Power of Residential Property Investment

“The more leases you read in bed the richer you will get”

Commercial property lease is the without doubt the most important document that defines the value of your investment. It will pay you to read the lease document line by line and word by word even if it looks like a standard lease agreement.

It is the capitalization rate and terms of the lease that a valuer will take into account when arriving at the value of a property. When you are buying commercial real estate it is not so much the building that you are buying but the right to a cash flow that comes from the property.

Unlike residential leases there are no restriction on the clauses that can be added to a commercial property lease. Landlords, tenants and their solicitors can add many non-standard clauses that can become legally binding once the lease is signed. This can lead you to great grief if you have not read and understood the clauses. Even a small word like ‘may’ instead of ‘shall’ can change the meaning of a clause.

Check the Original Commercial Property Lease Documents

When you are purchasing commercial real estate you will be given photocopy of commercial property leases pertaining to the building. These can at times can be different from the original lease. There are fraudsters who for example may change the values of the outgoings to increase the net return so as to get a higher price for the property.

It is prudent for you or your solicitor to demand and have a look at the original commercial property lease documents during the due diligence period. This will protect you from any potential fraud.

Please also make sure that all the pages in the commercial property lease agreement are signed by both the tenant and the landlord and no extra pages have been added to distort the lease.

Is it Gross Rent or Net rent?

It is important for you to arrive at the correct net rent figure. Most commercial property leases are net but at times landlord pays certain portions of the outgoings. These will need to be deducted so as to arrive at the correct net rent figure.

What Chattels are included?

It is very important to what chattels belong to the landlord? Over a period of time both landlords and tenants forget who owns what and a dispute can arise. Normally a lease should contain list of chattels that belongs to the landlord. This chattels list is important for you to claim depreciation and save on your taxes.

Rent Reviews

You should check how often are the rent reviews? More frequent the rent reviews the better it is for you to increase cash flow and value of your property specially if it under rented. Three yearly rent reviews are common. It is better if you have yearly or two yearly rent reviews.

It is also prudent to check the terms of the rent review. Is the rent review to market or tied to CPI? Rent reviews that are ‘to market rent or CPI which ever is greater’ is better to you as an investor. Market rent figures can become point of argument between valuers but CPI figures that are published by the government agencies are generally accepted by both tenants and landlords.

You must also check on the time limit and procedure for the rent review. In some leases you can not ask for a rent review if you cross the rent review date due to over sight.

In so far as possible the rent review dates should not co-inside with renewal dates. If this happens the tenant can use it as leverage not to renew the lease if you increase the rent.

Ratchet Clause

A ratchet clause in the commercial property lease protects you as a landlord from any rent decreases in case of deflation. If a soft ‘ratchet clause’ is in place then the rents can not fall below the initial contracted rent at the commencement of the lease. In the case of a ‘hard ratchet clause’ the rents can not fall below the last reviewed rents.

Although having a ‘hard ratchet clause’ favors you as an investor or a landlord it can become counter productive if there is a downturn in the economy. The tenants can become dissatisfied if they find it difficult for their business to support the rent and they tend not to renew the lease when it comes up for renewal. A soft ratchet clause provides some flexibility to drop the rents.

It is always good to have ratchet clause in place. Banks love it because they are sure that the rents will not fall below a predetermined value.

Right of Renewal

Right of renewal clause in the commercial property lease contract is of no advantage to the landlord but gives the right only to the tenant to remain on the property.

If you are a landlord you should ask for a long initial term of lease and avoid giving any rights of renewal or keep them as short as possible. It is the initial lease term that determines the value of your property and not the rights of renewal which favor the tenant. Once you give rights of renewal you give effective control of your property to the tenant. You can not redevelop it or sell it to an owner occupier who may be willing to give you a high price for the property.

If you are a tenant it goes in your favor to go in for a short initial term to see if your business works from the premises and you must negotiate as many terms of rights of renewal as possible to ensure that you are not prematurely ejected out of the property once your business is established at the location.

The length of the initial term and rights of renewal are negotiated at the time of agreement to lease. If you are a landlord it is a good philosophy to agree to right of renewal for the number of years the tenant is willing to sign for the initial term of the lease. For instance if a tenant signs for an initial term of 4 years then you should be willing to give him a right of renewal for another 4 years.

Outgoings

If a building you are buying has several tenants then each tenant will apportioned a portion of the outgoings according to the size and value of his area. You must add up and check that tenants are paying 100% of the outgoings. There are times when you will add up and find that tenants are only paying 85% of the outgoings or some outgoings are crossed out in the lease. If you don’t check this you will find yourself paying the shortfall and receiving much less rent than you had anticipated.

You must remember that property rates or taxes are paid by the tenant but are responsibility of the landlord. The Council will come after you in case of a default.

Can You Charge the Tenants a Management Fee?

Most commercial property leases allow the management fee which is 4%-5% of the rent payable to be charged to the tenants. If you are managing the property by yourself you can still charge this fee for your time and effort. In some countries you will need to form a separate management company in order to charge the management fee. It helps to have the management fee built into the lease.

Building Area

It is very important for you to check the building area in order to work out the rental per square meter being charged to the tenant. By doing so you can find out if the property is rented above, below or at market rental. This is a very crucial information to you as on investor to determine the value of a building. I have seen developers and sellers exaggerating the building areas to attract investors into buying their property at a much higher price.

You must always request for a valuation report before going unconditional to buy a property because the valuers report will give the actual measurements of the area that have been leased out.

Building Use

It is advisable to have a lease that clearly specifies the type of business that can be conducted from the property. This gives you control and is helpful if you wish to evict a tenant in case of a breach. This clause also helps you when the tenant wants to assign the lease to a third party or wishes to change the nature of his business. You can ask the tenant for increase rent or length of the lease if he wishes to change the building use. You must avoid general terms and make the building use as tight as possible.

Personal Guaranty

This is a very important part of the lease. Companies fail due to one reason or the other. A personal guaranty from the director or the proprietor improves the quality of the lease and it helps to get funding from the bank. If the tenant is unwilling to give a personal guaranty then they are telling you that they are not very sure as to how their business will perform.

If a tenant is not willing to give a personal guaranty or does not have sufficient assets to back the guarantee then it may be advisable for you to insist on a bank guaranty in case of a rent default.

Reinstatement Clause

It is good to have reinstatement clause in the lease which means that the tenant will return the property in the same condition subject to fair wear and tear.

You may have to shell out considerable amount of money when the tenant vacates the property if this clause is not in the commercial property lease. These expenses can be exorbitant in case of polluting businesses and tenants like service or petrol stations that cause soil contamination.