What are some major items you should keep in mind when negotiating and reviewing an industrial lease? What are some potential major pitfalls? Chad Griffiths a commercial real estate broker and industrial investor will share his knowledge with us.
Tell us a little bit about you.
I started in industrial real estate in 2005 as a broker, and after about eight or nine years of being a broker, I started investing myself. In 2014, my partner and I started buying industrial properties and we've pretty much been buying one a year since. We've a large property under contract right now that we're going through due diligence with as well. We started with a really small, industrial condominium. And since then, we've been buying larger properties.
I would love to focus on industrial leases, can we maybe go page by page on your lease and review some things that we could potentially give and take from potential tenants?
The lease is the governing document that organizes and controls the arrangement between you and the lessee for the term of the lease. I don't necessarily want to get into the deep weeds of it. There are a lot of legal nuances that get put into a lease. Depending on whether it's a strong landlord, or a strong tenant will determine how that lease is favored. An example might be Amazon going in and negotiating a lease with a local company, Amazon is going to heavily influence that lease process. Whereas if it's a large company like Prologis, and it's a small local tenant, then Prologis is going to have a lot of influence over the content of that lease.
What we could cover is some of the key things that people want to be aware of that at the very basics, a lease is going to spell out who the tenant is, who the landlord is, who the parties are, the size of the space, when it commences, how long of a lease term it is, what the lease rate is going to be, and that can be a fixed rate for the duration of the lease, or it can be a lease that has predetermined escalations in it. Let's use a quick 10-year lease as an example, it might start at $10 a square foot and go to $15 a square foot by the end of the term. What we're actually seeing is quite common right now is a rent increase tied to some percentage, so it could be tied to CPI, or it can just be a percentage that's put in. I just did a lease late last week. It started at $8.50 a square foot and had two and a half percent yearly escalations for a five-year term. We're starting to see that that is pretty common as well.
Once you start getting beyond the obvious terms of what's in the lease, who the parties are, how long it's going to go for, what the rent is, then you're going to start getting into provisions that deal with the operating costs, or the additional rent as it's sometimes called. For those needing a quick refresher on it, the majority of leases are going to be structured, I should preface that there are NNN leases. You'll have one lease, it'll say that this is the base amount that they pay, then the tenants also pay for their proportionate share of all the operating level expenses of the building. That's property taxes, building insurance, commentary, maintenance, management fees, and that's always going to be an estimate. The landlord will give the tenant an estimate on what it's going to be in advance. After the year ends and all the bills come in, then they reconcile it, they either give the tenant a credit, if they charged too much, or they invoice them if there was not enough paid throughout the course of the year. That language is probably the most important thing as a property owner myself, you want to have it very clear that any increases in those expenses can get passed through to the tenant. If that language is vague or not very clearly explained, and it becomes contentious, it might not be a big deal if it's a small lease like a 5,000 square foot lease, and those discrepancies, a few $1,000 might not be worth making an issue of, but you can imagine when some of these big distribution centers are approaching a million square feet, if there's a small discrepancy between how the landlord expected it to be and what the tenant interpreted it at, that can be 10s, hundreds of 1,000s, if not millions of dollars.
When you're working through a lease, whether it's through the eyes of a tenant or the eyes of the property owner, it's imperative that the language surrounding the handling of property level expenses, what's usually called operating costs or additional rent, the terminology varies all across North America, like I've heard people call NNN, NN, or single net, fully net. But it's all relying on the same premise that the tenants pay for their proportionate level of expenses, and any increases. That can be worded in an indefinite amount of ways. You start involving different lawyers and some big companies will have an internal legal department and they'll also have outside counsel, you start involving multiple lawyers and agreeing to that term, it can become very nuanced, or it can be very straightforward. Whatever side of the table you're on, you just want to make sure you've a clear understanding of how those expenses are handled.
Another one that I think is also really important are any options, it's usually going to be a tenant option that they have the unilateral ability to exercise, the most common one is a right to renew. I always remind people that that is a tenant benefit. Having an option to renew is solely for the tenant, because if the landlord looks at it through the lens of yes, you will always want your tenants to renew, but that could prohibit you from expanding a neighboring tenant. It could prohibit selling the building. There are all sorts of reasons on how an option to renew can actually be a detriment to the landlord.
Giving an option to renew is a tenant inducement that you're giving them, it can be treated differently as a tenant improvement allowance, or free rent, or any other inducement, but it's still an inducement. Nonetheless, it's a tenant favored option to renew. Look to see if there are already any options and look to see what the language is on that. I've seen leases that were structured where there's an option to renew at a predetermined amount. Let's go back to the lease I just did last week, let's say hypothetically that both parties agreed that it's a five year lease at $8.50 a square foot escalating at some amount, they could in theory agree to fix the renewal rate. This happens with tenants that have a lot of influence, they'll say the renewal rate shall be no higher than x. It might be that the renewal rate might not be higher than $9.50 a square foot and that's fine if both of those parties agree to it. The landlord then goes and sells that property, and a new owner comes in thinking that they can raise the rates to market, and they might be handcuffed if there is actually a ceiling on what they can raise it to.
Most commonly what I've seen the majority of the time is that leases will say that the lease renewal rate will be at market. If both parties can't come to some understanding then it will go to arbitration. It's very rare that it gets to that level. Probably the most overlooked thing that investors tend to neglect when they're looking at properties are the options to renew, is there an option to purchase in there? Is there a right of first refusal if another tenant wants to take the neighboring space, or if the if there's a right of first refusal, that they get the chance to buy the property, if another buyer comes forward? That language often isn't prevalent, it's not on the first page of the lease, you'd see the size and the lease rate and a term that's usually buried deeper in the lease, but those can have incredibly powerful implications if they're not caught. I'm not a lawyer, I'm fairly experienced as both a broker and an investor, and one thing that I always advise is, I would never get into a deal without having my lawyer look at at a document. Even though I've got a pretty good degree of comfort, having looked at many leases, I'd never do a deal myself without having my lawyer vetted, and that's a recommendation that I make to everybody as well. You can read through it, it's good for you to read through it, but you also want your lawyer catching anything that you might have missed.
And depending on how big the deal is, or the lease, or the tenant, have another lawyer review that because I was just reading Confessions of a Real Estate Entrepreneur book, he is a lawyer himself. He admitted that he missed something on some bank documents, and his client found it, so even an experienced lawyer with many years of experience might not be thinking from an investor's perspective, or there's one little thing that he might not catch. If it's a significant deal, you should have a backup lawyer as well.
I don't think that it's ever wrong having too many eyes on it, the bankers are probably going to look at it, the appraiser might look at the lease to see if there's anything in there. But at the very least, you want to be going through it diligently yourself, and then have your lawyer. I think a lawyer is absolutely fundamental to have on a deal. Although they can compromise some deals, there's always that saying that lawyers kill deals, I err on the side that if they're killing deals, they probably should have killed the deal. There's probably something that wasn't above par there, there may have been a term, there could have been that right of first refusal that nobody else caught. At the risk that a lawyer might jeopardize the deal, I think that the benefit that they bring far exceeds that risk.
And when you were saying that you should always read all of the documents as well, that's another thing that he covered in that book, that somebody went bankrupt because of one technicality on one of his developments that he did not read because it was 100 pages long, and his lawyer didn't catch.
I just did a lease a couple of weeks ago, and it was 80 pages, and it was so dense with legal terminology. It should always be going through it as a partnership with a lawyer saying, here are the things that I'm concerned about. The lawyer's going to point out things that they should be concerned about, just view it as the two parties, the buyer or seller, and the lawyer going through that document and identifying areas of risk or areas that should just be noteworthy.
I also want to highlight your comment about when your expenses increase, that the tenant is also going to be responsible for that increase, especially with regards to taxes. When somebody buys a new property, in some states at least here in the US, the old taxes are not based on the current assessed value. They're based on what the owner had purchased many years ago with a very small yearly increase. And that's going to be a huge difference upon a sale, and if that is not on the NNN lease, that the tenant will pay for this new tax increase, that can be a deal breaker, and also making sure that that tenant can afford this increase before you buy this property. This varies by state, but in California, that is the case for instance. On another note, with inflation going on right now, is 2.5% rent increase a good increase every year? I know some leases are every five years, how do you prevent that when high inflation is happening like now?
The latest CPI numbers said it was 8.3% in the US , and that follows a series of increases that were around that 8% range. It is a topic that's very on the mind of landlords right now. In some ultra hot markets, they're not even committing to longer-term leases, because they think that they can get more upside by doing shorter, one to three-year leases, realizing that after three years, they can get much bigger of an increase. It would be difficult going to a company like Amazon, as an example, saying your rent starts at $10 a square foot, but we're going to have 8% increases every year, that's going to be tough for them to agree to. I suspect that there will be landlords out there that will say that we'd love to have that covenant. We don't think inflation is going to be 8% for the next three years. It might be that for the next several months, but it should normalize.
The trade off is that the Feds are just going to keep raising interest rates. I think that there's a solid commitment that the Fed has gone from saying there isn't any inflation to, the inflation is transitory, to inflation is temporary, to inflation is finally here, to we don't have any control over inflation, I think that they're now realizing that they have to keep the pressure on this to avoid having several months more of this high inflation. I think interest rates are going to keep increasing until those numbers normalize. I don't think that there are landlords out there that are saying, let's ask for an 8% increases in line with CPI, as much as they're just saying that this should normalize, but the trade-off is that some landlords are just saying, We'll take a short term deal right now and we'll look to see what the lease rates are in a couple of years. In my mind, there's always that trade-off, do you want to have the risk that in two or three years perhaps the economy softens, and we go into a deeper recession than anybody expects, and then you're in a position where you might lose your tenant to another building, versus having that ability to realize upside potential. If you're more on the side where you like the stability of knowing that you have tenants that are going to be in there for some amount of time, if I leave a little bit on the table, then that's the price of having peace of mind that the tenants are going to be there. Some landlords, especially institutional landlords, might not take that same approach because it doesn't hit their pocketbook the same way, if they lose a big tenant, as it would for me. Everybody's going to approach it somewhat differently.
Is there anything else with regards to industrial leases that people should really be mindful of, for their investments?
Just make sure that you understand all the little details, even insurance could be another one that becomes contentious, it varies market to market, but in my market it was common that tenants had to have $2 million worth of insurance. And now almost every landlord has increased that to $5 million of insurance, and there'll be markets where I'm sure it's even higher where prices are higher. But just making sure that that insurance provision is correct, involving your insurance agent, but at least it should be viewed as a document where a number of people have input into it, and the accountant might want to have input into how some of these costs are handled, your lawyer definitely needs to be involved in it, insurance broker is another one.
It's governing a long-term relationship. Some commercial industrial leases last longer than a marriage, and these parties are in this relationship together. If the lease goes according to plan, and the tenants pay their rent through the whole duration of the lease, and there are no problems with it, that document will sit in a file on your computer and you'll never even think about it. Where that lease becomes so important is if there is a problem. That's how I approach it from a property owner level, I want to be confident that that document is going to prevail if something does go wrong, you're always hoping that nothing goes wrong, but that's why we have insurance, that's why you have a lease, what happens if the tenant stops paying rent? What are your rights of remedy? There are all sorts of things that have to go in there if something goes wrong.
That's perhaps one way to look at that document as the emergency guide on what you can do if something bad happens. If the lease goes according to plan, you know what your rent is, you know that they're paying for any increases, you know that they're staying for some amount of time, if they have an option to renew, there's language on when they have to give you notice, that's fine, you know all of that, and if the lease goes according to plan, you'll maybe never look at that lease again. But as soon as something goes wrong, there's a fire in the building, or we run into an epidemic where some tenants are forced to close down, what happens in those scenarios? And if you look at it from that break glass if the emergency type of situation, and you have to dive into that lease, you want to make sure that it's not silent on some of these topics. Because if it is silent, and it goes before a court, you're at the mercy of either the judge or whoever is going to make the decision on it. Just make sure you're protected if something goes wrong, hopefully nothing does go wrong, but things do happen. It's business.
Chad Griffiths
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