If you plan to develop a small or medium size project on the local commercial real estate market – e.g. revitalize the tenement house and adapt it for office purposes or build a small shopping center – you should make sure that the lease agreements you use will meet the standards of the professional real estate market. In this way, you will reduce many risks, increase the profitability of the project, and expand your opportunities for sale of your project at an optimal price.
The standards of the lease agreement that have been shaped in the western more developed markets for many decades, have become more and more common at Polish commercial real estate market in the recent years. Commercial real estates have specific functions, surfaces, finishing standard, but their main value in the eyes of potential buyers (investment funds and other professional investors) is primarily the result of factors such as location of the real estate, tenant mix and financial standing of tenants, the amount of revenue generated by the lease agreements and content these agreements.
Experts would say that office buildings or shopping malls are worth as much as lease contracts for renting their space.
While it may be difficult for the investors executing smaller or medium size projects to choose tenants according to the ideal tenant mix or reject all potential tenants who do not meet strict requirements concerning their financial standing confirmed by rating agencies (not at this level of the market and not in these market realities), it is within everyone’s reach to ensure the right quality and standard of lease agreements. It is a sure way to increase the value of a property and reduce the risks that do not depend on the landlord.
The Triple Net Lease structure (“NNN”) is one of widely recognized international standards for lease agreements concerning office and retail projects. What does this term mean? In our Polish reality, it means that, apart from the rent, the tenant is also required to cover all operating costs within service change paid by the tenant and cover all utility charges based on re-invoices.
At first glance, this is not unusual when we take, for example, the commonly concluded residential lease contracts, based on which tenants usually bear several different costs of varying amounts, depending on how intensively they use the premises. In the case of commercial real estate, e.g. office premises, we are dealing with additional charges – in this case, the following should be taken into account: real estate tax, perpetual usufruct fees, insurance premiums, security costs, repair and maintenance of the building and its technical infrastructure, cleaning of the common areas, clearing snow, taking care of greenery and external areas, remuneration of the property manager, and in the case of shopping malls – also the costs of joint marketing campaigns. The “NNN” standard assumes transfer of these costs to the tenant within the service charge payable by the tenant next to the rent. This also means transfer to the tenant (all tenants occupying premises in a given building) of the risks connected with any increase of costs related to the leased real estate, in particular the costs which are not controlled by the landlord, such as increase of the property tax, perpetual usufruct fees or costs related to raising the amount of the minimum wage by the government.
The “NNN” standard is not widely used in lease contracts concluded by owners of smaller office or commercial buildings. This situation may therefore apply to a wide range of local entrepreneurs who more and more often undertake the implementation of smaller projects, including regeneration projects. As our law firm often participates in transactions on a supra-local, professional real estate market, as well as on a less standardized local market, we know that the lease agreements on the latter are not always prepared according to the “NNN” standard. In the case of many smaller projects, the lease contracts either lack the mechanism for covering actual operating costs by the tenant at all, or this mechanism is constructed in such a way that the tenant is not obliged to cover all the operating costs incurred by the landlord, in particular if these costs increase during the lease period. The vast majority of contracts also lack a clear solution to the issue of settlement between the landlord and the tenants of the costs of the perpetual usufruct fee that the landlord may potentially be obliged to pay for the period of the dispute concerning its level between the landlord and administrative bodies.
Any deviations from the “NNN” standard may influence value of commercial real estate in the eyes of the professional investors and in many cases also their decision on whether to purchase the real estate or not.
It should be remembered that professional investors usually make initial valuation of commercial real estate assuming the use of the “NNN” standard. If the subsequent legal examination of the lease agreements shows that part of the property’s operating costs will not be covered by the service charge payable by the tenants, the valuation will most likely be adjusted. In extreme situations, if the amount of these costs, which in contradiction to the “NNN” standard is to be borne by the landlord and not by the tenants, is high and difficult to predict, this may from the point of view of a professional investor mean a risk that is unacceptable due to its internal regulations or the requirements of its financing institution. The investor will simply not be interested in purchasing such a property until the lease agreements are adjusted to the “NNN” standard.
It is also worth noting that more and more investors are interested in smaller, profitable projects in regional cities. There are many reasons for this. One of them is the lower price of these projects, which allows lowering the barrier for entry at the commercial real estate market for new, independent investors with professional experience. The large growth potential resulting from new global or local trends may also be a significant reason. For example, in Łódź, where our headquarters is located, a large group of highly-valued programmers and other professionals appeared on the labour market, often working remotely for international firms. These professionals often prefer to choose for their workplace a more intimate, revitalized old factory or residential building turned into office premises with true character, history and identity rather than large glass and steel office buildings. In addition, it cannot be ruled out that due to the current pandemic, some retail chains will decide to leave shopping centers and will turn their interest towards retail premises located in the main shopping streets of Polish cities which will become fashionable again. In this situation, those who own small office or retail project with high potential and ensure that these properties fulfil all relevant market standards will benefit the most in the future. If you have already concluded lease agreements for your project which do not fulfil “NNN” standard – nothing is lost – think about annexing them, proposing to the tenant the transition to the “NNN” standard while maintaining the total cost incurred by the tenant today. It is possible and we know how to do it. We specialise in legal matters concerning real estate.