The Finer Points of Leasing Space

Start-up businesses that are in the enviable position of setting up shop outside the home, often as a result of having contracts in hand, still have a lot of homework to do in finding the right space and negotiating lease rates. As a whole, the Madison area commercial space market remains a tenant's market with a lot of options for most business tenants, meaning landlords are willing to be more flexible in lease negotiations than they would if the market was in "equilibrium."

That's usually anywhere between 10% and 12% vacancy metro-wide, and the current vacancy rate is 16.2%, so landlords are still in an accommodating mood in most Greater Madison submarkets, and for most property classifications – more so in Class B and C spaces than in Class A.

But even with a favorable environment, there still is homework to do.

 

Lease of your worries

Tim Rikkers, principal with CresaPartners Madison, said that for entrepreneurs, the most critical component in leasing is aligning a lease agreement with your business plan. If the business plan calls for growth over the next 36 months, do you have a lease to accomplish that? If the business plan calls for accelerated and possibly exponential growth, then you need to make sure it's tailored with short-term leases with appropriate expansion, relocation, and/or termination provisions.

"I can't say enough how important it is for the entrepreneur to maintain flexibility in a lease situation, especially for the new entrepreneur," Rikkers said. "Having a lease that ultimately hampers operations, whether that's in terms of size, or rate, or location, or infrastructure can have tremendous negative impact on a business."

According to Rikkers, not every landlord operates the same way. Some prefer to dramatically reduce lease rates and provide zero tenant improvement dollars because they simply don't want to drain their own cash. For others, it's more important to maintain a higher lease rate for the valuation of their properties, but in return they are willing to trade free rent and/or increased tenant improvement allowances. "The take-home message is looking at the deal holistically for the tenant, and figuring out the various pools and pots of money," Rikkers said. "What are we actually spending?"

Annette Gelbach, a partner with Key Commercial Real Estate, said start-up owners will have to share financial projections with prospective landlords. When an entrepreneur is in a pre-planning phase and won't have the profit-and-loss statement or the balance sheet of an existing company, he or she will need a business plan because the landlord will want financial projections. "A start up will require flexibility since growth can't be as reliably predicted," she adds.

To provide that flexibility, Gelbach recommended a shorter-term lease – three years in length or perhaps a year-to-year lease. For future consideration, a three- to five-year lease is fairly standard, especially if space improvements are needed. Longer leases would be in the five- to seven-year range and typically require more extensive improvements.

To determine whether you're paying the right amount of rent – keep in mind the difference between advertised rent and negotiated rent – there is a simple metric: rent as a percentage of revenue. Rikkers has seen occupancy costs as low as 3% of gross annual revenues; however, it's generally accepted that anything less than 10% of gross annual revenues is a reasonable occupancy cost.

The second component involves the cash burn rate. "What it comes down to is how much do we have in the coffers and what's the burn rate? If we don't get another influx of cash, when are we out of money?" Rikkers asked.

Also consider the location for key employees, the look-and-feel amenities, security, and data connectivity. "Particularly beyond these budget numbers, it's location, look, and feel, and of course buildout is another issue," Rikkers said. "Does the existing layout support operations? Does it support enhanced communication and efficiency?"

If there is a common mistake entrepreneurs make in the lease process, it's not making enough time for the process. With so many things to consider, and other business operational matters to attend to in the pre-launch phase, not giving lease issues the requisite time is easy to do.

Related to not giving the matter enough time is not leveraging the various options of the marketplace against each other to win the best deal. That comes with not understanding options in the marketplace. "If you don't have enough knowledge of the various options, and the concessions that landlords have provided, you can't negotiate because you don't have all the data," Rikkers said.

Another mistake is not understanding all the components of the lease that can add dollars to the lease cost. Deb Ersland, also a partner in Key Commercial Real Estate, said those applicable costs include base rent, real estate taxes, common area maintenance, amortized tenant improvements, utilities, trash removal, and parking. "Know your cost of occupancy," Ersland advised. "Make sure you have a clear handle on that."

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