How to budget effectively before leasing a commercial space
With rent likely being one of the biggest costs of your business, it’s important to budget effectively when leasing commercial real estate.
“You really have to research all the costs to operate a space,” says BDC Major Accounts Manager Brett Prikker, who has financed numerous commercial real estate transactions. “Many businesses wind up over budget because they didn’t review all the lease costs and end up hurting their profitability.”
Follow these three essential steps from Prikker to budget effectively for your commercial real estate lease.
1. Understand hidden costs
The first step in an effective leasing budget is to account for all expenses. It’s all too common to underestimate or forget about major hidden costs, such as the following.
Hidden cost #1: Incidentals
Apart from the base rent, lease costs may also involve numerous incidentals. These can include utilities, property tax, insurance, maintenance, repairs and “common area” expenses, such as snow removal, janitorial services, landscaping, grass cutting and general building maintenance. Some leases also charge a property management fee.
Carefully review which incidentals you have to pay for and how much they are expected to cost. “It’s common for businesses to focus on the base rent and forget about the incidentals,” Prikker says. “Those can represent a large additional expense that can significantly impact your profitability. You need to do your homework to understand their true cost before you sign a lease.”
Ask the landlord for copies of past bills. If the landlord is paying for some incidentals but charging for them as part of your rent, review the bills to be sure you won’t be overpaying.
Hidden cost #2: Increases
Be sure to check how much the base rent and incidentals will increase over the lease term. This is important because some leases start off with a lower base rent in the first year but have large built-in increases in subsequent years.
“Businesses often miss the escalation costs and underestimate their impact on profits,” Prikker says.
Also consider whether you will use the space differently than the previous tenant did. For example, if the former tenant used only part of the space, your heating bill is likely to be higher.
Hidden cost #3: Moving
Be sure to research all costs associated with moving to the new location, such as setting up the new location (for example, getting phone and Internet hook-ups), making signs and marketing your new address.
Hidden cost #4: Renovations
You may need to renovate the space to make it suitable for your business. Bring a contractor and key employees to the site to figure out the costs. Before doing so, review how you use your workspace to see whether you can reorganize it more efficiently.
Hidden cost #5: Downtime
Also often overlooked is the cost of downtime during the move and any extra production needed to accumulate inventory to avoid interrupting supply to clients.
Hidden cost #6: Repairs
Consider any repairs needed to your existing location to return it to its original state.
Hidden cost #7: Lawyer fees
An important time to learn about and control hidden costs such as these is when you’re negotiating your commercial real estate lease. Having a lawyer—preferably one with commercial real estate expertise—review the lease will help you understand what you’re responsible for before you sign. You’ll also need to include the cost of legal advice in your budget.
2. Create a forecast
Now that you have a more complete sense of the numbers, plug them into an income statement forecast for each year of the lease term. It’s helpful to break out each item related to the new location to get a good sense of where your costs are and how you expect them to fluctuate over time. (For valuable tips on cash flow management, be sure to download BDC’s free guide, Taking Control of Your Cash Flow.)
Then, evaluate whether the expense makes sense based on projected revenues. Also, input the same numbers into your prior year’s income statement to see how they would have affected your profitability.
“If your lease costs go up, how much more money will your business have to make to offset the difference?” Prikker asks. “Will the new space help you increase sales to pay for those costs? Knowing the true cost of moving will help you answer those questions and figure out if the move makes sense.”
3. Track the numbers
Finally, make sure you’re keeping track of your real estate operating and improvement costs in your annual budget for your company. Be sure to understand your costs so you can provide sufficient funds in your budget and be on the lookout for savings.