility, which include the tenant’s insurance, operating expense pass-throughs, escalations, and system failures.
Deregulation of electric and gas utilities means volume users can purchase directly from low-cost sources; however, the electricity and gas will continue to be delivered via the existing local distribution systems. Owners of buildings whose tenants use large amounts of electricity may purchase power to sell to their tenants. Commercial tenants may choose to purchase their own power directly, and leases need to accommodate these changes in their utilities provisions. In addition, pass-through common area charges may be affected.
Some tenants’ leases may need to address regulatory compliance. Disposal of hazardous waste materials is an issue when health professionals lease space in medical office buildings. Additionally, a separate clause should specify the owner’s and tenant’s responsibilities for compliance with the Americans with Disabilities Act (ADA)—including provisions for indemnification of either party from liability for costs arising out of the other party’s noncompliance. For instance, nonprofit organizations that provide a real property tax break may contain lease clauses that require the owner to pass the savings onto that particular tenant or all of the tenants in the building.
As with all other aspects of tenant relations, tact, diplomacy, and goodwill are essential to the collections process, but it’s important to also be firm in requiring payment of rent on the date it is due. Real estate managers pay operating costs, taxes, and other property expenses out of the rental income, and expenses accumulate daily.
Timely collection of rents is imperative for timely payment of the property’s bills. In addition, some portion of the manager’s compensation is usually a percentage of the total rent collected, and any decline in that amount reduces the income. These two concerns—(1) operating expenses and (2) personal compensation—are incentives to collect the full amount of rent on time.
The advance payment of rent is an accepted practice—leases with federal agencies are exceptions because the federal government always pays one month in arrears. Monthly rents are usually due on the first day of each month, although some are due on the lease date. To streamline accounting, rent collections, and payment of the property’s expenses, all leases should have rent due on the same date. To accomplish this effectively, the first month’s rent should be prorated for tenants who do not take possession on the first of a month.
Most tenants pay their rent on the date it is due, but inevitably, some will be late. Three significant reasons for not tolerating any delay in rent payments follow:
Most real estate managers and owners expect payment in full by the first of the month, and they impose late fees as a reinforcement of their policy. Late fees may be a residual source of income for management, but the delay in receiving the rent and the time spent accounting for the fees tend to cancel any expected benefit.
A small late fee actually encourages late payment because such a policy has an inherent grace period associated with it. For example, if management imposes an extra charge for payments received on the sixth of the month or later, the tenant has no compelling reason to pay the rent until the fifth.
If late fees are used, they should be large enough to encourage prompt payment. Some municipalities limit the maximum late fee that a property owner can charge on residential rent, and this must be a consideration as well.
Back rent is a debt, and collection of back rent is subject to the requirements of the Fair Debt Collection Practices Act. Statutes always control delinquency, collection, and eviction rights and procedures. It’s important to be familiar with and understand the laws and the practices that govern these matters. Local law may be more favorable to residents and commercial tenants than to property owners, and the laws in nearby municipalities may differ from each other.
In terms of facing delinquency, encourage payment on the first day of each month. Keeping that simple policy justifies distributing notices of delinquency very early in the month, followed by a personal contact soon thereafter if payment is not received.
All residents and commercial tenants should have a clear understanding of the rental collection policy before signing the lease. Be careful not to compromise any of the owner’s legal rights by presenting a policy that is more lenient than the law requires. It’s important to explain the policy in a firm manner that does not jeopardize the extension of goodwill toward the tenant.
A series of forms is the basis of a good collection system. A notice should be delivered to the resident or commercial tenant on the first day the rent is delinquent; it should be a strongly worded but a friendly reminder. The check may be delayed in the mail, so the reminder notice should simply state that the rent has not been received and ask the tenant to contact the office about the matter.
If the resident or tenant does not respond to the reminder notice and the rent is still delinquent, the next step is to send or serve an eviction notice or such other notice as state or local law may require to initiate eviction.
Eviction is ejection of a tenant from the leased premises by the property owner. It is a drastic measure. It can result in the forcible removal of the tenant’s possessions from the premises if the tenant refuses to move out. State laws governing eviction vary widely, but most provide for the property owners or their attorneys to serve eviction notices or notices to cure a lease violation within a specified period. Municipalities frequently have laws concerning evictions and tenants’ rights as well.
Eviction Notice. This notice should be a demand that the tenant pay the rent within a specified period or vacate the premises within that same period. State and/or local laws prescribe the time allowed, the form, how the notice is served to the tenant and the content of the notice. If the law permits a late fee, the notice should state that amount.
By law, such a notice may automatically terminate the lease, so the manager must understand its effect. In some states, an owner may accept a partial payment of the amount due without compromising the notice or the owner’s right to bring suit for the whole amount of the delinquency. In some jurisdictions, accepting a partial rent payment may preclude collection of the total amount that is in arrears. Because an error can lead to the owner’s or the real estate manager’s liability to a tenant, an attorney must be consulted to determine the requirements of state and local law.
Eviction Proceedings. If a tenant refuses to pay all the delinquent rent specified in the notice or violates the lease in some other way and fails to cease or cure the violation within an allotted period, eviction proceedings can be initiated. The management agreement should expressly grant the real estate manager discretion to evict tenants or specify a procedure for obtaining the owner’s approval. An eviction should never begin without the owner’s approval.
In the case of nonpayment, if the tenant has not responded to the demand for payment within the time allowed, the real estate manager must file a complaint with the court. The complaint prompts the court to issue a summons to appear in court. A third party, such as a sheriff or private process server, delivers the summons. If the summons and complaint cannot be delivered personally to an occupant, state or local laws will specify alternate procedures, which must be followed exactly. Sometimes a notice may be affixed face-up on the front door of the premises or in another conspicuous place.
The complete form usually includes an affidavit of service—a sworn statement that the notice has been properly served—which the process server completes. This affidavit is then presented in court. The form must be completed and delivered exactly as stipulated by the legal procedures specified in it and by state and local law or court rule, or it may be ruled invalid.
Any procedural inconsistency, if the notice is served impartially, may permit the tenant to avoid the eviction—necessitating a complete restart of the process—or leave the tenant with a claim for a countersuit. The tenant should not be harassed, intimidated, or denied access to or use of the rental unit or specific services—such actions can also be cause for a countersuit.
In court, the judge may give the tenant an opportunity to pay the rent, but state or local law determines whether the property owner has a legal obligation to accept the rent. However, if the tenant offers to pay, the judge may direct the owner to accept payment. If the tenant cannot pay, the judge will usually render a decision or award judgment in favor of the owner—for possession, rent due, and (possibly) court costs. As part of the judgment, the tenant will be given a date by which to vacate the premises. If the tenant does not yield the space by that date, state and local law dictate further procedures.
Other Eviction Types. There are two reasons for eviction: (1) monetary, nonpayment of rent, (2) and non-monetary, breach of a lease covenant. Examples of non-monetary eviction involve keeping a pet when the lease stipulates that no pets are allowed (for residential properties), or manufacturing products in space leased for use as offices (for commercial properties). In addition, the owner may terminate a tenancy without stating a cause if the tenant has a month-to-month lease—this is a no-cause action, not an eviction. It’s important to understand the differences between the two types of evictions and the owner’s right to terminate a month-to-month lease because they involve different procedures.
Evictions can be expensive even though the fee can be negotiated with an attorney. In the best circumstances, an eviction may require months to complete. Some states allow tenants to claim retaliation for an eviction if the tenant has complained about certain deficiencies or other matters prior to the eviction. Every such lease violation should be documented thoroughly or be reviewed by an attorney before any eviction process is initiated.
The best way to minimize the need for an eviction is to be diligent in selecting tenants, perform credit checks, and verify credentials for all prospects before they sign leases. Although the staff of a property must be diligent and prompt in taking action when rent is late, or if tenants fail to respect any section of the lease, the most effective means of maintaining harmony on the property is to give tenants the respect they deserve. If the staff treat residents and commercial tenants properly and professionally, give them prompt service, and respect their privacy, the great majority will faithfully observe the requirements of the lease.
In addition to rent payments, almost all leases require a security deposit that the resident or commercial tenant pays in advance and the owner holds to ensure the tenant’s performance under the lease. The amount of the security deposit is often equivalent to one month’s rent, although it can be any amount for commercial properties. Residential properties are governed by the Landlord Tenant Law in the specific state and there are often stipulations on the security deposit.
Real estate managers should not permit tenants to apply the security deposit to the last month’s rent, especially if damage occurs to the premises, excluding normal wear and tear—the deposit will not cover both repair expenses and the rent. The deposit must be large enough to be an incentive to the tenant to take care of the premises, but that does not always necessitate the equivalent of one month’s rent. On the other hand, a leased residence that includes furnishings has greater potential for damage and warrants a larger security deposit.
If the tenant fulfills all the obligations of the lease, the security deposit should be returned within a reasonable time after the tenant moves. However, the deposit should be held until damage charges can be itemized and deducted. The turnaround should be finished quickly so the space can be made market ready immediately. If feasible, inspection of the unit in the tenant’s presence on the last day of the lease is helpful in explaining the need for damage or cleaning charges.
Leasing success depends on staff members having a shared commitment to the goals determined by property ownership and management. A variety of staff members may perform leasing activities, including the real estate manager and on-site leasing agents for residential properties and on-site leasing agents and leasing brokers for commercial properties. It is important to remember that the staff must work as a team to achieve the leasing objectives. An on-site leasing staff member performs full-time leasing duties for the property. For on-site staff, a professional dress code should be established and should coordinate with the property’s image or theme. It is important to minimize the chance of the staff member failing. It’s also important to establish clear job descriptions that detail the scope of tasks, and these responsibilities should be developed and shared with the staff. Initial and ongoing training should be provided for the staff so that they are familiar with the leasing goals for the property.
It is also important to encourage the leasing staff to perform well by learning what motivates them. Some employees are driven by awards, contests, letters of recognition, and public acknowledgments. Other staff members might be concerned with power-related motivators like a tough challenge or increased authority. Money-motivated employees will be inspired by the potential for increased compensation. Bonuses and incentive plans are always successful when motivating most staff members. Nonetheless, all leasing staff members should be recognized and rewarded for their successes—such as an increase in occupancy rate or a decrease in turnover.
The leasing plan should always reflect the goals and objectives of the owner. A basic lease displays different components that are suited for different types of rental space. The core of the lease describes the duration of the agreement, amount of rent, and when and how the payment is to be made. After the marketing plan is implemented and attracts prospects to the property, an outline for the lease plan should be developed, and should include a site plan of the property, unit numbers, and square footage dimensions, along with the rent schedule that outlines the current or desired rents for each space, lease expiration dates, and any concessions. Real estate managers should always anticipate and also participate in lease negotiations. Whether or not a leasing agent works out the details, real estate managers represent the owners and are instrumental in suggesting possible compromises and clarifying the tenants’ questions.
1. In many areas of the United States, the CPI is rarely used as a basis for escalations in new leases because the values can fluctuate widely. Since fluctuations are less prominent in the northwestern part of the country, management firms there still use the CPI—usually with a five percent cap and a three percent floor. Older, long-term leases may still reference the CPI.