Thursday, October 8, 2009

How Rent Works (Tradecraft)

If you're starting a business, you might think you rent a commercial space like you rent an apartment. You pay month to month or a six month lease, the landlord comes over to fix your sink when it backs up, and you do a little vacuuming when you want to leave. First, let me tell you that it's possible that's your scenario, but highly unlikely. Also, retail leases are vastly different depending on where you are in the country and your landlord.

The first thing to know about commercial leases is they're generally long term, usually three to five years. This is actually the biggest liability for our business (and my life!). So what happens if your business fails after the first year into a five year lease? You might have been smart and acquired enough cash to run your business debt free, but you now owe hundreds of thousands of dollars on your lease. Since no landlord lets your corporation or LLC sign exclusively on a lease, you're on the hook and now have to declare personal bankruptcy if you can't arrange for someone else to take it over.

Second, most commercial leases don't cover inside repairs. When my sink is broken, my landlord tells me to fix it myself, or he'll send his guy over to fix it and bill me later, both of us knowing he charges outrageous amounts for this service. At the same time, I'm responsible for "common area maintenance" or CAM charges. This includes things like fixing the roof, painting the building, plowing snow if that's an issue, and mowing the lawn. It's highly discretionary on the landlords part and can include nearly anything, billing you later at the tune of thousands of dollars beyond your agreed upon rate. My own property manager has this little scheme where they subcontract CAM work to their own subsidiary. Part of their management fees is a percentage of the cost of this work, so they're constantly painting poles, trimming hedges and dusting the eaves. It makes me fume.

Finally, how much do you pay for space? It's highly variable, again depending on where you are. About a quarter to a third of your projected expenses is a good guideline. A couple dollars a square foot per month and fifty to seventy cents per foot in CAM charges is about average in the SF Bay Area. We've got 3,300 square feet, so you can do the math. For half this rent amount you can get a light industrial location out in the sticks. Store owners in other parts of the country would be aghast at those numbers.

Will rent go up? Absolutely and it's part of most contracts. Our first property gauged it on a regional inflation rate, while our new property has an annual rate of 4%. That kind of sucks now that the country is contemplating deflation. As you can begin to see, this is all to guarantee steady, long term income for commercial property owners. It lets them ride out recessions and short term economic trouble, provided their clients don't default completely.