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 minimal reason for them to move.
So, in my experience, there are many benefits to this niche, but here are the top advantages that you should consider when looking to invest in buildings with commercial spaces.
Some Advantages Commercial Space Has Over Residential Property
Longer Lease Term
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.
Improvements Performed by Tenants
In residential units, the property is normally in great condition when the tenant moves 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 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 those 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.
On a residential lease, the main collateral is the tenant’s security deposit. 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.
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 as 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.
The Use of Exclusivity
So the last item we are going to address 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 storefront and get to business immediately.
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Ray Martin Easton CT
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