Hey there, BP!
I love being a residential landlord, don’t get me wrong. As they say, people always need somewhere to live, so you can always find a tenant for your residential rental. That being said, there are some major advantages to commercial properties. Over the years we have acquired several commercial buildings, ranging from an office building to a mixed use property with storefronts on the first floor and apartments above.
Although getting the right tenant for the space can be a challenge, once you get a tenant, there are some significant advantages to having commercial tenants. Leases for residential space are heavily regulated by the government — for good reason, as people’s homes are involved. Commercial leases are not subject to the same scrutiny, which opens up the possibilities for you to negotiate a deal, which protects you and also gives the tenant more options.
Another reason that commercial leases are different is that the tenant doesn’t live there; they are running their business out of the space. Residential tenants move, even when they are happy. Things like a job change, getting married or having another child will cause your residential tenant to move out of a unit. It’s hard to move a business once it’s established in that location. If the tenant is happy, there is little reason for them to move.
So, in my experience, there are many benefits to this niche, but here are the top five that you should consider when looking to invest in buildings with commercial spaces.
5 Major Advantages Commercial Space Has Over Residential Property
Longer Term of Lease
For the most part, residential leases are for 1 year, with the tenant getting an option to renew for another year or go month to month. Some residential landlords can get a 2 or 3 year lease, but it is much less common. It’s much more common to see a lease that expired a while ago and is now in month to month status, meaning the tenant can move on very quickly.
Commercial leases rarely have 1 year terms because that’s not beneficial for the landlord or the tenant. The tenant wants a long lease, as they want to lock in their overhead expenses over a longer period. If they are a retail tenant or someone who gets visitors, the location and locking it down long term are even more important. Landlords benefit from long term leases as well, of course. An added benefit is that banks look very favorably on long term leases when they consider you for a refinance.
Lucrative Rent and CAM Charges
Rent charges on residential spaces are fairly straight forward. This is how much you pay per month, and this is what that includes. The end. Commercial leases don’t have to be that way. If a tenant is new in a business, it’s common to give them a “ramp up” period so they can get their feet on the ground over a few months. Rent is discounted or even free during this period. If the tenant has lots of “fit out” to do, expect them to ask for this also. We will discuss “fit out” in a minute.
As much as rent can be discounted in the beginning, it is expected to go up as well. Many residential leases are protected by rent control laws. Those don’t apply to commercial leases, so it’s not uncommon for the rent to go up quite a bit over time. The more established the business is in that location, the more they may be willing to pay to hold that spot. Commercial leases can have a ratchet clause, which means that the rent goes up every year by an agreed upon percentage. Even though it’s a multi-year lease, the rent goes up regularly.
Tenants pay other things in addition to rent in a commercial lease. It’s common for tenants to pay a portion of utilities, especially the water bill. In some locations, you will see tenants pay something called Common Area Maintenance (CAM). We charge this in our office building to each tenant per month, and it goes towards things like cleaning the hallways, trash removal, restocking the bathrooms and even shoveling the snow in the winter.
This can go a step further and turn into a Triple Net lease (NNN), meaning that the tenant pays rent and all expenses. Those expenses include things that you most always see the landlord paying in a residential lease. Real estate taxes, insurance and all maintenance are paid by the tenant. These types of leases are common on pad sites and large office space.
There are even complicated rental arrangements, where the tenant pays a portion of their gross sales to the landlord as rent. If sales are low one month, the rent is too. This is fairly common in shopping malls and large retail centers.
Improvements Performed by Tenants
In residential units, the property is normally in great condition at tenant move in. There is little work to be done aside from personal touches by the tenant. In commercial units, it’s different. They are running a business from the location and need to tailor the space to fit their needs. The tenant has to do work to the space once they move in to make it suit their business – this is called “fit out.”
Fit out can include everything from painting to freshening up the space to full renovations. If the tenant runs a restaurant, their kitchen equipment, vent hoods, tables, bar, etc. are all included in the fit out expenses. Other tenants just have a certain “feel” they are trying to create in their space – they want to pick the wall colors, flooring, shelving, lighting, and on and on. Typically the tenant pays for the majority of this work. The landlord can also contribute to fit out, but if so, the rent should reflect this investment.
All of this equals further investment from your commercial tenant in the space. If they pay a bunch of money for fit out, they are financially anchored to your space and wouldn’t want to abandon that investment any time soon.
So let me say up front: I am not in this business to throw people out of their rental units and take their stuff. I hope that all my tenants stay in place for many years, as long as the unit they are renting serves their needs. That being said, it helps my investors and I sleep better at night knowing that I have some collateral I can fall back on if I have a problem with a particular tenant.
On a residential lease, the main collateral is the tenant’s security deposit. In New Jersey, that is limited by law to 1 and 1/2 times a month’s rent. In Pennsylvania, you can charge a month’s security and also collect the last month’s rent up front. Most states won’t let you go much further than that for collateral. If you end up having to evict a residential tenant, you can get stuck with well over that security deposit in back rent plus damages to the apartment. You can get upside down very quickly on a residential tenant — believe me, I know firsthand!
For commercial tenants, it’s much different. First off, you can take whatever deposit is agreeable to you and the tenant. I have some contracts with 2 and 3 month’s rent in security. I have heard of other landlords getting even more.
You can also take other things in collateral. Remember all that fit out the tenant did to make the space their own? You can add a clause to the lease that all those improvements become yours if the tenant goes into default. You can get the tenant to sign a personal guarantee also, meaning that they personally are liable for any damages or lost rents caused by the business. This is a huge value, as most commercial tenants are LLCs, which can easily be bankrupted if trouble arises.
Yet another thing that can be used as collateral for a lease is the rest of the lease. If a residential tenant moves out 3 months into a 12 month contract, the landlord may (or may not) be able to collect the months of rent it takes to fill the vacancy. You are lucky in most residential leases to get anything at all!
For commercial, there is something you can put in your lease called “acceleration.” This means that if a tenant breaks a 5-year lease in the first year, all the future rents become due also. Let’s do some math. You are collecting $800 per month on a store front, plus a $200 contribution towards CAM and utilities. All in rent is $1,000 per month on a 5-year deal. The tenant is in the space for 1 year and goes into default. If you have an acceleration clause, you are now due 4 x 12 x $1,000 = $48,000. Odds are, the tenant will find a way to get caught up with you versus having that large of a penalty on them, especially if they signed a personal guarantee!
The Use of Exclusivity
So the last item we are going to talk about today is exclusivity. This goes both ways, but can benefit both the landlord and the tenant. Exclusivity limits who the landlord can lease to in locations near the tenant and also limits the locations the tenant can open if they vacate the rental unit. Let’s say you rent a storefront to a tenant and they open a Chinese restaurant. Under an exclusivity clause, you can’t rent to another Chinese restaurant and may be required to get your tenant’s written permission to rent to another restaurant of any type within a certain geography — let’s say a 1 mile radius from their store.
The way this benefits the tenant is limiting their competition. This becomes very crucial in strip centers and shopping malls. We have a strip center near my house where there are 2 pizza places in the same complex! I can’t imagine what the tenant — and the landlord for that matter — were thinking. As a landlord, you want your tenant to be successful, so it makes sense to talk to them about potential competitors looking to lease spaces near them.
There’s more to exclusivity. The tenant would agree that if they vacate your space, they would not open a new store in that radius either. This greatly benefits the landlord, especially if you have a claim on the tenant’s fit out. If the tenant goes out of business altogether, you can easily find a new business owner who can step into the redone store front and get to business immediately.
Don’t get me wrong; I love being a residential landlord. It’s where I got my start, and it’s the bulk of our business. Even if you are strictly a residential landlord, if you decide to get into multifamily, you may encounter a building with a retail tenant on the first floor. You may also decide to expand into the retail market to broaden your portfolio. Either way, it pays to know the benefits of these types of leases.
I hope to hear some of your thoughts on this, so please post below. Let’s get a convo going!
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