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Leveraged Breakdowns

A Beginner’s Guide To Commercial Leases, Part Three: Other Terms

The third and final installment of this series covers several of the other key terms contained within commercial leases. Some of these terms may come up as part of a real estate private equity interview case study. You can rehearse these on your own or even practice them as part of the real estate private equity career development courses available on this site.

Tenant Improvement Allowance

Landlords frequently offer cash payments to help offset the cost of building out the leased space to the tenant’s specifications. This is referred to as a tenant improvement allowance, TIA, TI’s, or sometimes a finish allowance. The dollar amount agreed to is an upfront capital expense to the landlord, and must be built into your LBO model. The amount of the allowance will also have a significant impact on the returns, so rent must be adjusted (or vice-versa) as the lease is negotiated. In some instances, the tenant may be willing to pay a rent premium for additional TI dollars, becoming a source of profit for the landlord.

Insurance, Types, and Who Buys it

All leases will have a requirement for general liability and property insurance. In Part Two of this series, we discussed who ultimately pays the premium, but which party provides the coverage is another question. In net leases, the landlord may either require the tenant to source their own insurance and name the landlord as an additional insured, or the landlord may provide the insurance coverage and simply require the tenant to reimburse. When one party to the lease is significantly larger than the other, there are usually economies of scale that can lower the premium.

Another type of insurance is business interruption. This is coverage that pays the tenant in the event that the tenant is unable to use some or all of the space. This enables the tenant to continue paying rent despite the interruption in use of the leased space (if there was a fire or significant water damage from a broken pipe). It is important to coordinate this coverage with language elsewhere in the lease covering rent abatements (a period during which the tenant does not have to pay rent or additional expenses) in the event the space is unusable to the tenant. If business interruption insurance is required, then there is no need to abate rent during an insured event. On the flip side, if business interruption insurance is not required (or is negotiated out of the lease), landlords may want to consider loss of rents coverage that pays the landlord if a casualty event allows the tenant to stop paying rent while the space is unavailable.

Other forms of insurance include named storm (hurricanes and tropical storms), earthquake, and flood. These types of weather events are generally excluded from regular property insurance, requiring a special coverage (and added premium). These coverages are often required by lenders based on the location of the property. You will want to be sure you don’t overlook these added premiums in your financial model, because they can add $0.50 psf or more to the annual expense load.

Wrapping Up

The basic terms outlined in these three articles are fundamental to your understanding of commercial leases. You will need to have these committed to memory in order to ace a REPE interview case study. One of the best ways to prepare is through a real estate private equity career development course like Leveraged Breakdowns.

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