How to Read Leasing Contracts Without Getting Burned
Breaking down the big three — listing agreement, letter of intent, and lease — and the one skill that makes them readable
We are making good progress in our discussion on leasing. Let’s anchor in on where we are.
What we have discussed thus far:
What is still to come:
Understanding broker listing agreements, letters of intent, and leases.
Analysis examples of new leases, renewals, expansions, contractions, and early terminations.
As you can see, there is a lot to cover. Leasing is exciting, dynamic, and complex.
But you don’t need to be intimidated.
As you spend more and more time on it, you will see that it is anchored in a handful of fundamental negotiation criteria: start date, lease duration, rent, leasing costs, and the rights both the landlord and tenant have during the lease term.
These are all concepts that end up in a lease. Understanding how to read and negotiate a lease will pay dividends for you over time.
Today I will focus on breaking down the three key contracts that go into leasing, culminating in a lease agreement:
Broker listing agreement.
Letter of intent.
Lease agreement.
These are the “big three” when it comes to leasing.
Let’s dig in.
What Is a Contract?
Let’s start by reminding ourselves what a contract is: a contract is a written agreement between two or more parties through which they commit to certain terms. We have covered contracts in three previous newsletters:
Selling/buying a property - Demystifying Real Estate Purchase Agreements
Hiring vendors to maintain your property - Vendor Service Contracts: What You Need To Know
Hiring contractors to upgrade your property - Navigating Construction Contracts
In the future we will cover two additional contracts: loan agreements and partnership/joint venture agreements.
Contracts can be short or long. They have a start and (usually) an end date and are signed by all parties involved. They are often written by lawyers.
And they have something called “defined terms”.
Defined Terms
To read and understand a contract correctly, you need to understand the concept of a “defined term”. Here are the basics:
It is any word or set of words that is capitalized, but not because it is the first word in a sentence. Examples: “Expansion Right”, “Effective Date”.
It means something special that may or may not be similar to what you think it means. That meaning will either be described in the paragraph in which the defined term is first introduced or in an exhibit that lists all the defined terms in the contract.
It usually is referred to in other parts of the document.
Here’s an example - “Expansion Right”: a tenant could have a right to expand into the adjacent suite under certain terms and conditions (a specific time window, rent, and tenant improvement package). The lease will define this expansion right and then refer to it in other parts of the document. For example, it might read: “If the Tenant is in default at any time, the Expansion Right shall become null and void.”
The use of defined terms reduces the need to repeat the same concept and words over and over again. They can be both helpful and confusing.
If you take one thing from this entire newsletter today, this is it:
As a reader, the key is to look out for these capitalized words and then look up their meaning. This way you will read and understand a contract correctly. Never assume a defined term means anything other than what is written in the definition.
Let’s move to the first of the three main leasing contracts.
Broker Listing Agreement
The broker listing agreement is a 2-6 page contract between a landlord and a broker. The landlord hires the broker to market and lease the property. There would be a similar agreement if an owner were to hire a broker to SELL the property.
At its most basic level, the listing agreement says that the broker will use commercially reasonable efforts to present qualified tenants to lease the space. The landlord will decide whether to lease to this tenant. If a lease is signed, the landlord will pay the broker.
Here are the key components that make up the listing agreement:
Listing Period (i.e. the length of the contract): Start and end date; typically, 6-12 months.
Commission Amount (note that structures and amounts vary between markets and product types). Here is an example: the broker will be paid if a lease is signed as follows:
6% of total rent for months 1 - 60 | 3% for months 61 – 120; nothing after 10 years. Note: it is typical for the broker to earn less for the latter years.
100% to listing broker if no outside broker involved | 50/50 to listing and outside broker if outside broker is involved.
Payment Timing: Example - 50% paid at lease execution | 50% paid when tenant takes possession of premises.
Re-Leasing: Listing broker may be required to re-lease space if tenant vacates/defaults within 1 year.
Marketing Budget: Owner may provide a specific marketing budget.
Exclusions: Renewals and expansions may be excluded from earning a commission; property sales are typically excluded.
I discuss this in further detail and have downloadable abstract templates for all three contracts in the Downloads section of my website: creprofessor.com/downloads.
I have a number of battle scars from poorly drafted listing agreements. Here are some things to watch out for:
If you are a new or smaller commercial real estate investor, the broker will prepare the listing agreement based on their company’s standard form. It often contains more than you want to agree to. Don’t be shy about pushing back on certain terms.
Make the duration of the agreement no longer than 6 months. You want the broker to feel the pressure that they don’t have unlimited time. You can always extend the agreement.
Exclude payments for renewals. I have seen situations where we renewed an existing tenant, not realizing that the listing agreement required the broker to be paid even though they weren’t involved in the negotiations.
Exclude a commission for a sale. I once had a situation where we decided to sell the property and found that the listing agreement, which had been prepared by the broker, included a clause that they would be paid 2% on any sale. We had to get out of this agreement before we could hire a separate broker that specialized in property sales to sell the property.
The key is to read and summarize the agreement to make sure you understand what you are agreeing to. As with all commercial real estate contracts, you can always (try to) negotiate out what you don’t want to agree to.
Let’s move to the next contract.
Letter of Intent
A letter of intent (“LOI”) is a 1-6+ page document that outlines the key terms under which a landlord and prospective tenant would use as the basis for a lease.
We went deep into negotiating LOI terms last week, so I’ll just highlight some key points here.
The LOI becomes the foundation for the terms that will be included in the binding lease agreement. In the majority of cases, most of the terms, other than confidentiality, governing law, and possibly exclusivity, are non-binding. This means either party can walk away from negotiations for any or no reason at any time.
Deal terms such as rent, start date, and tenant improvements are negotiated using the LOI. We discussed this process last week in Why the Highest Rent Isn’t Always the Best Deal.
Here are the key terms in an LOI:
Start and end date.
Rent, annual increases, and free rent.
Security deposit and any personal guarantors.
Condition of the space and any tenant improvements.
Options and rights such as renewals, terminations, expansions, contractions, and right to purchase.
Any brokers involved and any commissions that are different from the listing agreement.
Most of the time a broker will prepare and negotiate the LOI on your behalf based on their advice and your decisions.
Always remember, you are the property owner and the one who makes decisions. Brokers (and any other lawyer, consultant, or advisor) are there to give you opinions, but the owner is the one who makes the decision. Never forget this.
Once the LOI is agreed to, a lease is negotiated. However, not all leases need to start with an LOI. I have done deals where we verbally agree to the key terms and go straight to a lease.
But before we get to the lease agreement section, let me share one story that illustrates the downside of an LOI being non-binding.
I was negotiating a large lease with an excellent credit tenant. We had a signed, non-binding LOI and the lease was fully negotiated and ready for signature. We were just waiting on the tenant’s proof of insurance before we signed the lease.
The next thing we knew, the tenant told us they were backing out of the deal. Something unrelated to our space had changed on their end. Because we hadn’t signed the lease, they had the right to back out.
Key takeaways: (i) an LOI is non-binding and (ii) a lease is not valid until it is signed by both parties.
Lease Agreement
Lease agreements are typically 5-15+ pages with a series of exhibits. They can be simple and not negotiated at all using the American Industrial Real Estate Association's standardized lease form or they can be complicated and highly negotiated over weeks and months, costing $10,000+ in legal fees.
It all depends on (i) how reasonable each party wants to be, (ii) whether the tenant is under pressure to move in due to their business needs, and (iii) whether either party has a biased lease template form that they want to use (i.e. overly landlord or tenant friendly).
There is not enough space to go into all the terms of a lease, so I will limit this discussion to the main sections:
General: parties involved, square feet, building, permitted uses, parking.
Key Dates: start, end, early possession, timeline for completion of tenant improvements.
Rent & Other Financial Obligations: rent, increases, free rent, reimbursement structure (NNN vs modified gross vs gross), security deposit, late charges.
Delivery Conditions & Tenant Improvements: condition of the space, who completes and pays for the tenant improvements.
Tenant Options/Rights: renewal, termination, expansion, purchase, sublease.
Landlord Options/Rights: relocation, termination.
Alteration Rights & Maintenance Obligations: who maintains what and whether the tenant has rights to modify the premises with or without landlord’s approval.
Defaults, Damage, Condemnation: what constitutes a default and what happens if the building is damaged or condemned.
Other Tenant Obligations: estoppels, financial statements, subordination and non-disturbance agreement.
Exhibits: such as rules and regulations, rent payment instructions, insurance obligations, tenant improvement details.
You can visit creprofessor.com/downloads to dig in deeper into what goes into a lease and download my summary template.
Leases can be 30+ pages long with exhibits, but make sure you read them in their entirety. One property acquisition almost fell apart due to a clause deep in the lease that gave the existing tenant the right to purchase the property.
The seller had missed the clause and had to do a last-minute scramble days before closing to get the tenant to waive the right.
The deal eventually closed, but not without some significant effort and stress.
Making Sense of It All
As I said before, don’t be intimidated by contracts. You can understand them if you follow these key steps:
Think about the purpose of the agreement and what each party is trying to achieve.
Listen to the advice of brokers, lawyers, and experts, but remember that you make the decisions. If the advice seems unreasonable, ask questions and/or don’t follow the advice.
Be reasonable. Getting through a contract usually involves compromise. Talk with the decision maker on the other side to understand their perspective.
Create YOUR best environment to read the contract. For me this means printing out a hard copy and reading it first thing in the morning without distractions. I highlight the important parts, strike out the parts I won’t agree to, and note the areas for further discussion. Find what works best for you.
If you don’t understand something, don’t sign the contract. It is better to be embarrassed by asking a question that might make you feel stupid than to agree to something that you don’t understand and could bite you in the future. Try saying: “I am not clear on what situation would come up where this language in the contract would come into play. Can you give me an example?”
Take your time.
Ask questions.
Keep learning.
You got this!