LEASING COMMERCIAL REAL ESTATE-ISSUES & NEGOTIATING

LEASING COMMERCIAL REAL ESTATE-ISSUES & NEGOTIATING

Contrary to popular belief, the most important aspect of a real estate lease is not the stipulated rent. The rent provision is important, to be sure, but the primary value of a lease for both a landlord and a tenant is to anticipate the unanticipated and control its outcome as much as possible. A landlord wants to assure an uninterrupted rental stream and preserve the property; the tenant desires quiet enjoyment of the premises.

The parties’ bargaining power will dictate the lease’s ultimate form. Particularly if more knowledgeable, sophisticated and enjoying greater bargaining power, a party will naturally seek strong language to favor his position. If a problem later materializes, the language in the lease often controls the outcome. Subject, of course, to good faith and fair dealing–while negotiating the lease and during the lease term.

Landlord Motivations. The fundamental source of revenue from owning investment real estate is income from tenants. Rental income, after deductions for operating expenses and debt service, indicates a property’s cash flow. Moreover, since tenant income is often capitalized in order to arrive at a sales price for income property, tenant income typically dictates the “value” of the property. Often overlooked, however, is how great an impact the tenant lease agreement(s) can have on this income stream.

A landlord should look upon his lease as an insurance contract: its provisions can protect an owner from unanticipated loss, tenant disputes, problems obtaining a loan or refinancing and unwanted obligations. In fact, a lease can be the primary vehicle to insure increasing future income from the landlord’s property. A lease is hardly a necessary evil; the value of investment property is inextricably interwoven with its leases.

The relationship of a commercial property’s leases to its value is critically important to a lender which intends to secure its loan to the landlord with a mortgage or deed of trust on the property. Essentially, tenant income is the lender’s security for its loan, and its officers will examine with great care the leases regulating that income. The lender’s ultimate decision whether or not to loan against the property will often turn on the leases affecting that property and income derived from it. It behooves the landlord to paying similar attention to his commercial leases.

The investor involved in commercial real estate who recognizes the significance of leases, then, is most prepared to obtain the highest values from his real estate holdings. But recognizing the value of leases is not enough; the sophisticated investor should be intimately familiar with common lease provisions. He can then understand–at least generally–their terms and be able to recognize alternative lease language.

Tenant Motivations. Many small business owners opt to rent retail, office or industrial space because it is more affordable than purchasing an entire property. Once having selected a home for his business among several possible locations, the businessman will then typically negotiate with an attorney or real estate broker who’s representing the property owner by himself. Six months, maybe a year later, a provision in the lease suddenly haunts him.

The best laid business plans all to often get mired in a landlord’s quicksand lease. Unfortunately, the small business owner is not in business to locate and then lease commercial real estate. His expertise lies in running his business. Yet, without advice and often without even negotiating, he will sign a lease that will bind him for a year or (typically) more.

Such a tenant sees no need to negotiate a lease. But when problems arise, and he blows the dust off his lease, he’s amazed at how fast he can learn lease terminology. Other tenants avoid having a written lease. There is no guarantee, however, that a tenant in the future will be dealing with the same landlord. Furthermore, parties to an agreement commonly have curious memory lapses unless there is a document to remind them of specific points. Finally, a lease of duration longer than a year, together with any modifications, must be in writing to be enforceable in court.

Lease Agreements. Lease agreements are an amorphous lot. There is no uniform length, content, structure or language since anyone can draft one. Yet many of the same problems have plagued landlords and tenants over past centuries and a lease professionally drawn by an attorney would typically have many provisions similar to a lease drawn by another attorney. Naturally, variation in leases is greatest among the uncommon provisions. Arguably, the greatest value of a lease is to anticipate the unanticipated, and one lease may anticipate different contingencies than the next. A party can best prepare for the lease negotiations by educating himself on the common provisions found in leases and being mindful of how recurring contingencies can be provided for in a lease.

Although it is standard practice for landlords to use their own lease form, the savvy tenant would, if circumstances permit, attempt to use his own. It is easier to negotiate from your own draft. If a landlord insists on using his own lease, however, the tenant should be aware that most property owners recognize that all form leases have clauses heavily favoring the landlord. A reasonable landlord would certainly agree to modifying some of these clauses to make them more palatable to his tenant.

Several types of clauses commonly appear in leases, and the prospective tenant should consider their actual as well as potential impact on his total cost of occupancy. Each lease clause ultimately has an economic impact although few deal with expenses and costs of managing the property:

  1. Basic Provisions. Namely, the who, where, when and how much. A precise reference to the parties to the lease, to the premises to which the lease refers, to the dates of the lease term and possession of the premises, and to the lease rental is elemental. First, the landlord and tenant should be named, and any representative signing on behalf of either should provide evidence of, or at least warrant, his authority to sign. Second, a complete description of the premises should include the location of the property, as well as what part of the property is the leased premises. Third, pin down the dates from when and to when the landlord is entitled to receive rent; these dates may be different from when the tenant actually occupies the premises. Finally, and most important to all concerned, the rental should reflect the total amount of rent to be paid during the lease term and contain clear language as to any rent increases (or decreases), be they in the form of fixed “step” amounts, percentage rent (in which the tenant’s rent obligation is typically tied to his sales), cost-of-living adjustments (to insulate the landlord from the impact of inflation on his rental stream), or some other form. A lease without all of the above is like a car without wheels; it simply serves no purpose.
  2. Use of the Premises. Limiting the type of use on the premises is most important to a landlord with many interdependent retail tenants. For example, integral to a shopping center’s success is foot traffic, and a good tenant mix will attract shoppers. A landlord, via lease agreements, can preserve the tenant mix by restricting the type of tenants who take possession. That way, an insurance office next to a bank cannot transfer its lease an abortion clinic. On the other hand, a tenant should resist a landlord’s effort’s to define narrowly the business use allowed on the premises, particularly if non-retail. The tenant’s business may change scope or the tenant may later wish to assign his lease to another type of business.
  3. Acceptance and Surrender of the Premises. This lease clause should stipulate that the tenant shall accept the premises, “as is” or subject to specified conditions, upon the commencement of the lease term to avoid the tenant’s untimely later objections. Upon the termination of the lease term, the tenant will restore the premises to their condition upon taking occupancy, reasonable wear and tear excepted. To measure such deterioration, including in the lease file some photographs of the demised premises (taken immediately prior to the tenant’s taking possession) is prudent. Either party will incur costs of preparing the premises for the current tenant, and of restoring the premises for the subsequent tenant, so its best to clarify whom and to what extent. The tenant’s bargaining power will ordinarily dictate how much of an outlay the landlord will make to attract the tenant to move in.

    Even if a landlord’s concern for his fellow man is inadequate, the tremendous exposure in tort liability dictates a careful inspection of the leased premises prior to the tenant’s acceptance. Notwithstanding any lease, local laws may hold the landlord responsible for dangerous conditions existing at the commencement of the lease term which he knew about, or should have known about, and which the tenant would not have reasonably discovered.

    The lease should provide that the premises shall be in rentable condition when the tenant takes possession. Specific remedies for the tenant are important if the landlord is “building out” the space and fails to complete in time. And if a retail property is new, a tenant should insist on the right to terminate the lease in the event a minimum occupancy level for the entire property is not reached. Numerous new and otherwise unoccupied Houston shopping centers sport a lone retail tenant, like so many bleached bones littering a desert.

  4. Security Deposit and Guarantees. Landlords often require security deposits to ensure the tenant’s faithful performance of his lease obligations. A landlord unsure of a potential tenant’s financial strength, e.g., a small, local, start-up concern, should require the tenant to put up a security deposit prior to taking possession. Typically, the amount is equal to one or two months’ rent. If the tenant defaults under the lease, such as failing to make required repairs or payments, the lease should provide that the landlord may apply the security deposit to correct the default and that the tenant will restore the security deposit to the original sum upon curing the default. If the security deposit segregated from other funds is refundable upon the tenant’s full performance under the lease and does not substitute for last month’s rent, the landlord need not report it on tax returns as income.

    If the lease is for, say, three years or longer, a tenant should ask for the earned interest the landlord would otherwise keep.

    Having a third party guarantee a tenant’s performance is another way a landlord can assure his tenant income stream. If the tenant fails to perform on the lease, the guarantor obligates himself to pay the rent. Guaranties are often signed by parent corporations for their subsidiaries, by individuals for their corporation, and by an original tenant assigning (transferring his contract rights under the lease; see below) the lease for the new tenant. A guaranty can become worthless unless carefully drafted, however, so an attorney should be consulted.

  5. Operating Costs for the Building and Premises. Local customary practices will have a profound effect on whether the landlord or tenant will absorb the cost of taxes, utilities (including gas, electricity, water, and garbage removal), property management and other overhead costs. In a multi-tenanted property, the fairest and most common method to bill the tenants is to prorate the operating costs based upon the square footage occupied by each tenant as a percentage of the property’s total area.

    The percentage allocation, and the square footage upon which it is based, should be preceded by such language as “mutually agreed by the parties to be …”. Otherwise, a tenant may later challenge the lease, arguing that the landlord misrepresented a material term. To obtain a concession from the tenant, such as a different lease term or size of rented premises, the landlord may consider “capping” (limiting) all or a portion of the operating costs that the tenant must pay. In a net lease, the tenant will pay for all the above costs; in a gross lease, the landlord will pay for “base” charges and the tenant will pay thereafter for any increases in cost over the base period.

    Landlords and tenants now bargain as readily over utilities as they do over rent, due to the ever-increasing cost of utility services. Operating costs for a building or its leased space, however, are rarely limited to utilities. A landlord concerned about maximizing his net income from rental property would want to have his tenants help pay for janitorial service, elevator repair, legal and accounting services related to the property, etc. A big ticket item is taxes and assessments, and the landlord bears the legal responsibility of paying them. A landlord could seek to pass this cost along to the tenant by either requiring the tenant to pay for only the personal property (e.g., tenant improvements) taxes, to pay for any increases in taxes or assessments, or to pay for any tax or assessment levied against the property.

    A tenant should try to exclude or limit (at least) increases in real property tax pass-throughs if the property is sold during the lease term. Most important, the exhaustive list of operating costs should be read carefully and the tenant should insist absolutely on an annual statement of expenses to insure against overcharges. Otherwise, the lazy tenant may find himself skipping through a minefield.

  6. Repair and Alteration of the Premises. Special care in drafting lease language is crucial where the economic impact is most felt. So both the landlord and the tenant need to specify in the lease not only who is responsible for–but to distinguish between–repairs (i.e., maintaining something which existed at the time the tenant accepted the leased premises) and alterations (i.e., materially changing the premises, such as reconfiguring the partition walls within the leased space) in the leased space. This is another area with tremendous latitude for bargaining and potentially involving large costs, particularly if the exterior of the building and its roof are concerned. Any right of the tenant to make repairs or alterations should be conditioned upon the landlord’s prior review of, and written consent to, the proposed repairs or alterations. The landlord must maintain control over the property to manage it properly and avoid unforeseen problems such as liens. (Liens are a form of statutory protection provided to contractors with unpaid claims and they attach to the real estate for work done on it.) A landlord may post a notice of non-responsibility to avoid a lien filed for work authorized by the tenant, but this presupposes that the landlord has been previously informed by the tenant of the work.

    The tenant should be aware that if he takes the space “as is,” his true rental cost after his “build-out” will be considerably higher at the time of moving in than the rent rate he was originally quoted. The tenant will want the lease to provide specifically that personal property which is installed, or affixed, to the premises may be removed by the tenant prior to the termination of the tenancy, as long as the tenant will repair any damage caused by the removal. This is because affixed personal property acquires the character of a “fixture,” and becomes a part of the real estate. If the landlord sells or mortgages the property containing the leased premises, the new property owner could have title to those fixtures or the mortgage could “attach” to them.

    Regardless of the applicable lease provisions, a thorough inspection by both parties of any repairs or alterations made to the premises or building is advised to avoid potential tort liability.

  7. Landlord Entry and Inspection. A tenant enjoys an “implied covenant of quiet enjoyment” along with his exclusive right of possession. Breach of this fundamental covenant by the landlord relieves the tenant of his lease obligation. To satisfy himself that the tenant is properly taking care of the premises, the landlord must provide for his right, upon reasonable notice to the tenant and during reasonable hours, to enter, inspect and make necessary repairs to the premises during the lease term. The creditworthiness and the business of the tenant should indicate how often the landlord should exercise this right. Additional language should also enable the landlord to show the premises to prospective tenants just prior to the end of the current tenant’s lease term.
  8. Insurance, Subrogation and Indemnification. It can’t be emphasized enough: each party must carry enough casualty and liability insurance. Landlord and tenant also should receive assurance, such as insurance certificates, that the other party indeed has its own. Coverage for other risks, such as business interruption, plate glass, liquor consumption, should be considered, too. A good, reliable tenant or landlord would obtain the insurance anyhow. For uninsurable losses, such as those caused by earthquake or flooding, a landlord might attempt to pass the risk to the tenant, particularly a triple net tenant (who obligates himself to take care of all taxes, insurance and repair). In any event, special attention is warranted here, because potential losses can be enormous.

    Landlord and tenant typically waive rights of subrogation, or their rights “to stand in each other shoes,” in the event of a loss. Their mutual agreement bars their respective insurers from seeking recovery of proceeds paid for the loss against the other party. The theory is that an insurance company should not charge a premium for risk exposure and then collect again (from the other party) when the loss actually occurs. In practice, the landlord does not want to risk losing a tenant’s rentals if the landlord’s insurer goes after the tenant.

    Landlords typically seek to insulate themselves from responsibility (by providing that the tenant will indemnify and “hold harmless” the landlord) for damages to, or losses of, the tenant or third parties at or near the premises. In essence, the tenant absolves the landlord of financial responsibility and acts as his insurer. But what if the landlord or his agents caused the damage? What if a tenant undertakes an insurance obligation he cannot meet, such as earthquake or mudslide damage? In the event of partial damage to the premises, a tenant should insist on an abatement of rent, and a termination of the lease if near expiration. On the other hand, because the tenant rarely has the financial muscle of an established insurance company, the wise landlord will have a tight insurance provision (see above).

  9. Reconstruction. Will the tenant be on the hook for rent if his leased premises are destroyed? The lease should clearly define what the parties’ responsibilities to each other are after destruction and this may turn on the extent of damage. Normally, partial destruction is distinguished from total destruction as a percentage of rental space, e.g., 25 percent; the tenant’s rent would be abated in proportion to his loss of use up to that percentage but either party may terminate the lease if the damage exceeds 25 percent. It may not be economical for the landlord to restore the premises, or for the tenant to remain, if the damage is major. A landlord would typically obligate himself to make the necessary repairs to restore the premises if they can be done within, say, 60 days. If the repairs would take longer, the landlord should retain the option of whether to restore the premises, subject to notifying the tenant. Also, if the damage occurs near the end of the lease term, either the tenant or the landlord may want to cancel the lease, particularly if the premises are let to a special use tenant whose tenant improvements would not be used by the next tenant.
  10. Assignment and Subletting. Practically any tenant or landlord who has felt the need to read his lease has done so to read this provision. In many instances a tenant does not remain in the leased premises for the full lease term. Rather than continue to pay rent for vacated space, the tenant will seek either to assign the lease or to sublet the premises. An assignment transfers contract rights in the lease, such as the right to possession, for the remainder of the lease term, while a sublease results in the original tenant becoming the new tenant’s landlord. The big distinction is that, in the event of a lease default, the landlord must first seek recovery from the new tenant-assignee in an assignment, but must proceed first against a tenant-sublessor who subleases his space.

    If a tenant wants no further contractual responsibility to the landlord, he must obtain from the landlord a full release or novation when he assigns the lease to another tenant. Assignment of the lease does not remove liability, a neat hat trick (it’s the law!) the unwary tenant only later realizes when he seeks to move out of the leased space.

    Many states still allow a landlord to forbid arbitrarily such a change in tenants. Understandably, the landlord withholds consent when market rent is higher than the contract rent in the lease, depriving the tenant of a windfall. The modern trend, however, is to condition the withholding of consent on reasonable grounds, e.g., if the proposed tenant is non-creditworthy, or if preserving the tenant mix is important.

  11. Tenant or Landlord Default. Another critical provision. A tenant may be in default under the lease by his failure to pay rent, or his violation of other lease terms, such as subletting without the landlord’s prior written consent or allowing his dog to recreate the Great Lakes on the newly installed carpeting. Conversely, the landlord might fail to render the premises tenantable or violate the covenant of quiet enjoyment.

    Because the result of a default is such a severe penalty, i.e., loss of the leasehold, and “the law abhors forfeiture,” a default generally may be triggered only after the nonoffending party 1) notifies the other party of the breach and 2) the offending party has failed to correct, or “cure”, the breach within a reasonable period of time. The notice must, therefore, follow “to the letter” the procedure detailed in the notice provision in the lease. Otherwise, the offending party will be able to postpone the default. The time period allowed to cure a breach should be only a matter of days for bringing current past due rent and other payments, but tailored to, say, repairing a wall.

    Each party might consider inserting language in the lease limiting their exposure in the event of their default. Depending on bargaining power, damages could be limited to, say, half of the value of the remaining term of the lease.

  12. Options. Options can have an economic impact that is not readily apparent. Yet landlords routinely grant options to tenants as if they were gift wrap for expensive purchases. An option to renew bestows upon the tenant a valuable right to extend the term of the lease, sometimes under existing rental rates. This option does not normally appear in a standard form lease. Neither does an option to expand space, significant to a tenant owning a growing business. The sophisticated tenant should seek to have as many options in the lease as possible. A landlord should also negotiate for mirror options to obligate the tenant or to excuse the landlord.

    A well-crafted lease should contain many other provisions to protect both parties. A landlord should avoid a tenant’s “recording a memorandum of the lease” clause because it may later be a cloud on the title of the property. The tenant, on the other hand, will want to put the public on notice of his lease rights, particularly if he isn’t occupying the premises. The landlord should always have a “time is of the essence” clause because the courts strictly construe this provision; it could be very important where, say, a tenant delays exercising an option to renew. Finally, both parties should seek to have a liquidated damages provision stipulating a damage amount in the event the other party fails to fulfill an important obligation, i.e., the landlord does not deliver the premises on time or the tenant defaults. Courts will strike the provision, however, unless very specific language is included.

Other provisions customarily included relate to condemnation, holding over, surrender, notices, cumulative remedies, and so on.

These issues and negotiating points barely scratch the surface. Leases are legal documents, however, and deserve serious scrutiny. Until they have consulted a real estate professional, the commercial landlord and prospective tenant should not make any firm lease commitments regarding technical and legal issues. The final business decision to sign the lease, however, must ultimately reside with the parties.

Leases, like all business transactions, involve some risk. But leases can, and should, be negotiated to minimize such business risk. The value of having negotiated important terms into a lease to protect against an otherwise unanticipated contingency is inestimable.

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