Say Hello to your Landlord!
SAY HELLO TO YOUR LANDLORD!
By Terry Jackson, C.G.A.
Imagine if you will, going to work one day and receiving a letter from your landlord that your lease has expired, and that you have to relocate your veterinary clinic within thirty days. Your business is ruined and you’re unemployed! Having witnessed such events over the course of my business career, I thought an article on premise leases might be a good thing to consider. After all, who’s going to remind you that your premises lease, entered into fifteen years ago, has expired and that the landlord is in the position to take possession of your clinic, the building and essentially your entire veterinary practice!
Allow me to begin by providing my laymen’s interpretation of words and phrases that are commonly used in the business of commercial leases for veterinary clinics and hospitals:
Term refers to the length of time the premises is going to be leased. Commercial leases normally have terms of three to five years and can occasionally be negotiated for up to ten years. Once the lease term has expired, the tenant and the landlord have to negotiate new conditions to continue occupying the premises, including a new lease cost.
Option to Renew is a phrase permitting the tenant to extend the lease term at the conclusion of the initial lease period for another specific term. In addition to containing the specific conditions under which the Option to Renew can be evoked, the lease term is generally a starting point to begin negotiating the new cost during the last six months of the concluding term. Should the parties fail to reach an agreement with regards to a new cost; the lease will then specify an alternate route to resolution. A lease document may have several Option to Renew terms; the important aspect to appreciate about this is that normally the only thing negotiated when exercising the Option is the lease cost. The only way a tenant can introduce a new term (adding additional Options to Renew), is with the landlord’s approval, and so it is critical to consider the length of time you wish to stay at the premises before you agree to an initial term and Option to Renew period.
Lease rate is a phrase that refers to the lease cost. In most instances, the lease rate is expressed in a per square foot basis. By multiplying the leased square feet by the lease rate, we are provided with the annual base lease rate. This is the rate that will be negotiated when the tenant exercises the Option to Renew at the conclusion of the lease term. Lease rates are dependent on a number of factors including: commercial vacancy as well as the age and location of the building. Within the veterinary industry, there are practices located in commercial shopping facilities that produce very high traffic volumes. Locations such as this will have relatively high lease rates, obviously reflective of visibility to potential consumers.
Triple net costs is the phrase that refers to what the tenant is going to pay in addition to the (basic) lease rate and specifically represents operating costs associated with the building in which the tenant’s business is located. Additional costs can include: property taxes, maintenance of lands and buildings associated with the leased premises, exterior light utility costs for the benefit of all the tenants, etc. The majority of leases include an additional cost for the outside management of the property, which is expressed as a percentage (3 – 5%) of the basic monthly lease cost. In so far as triple net costs can be upwards of fifty and sixty percent of the lease rate, it is very important to review the triple net costs associated with any real estate premise that you are interested in. Speak with other tenants to get their opinion on the management of the property, as well as any problems occurring of which the landlord has not pursued.
Right of first refusal is a phrase referring to the obligation of the landlord to grant the tenant the opportunity to purchase the leased real estate under the same terms and conditions as detailed in a bona fide offer to purchase. When leasing property that will suit your long term business objectives, and with a manageable purchase price, you should attempt to have such a term included in your lease.
Tenant Inducements is a part of the lease in which the tenant and landlord agree to certain incentives or inducements that will be to the benefit of the tenant signing the lease. Examples of Tenant Inducements include: free rental period (construction period), a capital expenditure allowance for the installation of new flooring or ceilings, etc. Because market value of commercial real estate includes recognition of lease revenue, landlords are highly motivated to obtain tenants for any vacancies. During economic uncertainty, no landlord wants vacant space with the market value of the property already depressed.
Now that you understand some of the terms used in commercial real estate, I will explore some of the finer points that require serious consideration. Firstly, I cannot emphasize enough the essential nature of having the lease arrangement documented. The cost of preparing the lease document is normally the landlord’s responsibility so there is no excuse for not having a lease document, unless the landlord doesn’t believe in contracts. Lawyers haven’t yet taken up veterinary medicine, and thus I don’t think you should take up legal work. Have your lawyer review the lease document!
Entering into a lease document is a very expensive agreement when one considers the monthly rent cost multiplied by the number of years the lease embodies. A thousand dollar a month lease payment equates to a sixty thousand dollar financial commitment over a five year period. What happens if the leased space isn’t big enough to operate your growing practice? What happens if you enter into a significant lease payment? Consider some of the following points…
- A companion animal practice generating less than seven hundred and fifty thousand dollars of revenue per year can operate efficiently in approximately one thousand to fifteen hundred square feet. As revenue continues to climb above the seven hundred and fifty thousand dollars and approaching the million dollar range, the practice will have to seek out a space in the two thousand square foot range.
- Annual lease costs, including common area expenses and property taxes, should represent between six and eight percent of annual revenues. This becomes relevant when lease considerations include locating a veterinary practice in a high traffic area where rental rates are significant. A good way to validate lease rates is to determine the annual rent costs and divide this cost by seven percent (7%) which results in the annual revenue that would have to be attained in order to achieve an efficient operating occupancy cost.
When discussing the terms and conditions of the lease with the landlord, begin by requesting a copy of the landlord’s standard lease document. This is a document that you can provide to your lawyer for advice as to the various issues that will have to be resolved in negotiations. In most lease documents, look for some or all of the following:
Right to Assign the Lease
A Right to Assign a Lease provides the tenant with the opportunity to transfer the lease to another company or, alternatively, to another person. This right is important when selling a business where the lease has to be transferred to the purchaser. Without this “right”, the landlord can withhold consenting to the transfer and thus completely frustrate the sale of the business.
Another concern when dealing with the Right to Assign section are provisions that allow the landlord to cancel the lease if they choose not to agree to the assignment of the lease.
A demolition clause contained in a lease provides for a certain notice period, after which the landlord can arbitrarily terminate the lease to destroy the premises. Demolition clauses are prevalent if the premises being leased is located in an older building or there is re-development in the area. I have experienced many occasions where the tenant did not realize that there was a demolition clause in the lease. In short, a lease with a demolition clause provides a lease term equal only to the demolition notice. Veterinary practices with a demolition clause in the lease agreement effectively eliminate any goodwill the practice would have.
“As Is, Where Is”
Unless specifically noted otherwise in the lease document, the Tenant assumes the premises on an “As Is, Where Is” basis. In other words, the Landlord does not affirm the premise’s condition, including heating, air conditioning, hot water tanks, etc. More specifically, this means that if the air conditioning unit stops working a week after one assumes a leased premise, the repair cost is the tenant’s.
Before signing a lease document, confirm the tenant responsibilities with regards to building equipment including: the furnace, air conditioning units, the boilers and hot water tanks. If warranted, hire a building inspector to examine the premises.
The lease document normally confirms the insurance coverage the tenant is required to maintain throughout the term of the lease. In so far as this would be a responsibility of the tenant, it is best to forward these requirements to the company’s insurance agent to ensure you have the appropriate policy coverage.
When speaking with an insurance agent about the landlord’s requirements, inquire into Business Interruption Insurance and Leasehold Insurance, which are transferrable. Both of these policies would be of valuable consideration if there were to be a fire and the premises were destroyed. Business Interruption Insurance will provide the necessary cash to keep the business intact, pay bills, pay key employees, bank loans, etc. Having transferrable leasehold insurance, allows the tenant to relocate the business and have sufficient funds in which to rebuild their business.
The theory is if you operate your practice from a limited liability corporation, the shareholder is not responsible for the debts and obligations of the company. Well, when the shareholder signs a personal guarantee (Covenant) on a lease, they become personally responsible for the lease. If the business is relatively new and doesn’t have a credit rating, or the business is new to the landlord, a Personal Covenant will be required. Most leases confirm that if the lease is assigned at some point during its lease period, the original tenant’s and Personal Covenanter’s obligations continue, despite the fact the lease has been assigned for the benefit of another. If the “new” tenant defaults on the lease, the Landlord has the right to come back to the original tenant and the covenanter for payment of the defaulted amount.
When negotiating a lease in response to the Landlord’s request for a personal guarantee, negotiate the guarantee for a limited time period. If the company and the shareholder have been responsible for the first three years, the guarantee should not be necessary.
The start of any new business is a dream of many. As business owners, we work hard for our success and we count on its success and value to provide for retirement or professional developments. Most of all, successful business people have egos, and the success of our business fuels (if you like) our egos. The facility, from which we create and live out our dreams, is a huge financial commitment. The true success of our business relies heavily on the terms and conditions we have with our landlord. Make sure this consideration is given the same amount of time and expertise as you devoted to the planning and strategizing of your career.