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What happens if I default on a commercial lease?

Commercial leases are generally much longer than a typical residential lease. The tenant is making a much larger financial commitment. In fact, the financial commitment is so large that new accounting rules were put in place to make sure that financial reporting by public companies reflected this commitment. For details see this NY Times article: http://www.nytimes.com/2010/06/23/realestate/commercial/23fasb.html?_r=0

For people new to commercial leases, it is important to understand the consequences of not meeting this obligation, or in other words, defaulting on the lease.  The exact consequences will depend on the terms of the lease, local law, and common business practices in your community.  That is one reason why it is so important to review your lease terms with an attorney before signing. And, if you think you may default, you should review the possible consequences with your attorney again.

I’ll cover two scenarios that I’ve seen expressed in commercial leases. One is more common than the other.

Can I get out of my lease without defaulting?

There are ways of avoiding default when you either can’t, or don’t want, to continue paying your lease through the end of the term.  The two primary options are subletting or assigning the lease. In both cases, you find another tenant to pay some or all of the lease.

When subletting, you continue paying your lease to your landlord, but you lease the space to a new tenant, who pays you. Most leases will only allow this with the landlord’s permission.  It is possible to make a profit doing this if the rent you charge is higher than the rent you pay. Your lease may or may not allow you to pocket the difference.

When assigning the lease, you find a tenant to take your place in the lease and they become the new tenant, accepting the original terms of the lease and paying the full rent.  This is most common when selling a business that occupies leased space. In most cases the landlord will ask that you remain secondarily responsible for paying the lease if the new tenant defaults.

In both cases, there will likely be some charge by the landlord to cover their time and expense in reviewing and approving the arrangement.

Scenario 1

Now, what happens when you default instead of finding a new tenant?  Most often we see a lease that describes the tenant and landlord responsibilities like this:  The tenant is responsible for the payments for the remaining term of the lease, but the landlord is required to try and find a replacement tenant. Once the landlord finds a new tenant, then they deduct the income from the new tenant, over the course of the remaining original lease, from the amount owed by the original tenant.  The landlord is allowed to deduct the costs of acquiring the new tenant, such as commissions or Tenant Improvement costs, or repair costs from damage caused by the original tenant, from the new tenant income, before subtracting it from the amount owed before totalling the number.  (Or, I look at it as they can add the cost to the amount owed).

The  ‘math’ looks like this:

Amount owed on remaining lease
-Amount that will obtained from replacement lease (rent)
+Cost of obtaining the replacement lease (commissions, TIs, etc.)
—————————————————————————-
Amount defaulting tenant owes

The logic here is straightforward. The landlord would have received x amount of dollars if tenant did not default. They have a right to collect the money. This is offset by their ability to collect from a new tenant (its not fair if they collect from both).  However, there is an expense associated with obtaining that new tenant, so its considered fair for them to deduct that expense from the amount recovered (or in my math, add it to the amount owed… equivalent math).

On a 10 year lease where the tenant pays $40,000 a year, if the tenant defaults in year 5, there is 5 years, or $200,000 remaining on the lease

If the landlord is able to get a new tenant at the 12 month mark, and gets them at a lower rent of  $40,000 per year, then they will obtain $160,000 on the replacement.

If the landlord has to pay $5000 in commissions, and provide $15,000 in TIs to get that replacement tenant the math would be like this:

$200,000 owed
-$160,000 replacement
+ $20,000 in leasing costs
—————————–
$60,000 owed by defaulting tenant

Scenario 2

The other way I’ve seen this done is for the landlord to say that the defaulting tenant owes the amount of the remaining lease, plus any ‘unamortized’ lease up costs from their lease, less the amount received from a new lease.  This concept of “unamortized costs” is a bit of a misnomer, as the costs are fully amortized for tax purposes in year one.  But, most landlords view it as an expense recovered over the term of the lease.  That is why most landlords are willing to do expense TIs for longer leases vs. shorter leases.  For a 10 year lease, with $20,000 in lease up costs , the landlord would figure those costs are $2000 per year.

If the tenant stays the whole, term they’ve recovered all of their costs.  If they leave in year 5, there is $10,000 in costs they have not recovered.

I think leases end up with this scenario through negotiations. In scenario 1, the tenant may feel they are at the landlords mercy during default and they have no control over the amount of TI allowance or commision the landlord pays out at the time of that new lease.  So, with this scenario, the amount they owe is more directly associated with their own lease.   The math looks like this:

Amount owed on remaining lease
-Amount that will be obtained from replacement lease
-Unamortized lease up costs for your lease (TIs/Commissions)
—————————————————————————
Amount defaulting tenant owes

So, using the same example from above (and assuming an original $20,000 in lease up costs), we get:

$200,000 owed
-$160,000 replacement
+$10,000 in unamortized expenses
——————————————–
$50,000 owed by defaulting tenant

Capping the default amount

These numbers can look pretty scary.  And, most landlords will require a personal gurantee of the lease by the business owner, so the protection of an LLC or Corporation does not protect the owner from the debt.  As a result, most tenants will want to try and negotiate some cap to the total default amount.  In many cases, this amount will vary over the term of the lease, with a higher cap earlier in the lease than later. For example, in a 10 year, lease the landlord may ask for a guarantee of the first 2 or 3 years of the lease, and then after than ask for a guarantee of only up to 1 year.  This is a point of negotiation.  The landlord would always want a guarantee of the full lease.  Its up to the tenant to ask for a cap on the guarantee.

I hope this was helpful and if you need help negotiating your next lease, please contact us.

10 Comments

  1. rattan on February 19, 2015 at 5:38 am

    Hi I just to know what happen if I break my lease? I own the shop in some shopping plaza which is very quiet. Sometimes I make only $10. I end with no saving and rent is too high more than $6000 for month. I always pay rent weekly depending on my sales more or less. Today I served the notice that your shop will be locked out in two weeks. No one is listening there is no traffic how I can make money. I already completed 3 years of my lease and 4 years still left? I just want to know what happen if they locked out my shop? If they locked out me so how I can make money then still have to pay rent for 4 years?
    Any help would be great.
    Thank you

    • Jason Hershey, Designated Broker on February 19, 2015 at 8:04 pm

      Hi Mr. Sodhi, Sorry to hear about the challenges. My first piece of advice is going to be checking with an attorney, because a lot of it will depend on the laws in the state/city where you are located. It might cost you a few hundred dollars, but you’ll make up for the cost in the long run.

      As a general rule, landlords can’t simply ‘lock you out’, legally. So, my first question would be… what is the nature of the notice? If you’ve received previous notices and there was a court ruling that you must turn over the space, that is far different from the landlord simply coming in and changing your locks.

      If its the latter, I suspect the landlord simply wants the space back and I doubt he would have much luck with a law suit for the rent.

      If possible, I’d suggest talking to the landlord. If the business isn’t working out in the space where you are, you may be better off closing shop and hopefully just giving him his space back and he can find another renter. Many landlords will let you out of your lease, for a relatively small fee (equal to a few months rent). If the overall lease market is poor where you are (lots of empty spaces in your and other centers), you can also see if you can renegotiate your lease terms. A good landlord understands that there are sometimes circumstances beyond your control, like the economy. If other folks in the center are struggling, it makes sense for him to work out terms that prevent stores form closing vs. having a lot of empty space.

      If only your business is struggling it might mean the location isn’t good, so you need to see what you can do to get out of the lease. Other things to consider are:
      Did you sign a personal guarantee for the lease? (If you didn’t, and only the business (LLC, corporation, etc.) signed the lease, you may be able to just close shop and walk away.
      Can you find someone else to take over the space? If you want to move your business and can’t get out of the lease, you might be able to find someone else to lease the space to. This is called a “sublease” and typically requires the landlord approval, but as long as that tenant is as good as you financially, they should not say no.

      Hope that helps.

  2. jaffery on October 19, 2018 at 4:15 pm

    hi
    i was going to enter in a commercial lease but i was not agree with some of the terms of the lease
    such as i have to pay landlord’s listing agent commission and fee for their lawyer.and their was some construction need to be done from landlord which i am asking them to complete but they say they will do it when i will sign the lease,so i decided that not to sign the lease and just walkout.
    can you please suggest me that if i do not sign the lease,still do i have to pay their lawyer fee or am i suppose to pay anything to them,while i did not sign the lease yet…..
    thanks

    • Tellus Real Estate on April 28, 2019 at 12:46 am

      Sorry for the delay. You should check with a local attorney. In Washington State, all real estate contracts must be in writing — so I doubt you could be held accountable for a contract you never entered — or held accountable for a verbal contract — but that is Washinton.

  3. emilly k. on December 15, 2018 at 2:55 am

    What can I do if I was never able to actually OPEN the business due to the landlord’s neglect from the previous tenant?
    The landlord kept asking when we would be open and did not seem to pay attention when I explained that the health department inspection and fire safety inspections needed to be conducted before we could serve ANYTHING. (it is a food business.)
    He is calling me in default on the lease (we served notice at the 6-month mark of a 1-year lease.) but its just a domino effect with all the repairs that we had to make — and he has yet to pay us the difference as listed in the lease terms.
    Does this mean we are truly in default — since he rented us a unit knowingly requiring extensive work but did not inform us of the problems?

    • Tellus Real Estate on April 28, 2019 at 12:47 am

      This is really something to discuss with an attorney. it will depend on your local laws and because its a coffee cart, I’m not sure that real estate rules would apply.

  4. Casey Eng on August 23, 2019 at 10:51 pm

    Hi,

    So I ran into business issues and was not able to pay my commercial rent lease any further starting June 2018 (I was carrying a 2 year lease that was set to expire Sept 2019).

    I had a personal guarantee on the agreement and the LLC business was dissolved back in 2018.

    However, I have been receiving letters from a collection agency for the remainder of the lease ($26k). They are threatening that if I don’t send in the check, it will go to the credit bureau.

    What can I do?

    I am considering calling the commercial management office to see if they can settle.

    • suzy on October 31, 2019 at 9:59 pm

      Dear CAsey,

      I would let it go to the credit bureau if obviously you can’t pay it or try to settle for half or less than half. Do you have an LLC for your personal assets?

      I am in the same predicament; I signed a commercial lease for 5 years back in March 2019 (took over a salon with 6 employees) however I lost 4 stylists within 6 months and they took clients with them. I didn’t have contract with them to stay because I didn’t want to force them to stay. I hired 2 stylists and it’s very hard to hire stylists because salon business is tough, too many salons in area and even though the salon is located in prime location in downtown Monterey and I pay good commission rate to stylists; I have already reduced stylist commission by 10% and gone to the cosmetology schools to hire from; no luck. Talked to the landlord to reduce rent, he says one 1 month for 10% and has to be paid back. Well the rent is $2834 and the salon income is dropping monthly since FT stylist with most clientele left to rent elsewhere for $200 less per month a mile away.

  5. Matt on September 24, 2019 at 8:01 pm

    My family owns a small business and we tried to talk to the landlord to get out of the remaining 3 years of our agreement because my dad died and we could no longer afford rent. We are now 5 months behind in rent but have not heard from the landlord. What would happen if we just simply locked the doors and told the landlord we are done?

    • Tellus Real Estate on November 3, 2019 at 10:33 pm

      Matt, its really going to depend on local laws and the terms of your lease. Also, who owns the business now with your father passed away. You could try selling the business or sub-leasing the space (or a combination). Sub-leasing means you rent out the space yourselves. typically this requires landlord approval — again, depends on terms of your lease. I’d talk to attorney

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