There are thousands of small businesses which have yet to be discovered. If you look around, shopping centers are predominantly made up of national tenants like H&R block, Great Clips, T-Mobile, and Starbucks. A number of economic barriers impede the survival of novel mom and pop businesses. But why? You’ve heard the statistic: most businesses will fail. But nobody talks about why. This article will focus on one of the most significant factors impacting business failure rates. The culprit in part might also explain why the price of a cookie is approaching $5 these days, or why many candy stores tend to sell liquor.
Let’s begin with the main issue. Why do candy stores have to sell liquor? Almost anywhere candy is sold, alcohol too is for sale. True, there are a few places which to this day still sell candy exclusively. Some have managed to stay alive, presumably through subsidies and other means. But the reason candy stores have to sell liquor is because commercial real estate costs have become unaffordable.
Provided is a simplified breakdown of how commercial real estate works. An entrepreneur starts their business from nothing. They then grow it to the point where they need to start looking for commercial space. Once they pick out a location, the following is what they are likely to face, starting with what it takes to actually move into a commercial space.
First, the negotiated rent cost is only the first step. There are other costs that tenants have to worry about. In addition to the cost of rent, usually the tenant is also responsible for their share of property taxes, insurance, and upkeep of the grounds; also known as common area maintenance or CAM charges. Whenever the tenant is responsible for CAMs, taxes, and insurance, it is called a triple net lease. It is the most common type of lease.
As part of a triple net lease, the tenant is also responsible for any utilities like telecommunications, water, and power. There is also what is known as a gross lease and a modified gross lease. In a gross lease, the cost of rent includes everything: CAMs, taxes, and insurance. A modified gross lease covers the rent and a portion of the utilities and other expenses.
What does it all mean? If a tenant agrees to a triple net lease and the base rent price is $3,200, they should probably account for an additional $1,000 in monthly expenses to be safe. It also means they will pay roughly $8,000 for the initial move-in, which includes the first month plus security deposit. There will also be a cost to setup utilities, insurance, and possibly other expenses like tenant improvements and moving costs.
A tenant improvement is any type of building modification that might be needed prior to moving in. Also, the electric and telecommunications companies will sometimes require a security deposit if you do not have a prior relationship with them. The reason is because if a tenant encounters financial trouble and is unable to pay the rent, the landlord could change the locks, which means they probably will not be able to pay bills.
It should be noted that any part of a commercial lease agreement is negotiable. The issue is most entrepreneurs have a limited or very specific set of skills. They may understand how to make money with their craft. But they may lack the broader knowledge that is needed for business survival. Hard work alone is not always good enough. It has to be paired with intelligence. And as you gain intelligence, hard work can be eliminated.
Fees Associated With Leasing a Commercial Space
The following are a list of fees that entrepreneurs should become familiar with pertaining to a commercial lease agreement.
CAMs – I briefly touched on this earlier. But general upkeep of the grounds (lawn care, repairs, etc.) fall under common area maintenance. It is important to note that monthly CAM fees are estimates. Occasionally, the landlord has to pay more money than expected in a given year to fix things. If the amount of CAM revenue received from tenants is lower than the actual amount paid out for services, they can collect that money through what is known as a Prior Year CAM Reconciliation Fee.
Here is how it works: A tenant completes another successful year in business. They upheld their end of the bargain by paying all rent and fees associated with occupying the space. But if the collective amount received by the landlord fell short of actual expenses, they will most likely attempt to collect the money.
In the first quarter of the following year, usually around tax time, expect the landlord to invoice each tenant to cover the shortage [from last year]. This form of billing is always inconvenient because it comes without warning and typically does not happen every year. It should be noted that the amount billed to each tenant is proportional to the size of the space being rented.
If the landlord determined there was a CAM shortage of $20,000 and a tenant was occupying 8% of the leasable space, the pro rata share would be $1,600. Another issue: While it is somewhat of a conflict of interest, it is perfectly legal for a landlord to retain a service company that they own to do the common area maintenance.
Escalating Rent – Every year the cost to lease goes up, typically by a minimum of 3%. For most businesses, the equates to an extra $100 to $200 per month. Rent escalations continue in perpetuity.
The rent goes up to account for things like inflation and property tax increases. There is also a general assumption that businesses achieve steady growth over time as their tenure increases at a given location. But on the tenant side, business is not always great.
For years they may have strong sales. Then something goes wrong and cash flow becomes an issue. There have been instances where the city started doing road construction which lasted for an entire year and it was nothing but traffic cones in the road, which impeded the flow of traffic... which meant a reduction in patronage to surrounding businesses. Or what if a competitor moves nearby? Any time there is an influx of new market entrants, it has the effect of eroding sales.
Lease Renewal Fees - Next, let’s suppose a tenant has successfully fulfilled all obligations and their lease term is coming to an end. Now comes the time to begin a new lease agreement with the landlord. Expect the new lease to increase by 20%. And yes, each subsequent year, the rent costs escalate by 3%.
Roof & HVAC – Since the landlord owns the building, it is assumed that they are automatically responsible for things like roof leaks or a broken air conditioner. Unfortunately, that is not always the case. In many instances, it is the tenant’s responsibility to maintain, repair, and even replace the HVAC system if it breaks.
Earlier, I mentioned that everything in a lease agreement is negotiable. It is a good idea to ensure that any HVAC issues fall under jurisdiction of the landlord. Tenants should also heed the language in the agreement because the landlord may agree that they are responsible for HVAC repair and/or replacement, but only under the condition that the tenant maintains it.
What this means is if the HVAC system breaks... before they get to the point of replacement, the landlord will want to see evidence (receipts) of a service plan.
Now you are beginning to see why many candy stores have to sell liquor to survive. Generally, there are no constants when you rent. The prices go up annually and there may be unexpected expenses incurred along the way.
What if things don’t work out? Is it possible to get out of a commercial lease agreement?
It is rare. After all, the tenant signed a legally binding document. Commercial real estate is set up in such a way that they typically cannot test the waters. Rarely is there a way beforehand to see if a specific location is ideal for business. This strategy might be helpful in the event a tenant wants to initially sign a short-term lease before committing to a multi-year agreement.
Typically, this is not an option in the good part of town or where the median household incomes exceed one hundred thousand. However, it might be possible in low income areas. A tenant can sometimes negotiate a month-to-month lease in lower income areas. But in the good part of town, landlords typically want to see 3 to 5 year lease terms. In most cases, the only option is to take a very expensive risk. Once the lease is signed, it is difficult to break if it was later determined that the location was not the best fit.
Have you ever noticed the shopping centers with only a few tenants? The center may have one anchor tenant (e.g. grocery store), but many of the adjoining retail suites are vacant. A prudent entrepreneur might see the low tenant occupancy as an opportunity for leverage in lease negotiations. The assumption is that if there are few tenants, the property owner is not making money. In reality, landlords who invest in shopping centers for a living often own as many as 20 other commercial properties. They are probably still making money and are not affected by low occupancy at a single location.
Let us refocus our attention on why candy stores have to sell liquor and why the price of a cookie is approaching $5. First, the cost to rent a commercial space is expensive. Second, commercial lease terms are not always favorable to tenants. And finally, the escalating cost of rent, which increases in perpetuity is a major issue. If you pair either of these factors with misfortune, it could spell disaster.
Are there ways to get deals that might be more favorable to the tenant?
Yes, there are a few ways to do this. A tenant can agree to a longer lease term; usually a minimum of 10 years for the most favorable deals. Or they can pay more money up front. For example, if the lease is for 3 years, they can pay for several months in advance to secure better lease terms.
Many entrepreneurs lack the means to pay large sums in advance. And it may be too risky to sign a 10-year lease term with an unproven business model. In this case, consider adding a sublet clause to the lease. This provision allows the primary tenant to lease any portion of their space to another business. Once a suitable tenant has been found, it must be approved by the landlord.
If the primary tenant owns a bookstore and is struggling financially... or maybe they simply want to maximize revenue potential, they can find another tenant that wants to open a coffee shop and lease out a portion of the bookstore to generate additional income. The bookstore owner now becomes a landlord to the coffee shop. This has the effect of decreasing the cost of rent.
How to Solve the Problem
Look around and you will see that just about every city looks the same. The same restaurants. The same retailers. If you fly to another state, the establishments will too be the same. How do we get more variety? How can we create more opportunities for small businesses?
Well, that is difficult because the cost of rent is too high. Landlords prefer to fill vacant spaces with national tenants because they have the money. They have already proven to be successful. The largest economic barrier preventing the next great idea, the next great entrepreneur, from being discovered is probably going to be the cost of rent.
Ideally, there would be a way to lower the rent since that is the main problem. But that is not easy to do. One way to do it is to reduce financial risk. The following is a possible solution that might work, and it would benefit everyone involved: entrepreneurs, landlords, and yes, even local governments.
Everything would begin with an incentivized entrepreneurship program. The program would be facilitated by the city, but done in tandem with property owners and entrepreneurs. In exchange for program participation, city councils could offer preference to landlords through various initiatives, such as contracts and tax benefits.
Small businesses would be more inclined to seek out commercial locations that incentivize entrepreneurship with lower fees or fixed rent costs. As a result, entrepreneurs would be more likely to stick with participating landlords beyond initial lease terms. Mentorship could also be incorporated into the program, which might help to reduce the rate of attrition among early-stage businesses.
For local governments, the primary objective would be to assist businesses that eventually develop not just local but national or even global impact. An advantage for cities and states is that it may birth the next great business, which would invariably become a boon to the surrounding economy and beyond. A significant portion of revenue for local governments comes from sales taxes. Accordingly, a program that helps businesses succeed would translate into more tax revenue for cities and states.
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