What are Leasehold Rights?
A leasehold right is the temporary right of a commercial tenant to occupy and use leased property. The leasehold right is memorialized in writing via a lease between the current occupant (or business owner) and the landlord. A commercial lease invariably allows for the transfer of the leasehold rights to a buyer of the business (subject to the landlord’s reasonable consent). Many times the commercial tenant builds out or improves the commercial space, and these tenant improvements are also a part of the transferable leasehold estate.
Leasehold Rights Affect Business Valuations
Leasehold rights are extremely important for the valuation and sale of many retail businesses such as beauty salons, auto repair shops, restaurants, and convenience stores. The location, tenant improvements of the property, and terms of the lease are all critical factors for buyers in these industries. Buyers will give a higher valuation of a seller’s leasehold rights when the lease is long-term and has favorable rental terms relative to the local market. Buyers will not want leases where they will have to personally guaranty the lease term.
Leases with Favorable Base Rental Terms Increase Valuation of Business
- The simplest way to judge the rental terms of a commercial lease is to determine the price per square foot that the tenant is paying, and comparing this figure with comparable leases in the local market area.
- For example, let us assume that a beauty salon owner is leasing a 2,000 sq ft space in a retail plaza for a total of $5,000/month or $60,000/year.
- As a part of the lease, let us assume the base rent is $25 per sq foot, or $50,000/year (2,000 sq ft x $25).
- The balance of the rent is for the CAM, or Common Area Maintenance Expenses.
- In order to judge the merits of this lease, one compares the $25 per sq ft base rent with other retail leases in the vicinity.
- If nearby landlords are demanding $35 per sq ft of base rent for similar retail spaces, then one will know that the beauty salon owner has a very favorable base rent.
- Conversely, if nearby landlords are only demanding $20 per sq ft in base rent, then one will know that the beauty salon owner has an unfavorable base rental rate.
Maintenance Expenses of Lease Also Critical
In addition to the base rent, CAM expenses and other expenses (not included in CAM) for the actual upkeep of the premises are important factors when evaluating a seller’s leasehold rights. Many leases have very high CAM expenses because the property is not managed in a cost efficient manner. Further, some expenses such as tenant’s share of property taxes, upkeep or replacement of HVAC, parking lot maintenance, and properly maintaining the exterior of the property may not be covered in the CAM expenses and hence not covered at all by the landlord. In other words, such expenses will be the tenant’s responsibility. A buyer will factor in all of these charges when calculating their actual occupancy expenses.
Buyers Will Generally Want Long Leases
Assuming a buyer wants to indefinitely stay in the seller’s commercial space after the sale, then the buyer will naturally prefer the longest possible lease. The buyer wants assurances that they will have the time to recoup their investment in the business without interruption from the landlord. Such interruptions can come through future rent increases, demands of negotiating a new lease when the current lease expires, or the ultimate business interruption in the form of being forced to move one’s business location upon the expiration of the lease! For retail businesses, being forced to move from a well established location to parts unknown is an extremely risky endeavor. Thus, for businesses that rely on customer traffic, it is essential to have as lengthy a lease as possible prior to selling the business.
Leases with Personal Guarantees Not Favored
Many landlords require a commercial tenant to sign a personal guaranty as a part of the lease. The personal guarantor (typically required to be the actual tenant and possibly their spouse) personally guarantees the performance of the lease for a certain length of time. Often the personal guaranty expires after a couple of years, but some landlords require the personal guaranty to be in full force for the duration of the lease. The landlord is more likely to require personal guarantees if the space has valuable tenant improvements or when the commercial space is highly sought after (giving the landlord more leverage against the tenant). For tenants with personal guarantees, the bottom line is that if the lease is in default, the personal guarantor may be sued personally by the landlord for non-payment of rent.
Some Sellers May Choose to Remain Personal Guarantor of Lease
A seller of a business who is also personally guaranteeing their lease may be forced to remain as the personal guarantor of the lease even after a buyer assumes their lease (and buys their business). The lease itself should address this possibility, and typically will not let personal guarantors off the hook even in the event of a sale of the business. In any event, sellers who are personal guarantors may attempt to substitute the buyer of the business as the new personal guarantor. But landlords frequently object to this option unless the buyer is very well established with ample liquidity. If the buyer is not willing to become the new personal guarantor (or if the landlord still requires the seller to remain as the personal guarantor no matter what), then the seller must decide to remain on the lease as the personal guarantor in order to effectuate the sale of their business. It is a difficult choice, and certainly subject to negotiation. Sellers should carefully weigh their options, and seek advice from their attorney and from their professional business broker.
A favorable long-term lease with strong tenant improvements is a very valuable asset for many retail-oriented businesses, and every seller should review their lease and attempt to maximize their leasehold rights prior to selling their business.
Give Martin at Five Star Business Brokers of Palm Beach County a call today for a FREE evaluation of your business.