Question

You and two business partners are considering the purchase of the following commercial investment property:

Commercial Property:

• Estimated purchase price: $600,000 (building only)
• Type of property: Mixed-use.
• Units: 3 residential second-floor Apts. - (A) 1,500 sq. ft., (B) 1,250 sq. ft., and (C) 850 sq. ft.
• 3 retail ground floor Units, with separate entrances, 1,200 sq. ft. each.     

Lease Information:

• Residential Apartments: All residential units are rented.
• Retail Units-annual rental revenues: Each Retail Unit is under a month-to-month gross lease.

Other Information:

• The property is subject to a 50 years ground lease (all property interests reverts to the seller at the end of the ground lease). The business partners with pay the ground lease landlord an annual ground lease payment of $20,000.
• Each business partner will purchase a 1/3 interest in the investment.

Provide your business partners with the following information:

• 1. The business partners did not negotiate an option to renew the ground lease. What challenges may arise if they now want to renegotiate the renewal option into the ground lease?
• 2. For the retail tenants, identify the commercial lease types that may be used for the three retail tenants.
• 3. Based on your analysis in item 6 above, provide a recommendation of a lease type that should be used for the three retail tenants that will maximize retail rental revenues.
• 4. One of the retail tenants will eventually need more space and may need to move to a different property within the next 12-24 months. This tenant is expected to ask for a provision in the lease that will allow the sublet or assignment of the premises. Describe the differences between a sublet and an assignment lease provision. Provide a recommendation as to which provision is most beneficial to the business partners.
• 5. The business partners are concerned that some tenants may not like the change in ownership and attempt to get out of their lease obligations. Describe how leases may be terminated.
• 6. List the remedies available to the business partners if a tenant breached the lease terms.
• 7. List the different ways to hold title in the investment. Provide a recommendation that will be acceptable to the business partners.

Answer 1

1. Since renewing lease contacts limits the flexibility of land owners, the partners might face reluctance. Moreover a renewal negotiation includes agreement on notice period, term, rental rate, fair market value. Rental rate are usually tied to fair market values. Hence the partners might have to accept higher rental rates at shorter terms since there could be other perspective lessee who are willing to pay higher prices. Also since it is difficult for the partners to move out and Rose on furnishing costs, the landlord will take advantage of it in renewal negotiation.

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2. There are three categories of leases when it comes to commercial real estate: Gross Lease (also known as Full Service Lease), Net Lease, and Modified Gross Lease. The main similarity among these leases is that they all provide a base rent with variations around who pays for which operational expense.

In a gross lease, the tenant’s rent covers all property operating expenses. These expenses can include, but aren’t limited to, property taxes, utilities, maintenance, etc. The landlord pays these expenses using the tenant’s rent to offset the costs. As a result, the base rent is typically relatively high, but is the only cost to the tenant.

The net lease is a highly adjustable commercial real estate lease. The base rent for a net lease is lower than a gross lease, but the tenant also pays fixed operating expenses such as property taxes, insurance, and common area maintenance (CAM) items.

The third major type of commercial real estate lease is the modified gross lease (or modified net lease) and offers a happy middle ground for both tenants and landlords. The modified gross allows a broader range of negotiations when it comes to operating expenses. The base rent will then be subjected to the terms agreed upon by both parties like the gross lease. The differentiating factor is that the lease rate remains fixed even if costs increase or decrease.

Source: https://www.vts.com/blog/the-3-types-of-commercial-real-estate-leases#:~:text=There%20are%20three%20categories%20of,pays%20for%20which%20operational%20expense.

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3. Of all the lease types, Triple Net Lease (NNN) offers the maximum benefits for the landlords. In this, the tenant is responsible for paying the building's property taxes, building insurance, and the cost of any maintenance or repairs the building may require for the term of the lease. Because the tenant is covering these costs, which would otherwise be the responsibility of the property owner, the rent charged in the triple net lease is generally lower than the rent charged in a standard lease agreement. However the loss of income because of the lowered rent is lower than the savings achieved though reduced expenses (savings = profits).

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4. A lease assignment agreement is a formal agreement transferring a tenant's rights and obligations to a new tenant. A lease subletting agreement is a more flexible arrangement that involves a lessee allowing an additional tenant to use the leased space, often on a temporary or short-term basis.

A lease assignment is always beneficial to the landlords over subletting. In subletting, the rent goes to the primary leasee and hence reduces the profits of the landlords. However in lease assignment a new tenant is brought in and hence the terms of lease can be negotiated between the new tenant and the landlord. This allows the landlord to negotiate for increased rents.