CRE 101

Commercial tenancy agreement? Financial and legal considerations

Signing a lease naked? Part 3 of 3

Have you ever heard a bad story about a commercial tenancy agreement gone wrong? This article aims to avoid this happening to you.

Commercial property is an incredibly complicated industry. This article is last in a series of three “don’t-leave-home-without” articles. We’re going to write this from the perspective of a tenant – so it is feels least intimidating.

We’re putting  this into the public domain because we think it will do good. Our aim is to help tenants, customers of the industry, to pick better service providers. And we hope service providers can use this to help train less experienced professionals in their businesses.

With reference to the subject, below is a quote by Donald Rumsfeld, the then US Secretary of State for Defence, stated at a Defence Department briefing in 2002.

‘There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.’

Our objectives

Commercial property is a wonderful industry, filled with many passionate, competent professionals and skilled advisors. With this article, we aim to do two things

  1. Upskill you sufficiently to eliminate your “unknown unknowns”, and help you add value to the process.
  2. Empower you to assess whether the service provider you are dealing with can deliver the professionalism your needs require.

Some context

First of all, commercial tenancy agreements need to be built on an understanding of your needs as tenant. This needs understanding allow terms to be structured that work for both tenant and landlord.

Above all, in CRE, nothing is set in stone.

Depending on the “season”, many of the below can be negotiated with a landlord. But always remember, while you are looking at many options, landlords in parallel can be looking at alternative tenants for your space. Negotiating here is about you knowing what is reasonable and what is not reasonable. Similarly, it requires hard-won experience to know what concessions are negotiable and which items, beyond a point, are not negotiable.

Landlords are more negotiable in “seasons” when supply of vacant space exceeds demand, and less flexible when their tenant options are many. This however varies from area to area, from property category to property category, and from properties of different grades and attributes (such as good parking ratios or visibility or stacking volumes).

The right professional, based on a combination of intellectual property ranging from market intelligence to skills and experience to relationships, can help steer you in this process.

Hidden expenses

No one likes bad surprises. So it is your right to obtain complete transparency about all your expenses, up front. Your advisor, if she or he doesn’t have this info on hand to disclose to you, can get you the following answers fairly fast.

  • What fixed expenses are payable by you, the tenant, to the landlord in total every month? What is payable on top of this to third parties? What are variable expenses?
  • How much are “add-on” expenses payable by the tenant like lights, water and sewage?
  • What are the escalations for rent, and estimated escalations for expenses?
  • Are these escalations above, on or below market?
  • What happens if the recovered expenses change – who pays for the increase?
  • How, in a multi-tenanted property environment, are expenses going to be allocated to your lease? What underpins this allocation calculation?

As a result of the above questions, you end up with hard numbers. These expenses (rent, recoveries (paid by landlord, billed to you), and add on expenses) can be packed into a financial model. And this model can give you a cost value of your lease, in today’s terms. This cost comparison is the next step in evaluating alternatives.

As a rule of thumb, provided all escalations are roughly the same, the property that is the cheapest in day one expenses, will be cheapest at the end of the net present value exercise above.

Offer to lease (OTL)

Beware: signature of an offer to lease by a tenant can be as binding as a lease agreement.

Commercial tenancy agreement TIAs

(Aka tenant installation allowances). This is money provided by the landlord and spent on the property, to fit the space out for the tenant’s needs.

Some properties need very little expenditure. For example the previous tenant has fitted the space out beautifully, and kept it in pristine condition. Other properties are in a “white box” state where they are a shell with the basics, and await carpets, painting, cabling etc. to the tenant’s requirements.

Because of this, don’t be fooled – no two TIA’s are the same! It all depends on what the existing space looks like. And it is not uncommon for additional expenditure, above a TIA, to be required from you to get your space working for you. So ask the questions, and budget for this.

Two word of warnings. Firstly, it is easy to underestimate the costs of a fitout – and this is the norm vs the exception. Secondly, if a TIA has been granted and the lease is terminated early, on top of other costs, you as a tenant will need to refund to the landlord that TIA relating to the unexpired portion of your lease.

Further, with TIAs, take on and take back inspections are extremely important. Your take on inspection, in most instances, sets the baseline for a tenant’s premise reinstatement obligations.

Beneficial occupation

This is a period of time that the landlord allows you to have use of the premises, rent free.

We see it used generally for the period of the tenant installation, and so it is important to understand what your tenant installation will look like, and how long it will take.

Moving costs

Often overlooked, these vary from business to business and property category to property category. Moving costs for businesses occupying industrial premises are high – think about racking, equipment, machinery and other infrastructure. Retail involves the movement of stock and fixtures. We see office, which generally covers furniture and furnishings, costing you the least. Beware however of cabling and IT infrastructure.

In your sums, you may overlook remediation costs (returning the space to original condition in accordance with the terms of your lease).

All these sums should be run and considered in your stay vs go analysis.

Cost comparisons: net rental, gross rental, total costs?

Is R190 gross rent / sqm cheaper than R163 “net rent”? It could be. Depending…

To make sure you are providing fair comparisons between landlords, figure out what metric you are going to use for cost comparisons.

In summary, <blog post to follow>, your rental expenses (as tenant) live on a continuum of values – from big to small. Pure rental (the money the landlord puts in his pocket after all expenses) is on the one extreme. And “all in” price starting with pure rental and including total tenant expenses (the highest number possible) lives on the other side.

For ease of analysis purposes, we would recommend you doing comparisons based on the biggest expense: total tenant expenses. This is the sum of

  • “Net rent”. Plus
  • Known tenant expenses paid by the landlord and recovered from the tenant (giving you “gross rent”). Plus
  • Costs for parking. Plus
  • Other property-related costs tenant must pay on top of the “gross rent” and parkings – such as cleaning or gardens or roof maintenance. Plus
  • Utilities (lights, water and sewage) – which vary based on usage

At the end of the exercise, if you do this with all alternative properties, the numbers will tell you how your different options stack up.

Deposits and guarantees

Landlords require some form of security in the event that you a) don’t pay your rent, or b) damage the premises. And there is an opportunity cost to your tied up cash.

Property owners or landlords can require larger or smaller deposits or guarantees than others, and this varies based on your credit rating, history and financial performance. You can expect your deposit to be calculated based on a combination of rental types, parking costs, and expenses.

Landlords also vary in terms of how and to who the benefits of your tied-up cash goes to.

Sureties

In the event that you as tenant cannot honour your rental obligations, you will owe money to the landlord. In turn the landlord, 99 times out of 100, has financial obligations to lenders or investors. The landlord is under pressure to recover the money you have committed to pay them, so they can meet their obligations. Where a surety has been signed on a lease, the person or firm who has underwritten such surety will be liable for the settlement of the debt relating to the lease.

Lease administration costs

We alert you that your lease agreement will attract these transaction charges. And this is a line item that you will be billed for. It covers legal fees for drawing up the lease, processing of KYC or FICA documentation, tenant vetting and performance of credit and other checks.

Indirect taxes such as VAT

To be safe we would recommend you confirm whether all provided costs are inclusive or exclusive of VAT. Generally prices are stated exclusive of VAT.

Furthermore, even if you are not a registered VAT vendor, the landlord is legally required to charge you VAT.

Consumer Protection Act (CPA) considerations

You are afforded zero protection under the CPA if the answer to either of the below is no. Similarly, if you get two yeses one each for A and B, you will be protected under the CPA.

A.  Does the landlord lease property in the ordinary course of their business?

This is currently a grey area. The rule of thumb here: does the landlord’s legal entity derive the bulk of its revenue from the ownership and lease of property. A landlord who is an owner-occupier, sub-lessor of property, or private investor would probably get the no answer here.

B. Are you as tenant a consumer?

If the lease is in the name of a natural person, then you are a consumer. And the answer is yes.

If the lease is in the name of a juristic entity (like a company or trust), then you need to check if one of the below is no (at the time of signing the lease agreement)

  1. Is your (the juristic entity’s) income less than R2M per year?
  2. Is your (the juristic entity’s) net asset value less than R2M?

 

We hope the above has made a fairly complicated process simple. Firstly the “unknown unknowns” should have been eliminated. Secondly, you should be empowered with the knowledge that can allow you to both

  • Proactively manage a leasing process. And
  • Easily distinguish the quality of professionals and advisors in this space.

A lack of knowledge and transparency creates expectation gaps, which in turn fuels your unhappiness as a tenant. No property professional likes to hear of this. It reflects poorly on the prestige of a great industry, and its skilled and passionate professionals.

Good luck and feel free to pass this knowledge around, it is only good for both tenants and industry professionals alike.

And, if interested, the other two articles in this series address soft considerations and flexibility and feasibility questions to ask.

Thank you to Wayne Warburton for your valued insights and contributions on this post

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