Residential and Commercial Leases
Owners and investors of real estate usually make money from the property by leasing it to others.
A lease is a contract that transfers the right to possess a property from the owner, the lessor, to another party, the tenant or lessee. The lease also stipulates other aspects of the agreement such as the length of time that the lease will be in effect, and the amount of payment that the lessor expects from the lessee for the right of possession. The lessor has a reversionary right to possession after the lease expires. The owner's interest in the leased real estate is sometimes called a leased fee or a leased fee estate plus reversionary right.
The statute of frauds in most states requires that leases with terms longer than 1 year be in writing. Both the lessor and lessee should sign the lease. Although leases for shorter terms can be oral, it is wise to have it in writing anyway as a way to document the terms and conditions and as a way to prove that the contract exists.
Some states have adopted all or part of the Uniform Residential Landlord and Tenant Act, which somewhat protects tenants to help compensate for the fact that it is the landlord who usually chooses the terms of the lease, especially for residential leases. This Act governs the landlord's right of entry, requires a minimum of property maintenance, protects the tenant against retaliation by the landlord for complaints, and requires that the names and addresses of the property owners be disclosed to the tenants.
The tenant's right to possession is called a leasehold estate in contrast to the freehold estate of the owner. Tenants of life estates and leases for long periods of times, such as 99 years or longer may have additional rights in some states that are usually granted only to owners. A leasehold estate is legally considered personal property rather than real property to the leaseholder.
There are 4 different types of leasehold estates that differ primarily in how the term of the leasehold estate is determined.
An estate in years (aka estate in term) is a lease for a definite length of time, which may be, in spite of the name, for less than 1 year, with a stipulated start and end date. At the end of the term, the leaseholder is expected to vacate the premises. No notice is required since the end of the lease is stipulated in the contract. If the parties to the lease want to extend it, they must agree to a new contract unless the original contract had a renewal clause, in which case the leaseholder has the right to renew.
An estate from period to period (aka periodic tenancy) is a lease for a defined initial period that is automatically renewable at the end of the initial period and after each renewed period unless either the lessor or lessee wishes to terminate it by giving due notice, which in most cases is 1 period in advance, although it may be less if the period is a year or longer. This tenancy does not have a specified expiration date. This is the estate possessed by most renters of residential housing, such as apartments, which, in most cases, is a month-to-month tenancy, where the tenant pays a monthly rent.
An estate at will is like a periodic tenancy, but no initial period is specified, and terminates when proper notice is given by either lessor or tenant, or if either one dies.
An estate at sufferance (aka tenancy at sufferance) is when a tenant retains possession of the leased property after the expiration of the lease, but without the owner's approval. If the original lease contains a holdover clause, then this clause determines the estate at sufferance; otherwise, state law determines the rights and duties of landlord and tenant.
If the tenant continues to pay rent and the landlord accepts it, then a holdover tenancy is created, where the terms and conditions of the original lease still apply. If the landlord objects to the holdover tenancy, but still accepts rent, then a month-to-month tenancy is created, where either party will be required to give due notice to terminate the tenancy. The landlord may also choose to treat the tenant as a trespasser, and begin eviction proceedings, but the landlord must comply with the notice to quit requirements of the lease and state law in which the property is located.
Like all contracts, a valid lease must have legal purpose, the parties must have legal capacity to contract, there must be an offer and acceptance, and there must be consideration, which is usually rent, but could also be in the form of services, such as managing an apartment complex.
However, lease agreements have additional commonalities. Most residential leases are based on preprinted forms; however, most commercial leases, because of the complexity and the specific needs of commercial tenants, are individually negotiated.
Lease contracts will generally have
- a description of the property,
- the term of the lease,
- he amount of rent to be paid,
- when it should be paid, and
- the amount of a security deposit.
State laws limit the amount of the security deposit, usually to 1 or 2 months rent for residential leases, and, in some states, there may be other restrictions or conditions, such as the payment of interest. In most cases, the security deposit is used to cover nonpayment of rent or destruction of the property by the renter; otherwise, the security deposit must be returned to the tenant after the expiration of the lease.
Implicit in all lease agreements is the covenant of quiet enjoyment, which allows the tenant to possess the property free of any interference from the landlord. The landlord may enter the premises for maintenance or repairs, but only with the consent of the tenant.
Neither the tenant nor landlord is required to make improvements to the property, but if the tenant makes some improvements, it usually becomes the property of the landlord. However, a commercial tenant does make alterations for its business, and generally restores the property to its previous condition after the lease expires, less normal wear and tear.
The landlord does, however, have to maintain the premises in a working and safe order, and must also maintain common areas, such as hallways and walkways, and some safety features may be required, such as smoke detectors.
The federal Fair Housing Act requires that landlords allow disabled tenants to make alterations to accommodate their disability. However, if the alterations would decrease the leasability of the property, then the landlord may require the tenant to restore the property to its previous condition when the lease is terminated. The Americans with Disabilities Act (ADA) requires commercial properties to be free of barriers to people with disabilities, or they must be accommodated in some other fashion.
Commercial leases usually have a nondisturbance clause that prevents the mortgagor from ousting the tenants in the event of a foreclosure as long the tenants continue paying their rent.
Assignments and Subleases
Sometimes a tenant wants to vacate a property before the termination of the lease and not have to pay for the remaining term. To do this without breaching the lease, the tenant may be able to either assign his leasehold estate, or sublease it. An assignment is when a tenant transfers all his leasehold rights to another party; the new tenant then pays rent directly to the landlord. However, the original tenant still is liable for rent if the assignee does not pay, unless the landlord specifically relieves him of the original liability.
When only some of those rights are transferred, then it is a sublease or sublet. The new tenant pays rent to the sublessor, who then pays the landlord.
Most leases do not permit assignments or subleases, and if they do, they generally require the approval of the landlord. However, if there is nothing in the lease agreement about assignments or subleases, then they are allowed.
Leases may also have options. The most common option is the renewal option, which allows the tenant to renew the lease by giving due notice. A lease option (aka right to purchase option) gives the tenant the right to purchase the property at a specified price within a specified time. When the time elapses, the option expires. A variation of the lease option is the right of first refusal option, which gives the tenant the right to purchase the property for the same price and conditions as that offered by another party.
Types of Leases
Leases are generally classified by what the tenant must pay or by the options available to the tenant. Most residential leases, for instance, are examples of the gross lease, where the landlord pays most of the expenses, such as insurance, taxes, water, and sewage, associated with the property while the tenant pays rent and those expenses that vary significantly by how much the tenant uses them, such as electricity and heat.
In a net lease, which is the type that most commercial tenants have, the tenant pays most of the expenses of the property, including taxes and insurance. With most net leases, the interior of the buildings are unfinished, so that the commercial tenant can customize the interior to the needs of the business.
Another type of commercial lease often used in retail properties is the percentage lease — the tenant pays a specified minimum rent plus a percentage of the tenant's monthly income exceeding a specified amount. For example, the tenant may be required to pay $1,000 per month + 10% of gross sales over $500,000. The percentage lease is often used for businesses with a significantly seasonal variation, which helps retailers to reduce their expenses when their income is less.
Other types of variable leases that lead to variable amounts of rent include the graduated lease, which has stipulated dates of rent increases, and the index lease, where the amount of rent is determined by an index, such as the consumer price index.
A ground lease is a net lease of unimproved land upon which the tenant will erect buildings and install fixtures to conduct its business. These leases are long in duration, typically 50 to 100 years, which enables the tenant to make enough money to justify the expense of building on unowned land.
An oil and gas lease is a special type of lease where an oil company will pay the landlord for the right to explore the land for oil and gas for a specified period that can be renewed annually. If oil or gas is found, then the landowner will receive a percentage of the income as a royalty, and the lease will continue until the wells are depleted.
A lease purchase is an agreement that allows the tenant to purchase the land after renting it for a time. The right to purchase is the primary concern, while the rental is a secondary consideration. The lease purchase allows the tenant to apply some of the rent toward the purchase price of the property, thereby building up equity while lowering the amount that needs to be borrowed.
A sale and leaseback (aka sale-leaseback) is an agreement where an owner sells the land, then leases the property back for a commercial project for a specified amount of rent and time. The sale of the land gives the tenant capital to finance the project. Or a company may sell its real estate for a leaseback deal to increase its liquidity, to pay down debt, or to profit from inflated real estate prices. For instance, some companies, such as AT&T, sold their real estate at the height of the real estate bubble in 2007 in leaseback deals. However, many companies seek leaseback deals because they are financially distressed. The New York Times, for instance, sought a leaseback deal for its real estate to repay debt during the Great Recession in late 2008 and early 2009. The companies as tenants in most leasebacks still continue to pay not only rent, but also taxes, and utility and maintenance costs. Sale-leasebacks were popular during the 1970's and 80's when they had some tax advantages.
Real Deal — The New York Times Seeks a Sale-Leaseback for its New Headquarters
According to this New York Times article, Cash-Hungry Companies Turn to Leaseback Deals, The New York Times Company was negotiating with one leader in the sale-leaseback industry, W. P. Carey & Company of New York, to sell 19 floors of its new headquarters building on Eighth Avenue in Midtown Manhattan for an undisclosed price, although it was reported earlier that it was seeking up to $225 million. Under the terms of the deal, the Times Company, which owns 58 percent of the 52-story building, would continue to occupy and manage its space for the 10-year life of the lease. It also wanted the right to purchase the property back at a predetermined price sometime in the future — hence, it would continue to be listed as a liability on its balance sheet. Often, companies seek leaseback deals to improve their balance sheet, because the leaseback obligations are an off-balance sheet item.
As a buyer of sale-leaseback deals, W. P. Carey & Company stated, in its annual report, that it seeks to purchase sale-leaseback deals where the real estate is strategically important to the leaseback tenant, so that even if the company experiences financial difficulty, it will strive to continue making payments on the lease.
Owners of agricultural land will often rent out their land to tenant farmers to grow crops on the land. The tenant farmer may pay a specific cash rent or there may be a sharecropping arrangement, where the tenant pays the landlord a certain percentage of the crop sales.
A lease can be terminated like most other contracts, such as by mutual agreement or by performance. However, leases are not terminated if the property is sold, unless there is a specific sales clause that allows the new owner to terminate the lease by giving due notice to the tenants. Leases also do not terminate if either party dies, unless it is a life estate or a tenancy at will. A lease can also be terminated by the bankruptcy of either party or by a condemnation proceeding or other operation of law.
Breach of a Lease
Sometimes a lease agreement is breached by either the tenant or the landlord. When a tenant breaches a lease, most often by the nonpayment of rent, the landlord can sue for actual eviction, which is a court order to vacate the premises.
If the landlord neglects the property or breaches the lease in some other way that makes the property unusable by the tenant for the purpose of the lease or that violates the terms of the lease, then the tenant may abandon the property as a constructive eviction with no further liability. However, to prove the case for constructive eviction, the tenant must leave the premises while the property is unsuitable for the purpose of the lease and may have to prove that the property became unsuitable because of the neglect of the landlord.
Some states require a warranty of habitability in residential leases, where the landlord must provide the tenant with housing that is fit for living; otherwise, the tenant can stop paying rent or abandon the lease.
Residential Leasing Tips
Although there are many forms for leases, there is no standard lease. Leases are generally written to favor the owners, but courts consider such contracts as unconscionable, and may not enforce all the provisions. Moreover, state and local laws may stipulate certain provisions or limit the scope or effect of others. As a property owner, it may be better to have an equitable lease to attract good tenants. Good tenants are more important than a perfect lease, because problem tenants can cost you time and money, and make you irritable. Additionally, you may not be able to enforce some of the provisions or collect payments for any damages or nonpayment of rent, since many renters are judgment proof. Nonetheless, leases are important, so you might want to keep these tips in mind:
- When 1st leasing to a tenant, walk through the property with the tenant, noting any damage or other imperfections of the property. Take pictures of the property and give copies to the tenant so that both of you have a record of the condition of the property at the start of the lease term. The tenant can also take his own pictures, but it still pays to give copies of pictures that you take right when you are there. You may even want to include the tenants in the photograph as you are taking the pictures. Another provision that can be inserted in the lease is that if the tenants find anything wrong with the rental within the 1st week, they should notify you, so that you can fix it promptly. On the other hand, if they do not call, then they must think that the living quarters are adequate.
- If you bought new appliances for the rental, then keep the receipts but also take photos of the appliances in the rental unit, so that if the tenant takes one or more appliances and replaces them with older equipment, then you have a record to prove that your new appliances were replaced with inferior products.
- All adult tenants should sign the lease. There should be joint and several liability, to inform the tenants that each will be liable for any damages and rent payments regardless of the cause or how the responsibilities are apportioned among them.
- Any new tenants must sign the lease. There should also be a guest clause, stipulating that any guests are limited in how long they can stay and there should also be limits on the number of occupants in the unit.
- Generally, it is a good idea to allow holdover tenants, those who stay beyond the expiration of the lease, to simply pay month-to-month.
- To attract quality tenants, it pays to charge less than market rents or to have desirable features.
- If the tenants do not pay their rent promptly, then proceed to evict them as early as the law allows. Never allow unpaid rents to accumulate, since the greater the amount, the less likely the tenant will pay it, and the greater your loss.
- There should also be a clause that tenants cannot modify the property in any way without written permission, since alterations may reduce the property value, and make it less desirable for other tenants.
- An owner access clause will allow you to enter the property with due notice during normal waking hours, so that potential new tenants can be shown the property, and the owner can periodically inspect the property to ensure that it has not been damaged. Without a specific owner access provision in the lease, owners do not have the right to enter the rental unit while the tenant is living there.
- Enforce a no loud noise provision so that neighbors are not disturbed.
- If there is no provision for subletting or assignment, then in most localities, the tenant will have the right to do both. Subletting is renting the unit to another tenant for a short duration, such as college students going home for the summer while subletting the apartment during the summer break. Assignment is when the tenant wants to terminate the lease, so they find someone else to take over the lease. Generally, a subletting or assignment provision, if allowed, should make both the old tenants and the new tenants liable for damages and for rents, so that the old tenants will be more careful in their selection of the new tenants.
- Another provision that must comply with the law is the security deposit:
- how much is required
- what interest rate, if any, will be paid
- under what conditions will the tenant will receive the money back
- how soon after the termination of the lease will the tenant receive the money
- a list of potential itemized damages and their estimated costs
- If you expect the tenants to provide yard care, then the lease should specify exactly what is expected, including cutting the grass, removing snow, and possibly watering the lawn, flowers, trees, and other desirable plants, if necessary.
- Specify the rules and regulations that the tenant should follow.
- Specify the minimum duration between when the tenants give notice that they are leaving and when they will actually vacate the property, usually 30 days, so that you can seek new tenants.
- A failure-to-deliver clause is necessary for holdover tenants, who do not leave when expected. New tenants, who were expecting to move in on a given day, may incur additional costs, such as staying in a hotel or storage costs. The failure-to-deliver provision usually does not allow the new tenants to cancel the lease because of the delay or hold the owner responsible for temporary charges. However, if the holdover period lasts too long, then a certain number of days should be stipulated where the new tenants can cancel the lease.
- How expenses are allocated between owners and tenants should be specified. Usually, the landlord pays water, sewer, property taxes, and any homeowners association fees, because if these fees are not paid, a lien is placed on the property, which the owner will eventually have to pay.
- What happens to abandoned personal property? If the lease does not specify, then the owner may have to hold onto the personal property for a certain amount of time, depending on local law. Therefore, to avoid ambiguous situations, the lease should specify that any property left after the tenants leave will either be disposed of or taken to a charitable organization, such as Goodwill or the Salvation Army. However, the lease must abide by any pertinent laws that may regulate what the owner can do with the property and how long it must be held.
- A non-waiver clause allows a landlord to make an exception for a tenant in regards to the lease, while still maintaining the enforceability of the lease later.
- There should also be a breach-of-lease clause, allowing you to terminate the lease if the tenants fail to abide by the terms of the lease or local laws or ordinances. The acceptance of rent does not protect the tenants from a breach-of-lease eviction.
- There should also be a full representations clause, whereby the lease is the entire agreement: there was no oral or other written agreement outside of the lease. This eliminates the possibility that tenant may claim that a promise was made to do something to the property, such as installing new carpet. Of course, it cannot be proven that such a promise was not made, which is why specifying that the lease is the total agreement is necessary.
- Altering the terms of the lease to satisfy particular tenants may improve your profitability. For instance, tenants may only need a place for 6 months instead of 1 year, so if other landlords are not willing to shorten the period, then you could probably charge a higher rent by allowing for the shorter lease period. Alternatively, you may wish to offer longer-term leases other than the standard 1 year to attract more stable tenants and to reduce vacancies in exchange for a discount in the rent.