How Leases In Commercial Real Estate Are Structured?

How Leases in Commercial Real Estate Are Structured?

Leasing a commercial space is indeed a big decision for any organization and it requires big amount of investment. Just like the other legal agreements, a commercial lease should also not be treated in a cursory way. Therefore, while renting a commercial space for business purpose, it is not only necessary to do your own due diligence about the market but also have a fair idea about the structure of commercial leases.

Commercial leases are more complicated than the residential ones as the terms are negotiable and vary greatly from lease to lease. However, the underlying principle in both kinds of leases is same – the exchange of property for generation income.

In this post, we will discuss how commercial leases work and what is its structure?

To begin with, let’s understand what is a commercial lease:

Commercial Lease

It is an official contract between a landlord and a business tenant to rent a building or property for the commercial purpose. Leasing of flexible workspaces is the perfect example of this. 

Suppose, if you want a coworking space in Delhi-NCR or an office space for rent in Gurgaon  for a shorter period of time, you have to contact an aggregator or a local agent and then a commercial lease agreement will be prepared between a tenant and the owner of the property.  

The companies take a commercial real estate on lease for the sole purpose of generating cash flow through the sales of goods, services or manufactured products.

How to analyze a commercial lease?

The commercial leases in India are term-based. Unlike the residential leases, this kind of leases are structured as 3+3+3 or 5+5+5. Now, you must be thinking what does it mean? Well, 3+3+3 means a nine-year lease contract, including escalations in every three years. The Escalation rate generally ranges from 12 to 15%.

When it comes to the commercial real estate, companies take the spaces on leases for a longer period of time because, as a tenant, the organizations have to invest significantly in the interiors of the property as the office space is handed over to them in bare shell form.

Speaking of the bare shell office, let’s understand what it is?

Bare shell property

A Bare shell property depicts the condition of a space after the completion of its construction and installations of basic building services. It includes plastered walls and basic flooring. When an office space is taken over by a company on lease in a bare shell form, then the company needs to install the wiring, lighting system, AC vents and other things for the furnishing of the interiors. In order to recover all the costs, the business tenant usually prefer at least nine-year lease term in the commercial real estate.

Lock-in period

Every commercial lease has a lock-in period, which is generally calculated for the time span of three years. During the lock-in period, the tenant cannot vacate the space which gives the landlord a security of a stable rental income. As compared to the residential properties, commercial units are larger in size and also take longer terms for leasing. Hence, the lock-in periods mostly favour landlords so that they can protect themselves from any kind of unpredictable changes in the lease.

But what if the tenant wants to leave the office space for some reason? What procedure he needs to follow as per the commercial lease structure? Well, the answer to this question lies in our next point.

Notice period

Before ending its commercial lease, the business tenant has to serve the notice period ranges between three to six months. And if we talk about the landlord, he sees this period as an opportunity to find a new tenant before losing his rental income for a long time.

Lease Break Clauses

Break clauses in the commercial leases refers to the right of both parties – tenant and owner to terminate the contract before the end of the lease term. However, the conditions of this important clause are different in India than the other countries. In India, the landlord cannot ask the tenant to vacate the space during the lease term but the tenant can give the notice period and leave at any time after the lock-in period is over.

Market yield vs In-place yield

The yield of a property refers to an annual return that an individual can get on the investment. Now, how it is related to the commercial lease structure?

The rental rates in the top cities of India have been increasing at 10-12% every year, which is much higher than the contracted escalations of 12-15% in every 3 years mentioned into the standard commercial lease. This restricts the value of the property as commercial real estate sells at a “yield” (also known as capitalization rate). In the case of an under-rented property, the cap rate eventually decreases, forcing the owner to sell his space at a cheaper price.

If the market rental yield is higher than the in-place rental yield, the tenant is least likely to vacate the space, which is an advantage for the landlord as well.