Commercial leases are different from residential leases in that the terms in Commercial Leases can be more complicated and left up to the parties to negotiate. Because the law assumes that parties to a commercial lease have more bargaining power, leases tend to be for much longer periods of time, and the responsibilities and obligations of the parties may be laid out in more detail.
In this article, we will discuss Mistakes to Avoid in Wisconsin Commercial Leases, Including:
- Insufficient Due Diligence
- Lack of Planning for the Future
- Taking on too much Debt
- Failing to Seek Advice
- Not Accounting for Size and Location
1. Insufficient Due Diligence
Due Diligence, in this context, generally refers to the steps taken by a buyer to appraise the property for value and inspect the property for issues that would cost money to fix or impair the buyer’s ability to use the property for its intended use, or sell the property in the future. People often take these steps when buying a house to make sure they know what they are getting and the issues that come with it. The same is true for commercial real estate.
While the buyer normally has the option to choose what they want to inspect, or waive their ability to do so, it is generally a good idea to be thorough. From roof, floor, foundation, plumbing and electrical, HVAC, and anything else, it is a good idea to know if there are any fatal flaws with the property, or what you should expect in upkeep costs for the future. Getting a clear idea of what costs will be required for repair, update, or upkeep can also help with your negotiation of purchase or lease price. It is possible that the real estate that you are buying is not up to building code requirements and making those changes could be a significant expense.
Zoning is another thing to watch out for. The real estate you are considering may seem to fit your needs, but if you are unable to use it for the purpose you intend, it might not be a good investment. It is possible to get property rezoned, likely though your municipality. However, there is no guarantee that you will be able to do so. Under the right circumstances, parties could agree to make the sale or lease of the property conditional upon successful rezoning.
2. Lack of Planning for the Future
Risks and unforeseen expenses are unavoidable. The best thing you can do is plan for them. It is common for estimates of profitability to include unanticipated lost profits, vacancies, or other currently unknown expenses. There is certainly more to consider than rent or mortgage payments. Operating costs (depending on the type and use of the property) including equipment, staff, utilities, or whatever is needed to keep the commercial property up and running should be taken into account. It is common to get average operating costs from the previous/current owner to help with your estimates.
Property taxes will be a part of such expenses. After purchasing a property, your property taxes may increase, especially if the purchase price is higher than the property’s previously assessed value. While it is possible to appeal a property tax assessment, it may we worth anticipating a change in property taxes in your overall budget.
What is your exit strategy? You might have found a good investment, but years down the road, you might have different priorities or want a change. Commercial leases are often for many years, and it is worth understanding what the terms are of the lease. Can you terminate the lease with notice? Can you lease to someone else? If you are the owner, do you plan to sell, and how can you go about doing so? Perhaps it is in your best interest to do a 1031 tax deferred exchange to purchase other commercial real estate and defer capital gains tax on the sale of your property. For more information about 1031 exchanges see article “What is a 1031 Exchange?”
3. Taking on too much Debt
Debt is not necessarily a bad thing; it can be a useful tool. A loan or a mortgage can help you invest in real estate, and make a profit, without using your personal funds. However, too much can be dangerous. If you or the entity you have created have taken on too much debt, and it becomes difficult to pay the interest, principle, and/or operating expenses, you will have a problem. This high debt to income/equity ratio is what it means to be ‘overleveraged.’ Sometime recovery can occur by restructuring debt by, for example, paying off the loan over a longer period of time so that the payments are smaller. If it is not possible to restructure or otherwise recover from too much debt, the problems could lead to bankruptcy for the person or entity that owns the real estate.
Something that many real estate professionals do is create separate legal entities (such as an LLC) for their investments or projects. If you can secure financing, this is a great way to protect your assets if one investment does not work out. You should be wary if you are personally liable for the debt, as default on a loan or mortgage could result in debt not covered by collateral becoming your personal responsibility. Sometimes lenders want assets or properties in addition to the property that you are attempting to get a loan for. This is called cross collateralization. If your loan is cross collateralized, in the case of default, the lender can go after the other properties or assets used to secure the loan.
4. Not Accounting for Size and Location
Knowing what you need and making sure that the property you will have is suited to those needs is important. For some businesses, location can be extremely important. If you are going to sell a good or a service, rent to tenants, or do anything that requires other people to pay you, it is a good idea to try and get an estimate of how much business you will be able to bring in. A market analysis might be an available tool to get an idea of either the building’s value or how much business you are likely to get at that location. You might also be able to get information from the building’s current owner, or nearby businesses to help give you a better idea of what to expect.
Size might also be a worthy consideration. If your business is likely to expand, you may want a space that you can grow into, rather than grow out of. Buying and selling property takes time and money, so if you can limit the number of transactions that you go through, you will likely be able to save yourself more.
5. Failing to Seek Advice
There are a lot of factors to consider when buying, selling, or leasing property, and it is important to make sure you are aware of what you are agreeing to. Some terms are relatively straightforward, like who pays rent, utilities, or taxes, and how much those are. Some terms might be a little less clear. Can you go about making improvements? Are there any easements of covenants on the property that give other parties rights to specific use of the property or limit your use of the property? How important is it that I negotiate an SNDA (subordination, non-disturbance, and attornment)? The SNDA agreement will prioritize the rights of tenant and the lender and will be most relevant if the landlord defaults on the loan at some point in the future. While it might not seem like an immediate concern, planning to mitigate risk in the future is a good way to set yourself up for success. Having someone that can explain terms, give advice, air concerns, and negotiate on your behalf can help you get what you want out of commercial real estate.
If you would like the help of an attorney with your real estate needs, please contact O’Flaherty Law for a consultation.
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