Commercial Leasing: How to Avoid Costly Mistakes
Virtually all of our clients have commercial real estate needs of some type, and most have leased some or all of their real estate locations. Despite this frequent need to negotiate real estate leases, we find that many of our clients are too quick to accept the landlord's "standard form" lease, in large part because they do not understand the terms of the lease being presented to them or the most advantageous way to proceed with lease negotiations. The following is a list of some of the most common issues that clients need to address when leasing real estate.
Virtually all of our clients have commercial real estate needs of some type, and most have leased some or all of their real estate locations. Despite this frequent need to negotiate real estate leases, we find that many of our clients are too quick to accept the landlord’s “standard form” lease, in large part because they do not understand the terms of the lease being presented to them or the most advantageous way to proceed with lease negotiations. The following is a list of some of the most common issues that clients need to address when leasing real estate.
The value of time. Prospective tenants often underestimate the length of time it will take to find a suitable location and negotiate a lease. If you are a prospective tenant, allowing for adequate time can create a significant advantage. It allows you to become more familiar with the market, which in turn opens up opportunities that could be foreclosed if you fail to allow for sufficient time. With adequate time, you can explore the possibilities of build-to-suits, new development projects that are not yet on line (land acquisition and development possibilities), or simply consider more of the currently available space. You may discover a location that is presently occupied, but is scheduled to become available within your desired time frame. As your possibilities expand, so does your negotiating leverage. It’s better to have multiple landlords/developers vying for your business. You are unlikely to obtain a favorable lease if you don’t allow time and opportunity to create competition between and among your prospective landlords.
The importance of having the right broker. It’s easy to criticize the broker. He or she typically works for a commission and is often viewed as representing the transaction more than his or her client. Although this may at times be a fair criticism, experience shows that a good broker can be invaluable to the prospective tenant. A good broker will work to understand your real estate needs and will help you focus on both your current and future needs. Many brokers assist in recommending contractors, architects and design professionals. They are familiar with the market and can help you evaluate the merits of both the location and the economics. Most importantly, they will help to create the competition that is essential to negotiating a favorable lease.
The importance of having a letter of intent or term sheet. Although letters of intent or term sheets are typically unenforceable expressions of intent, they are a useful tool in negotiating a favorable lease. It is impracticable (although not unheard of) to negotiate leases with multiple landlords simultaneously. It’s much easier to focus on the key elements of the lease, have your potential landlord submit its lease offer in writing, and then compare all of the offers you receive. In negotiating term sheets, it is important to set parameters. If you need expansion options or renewal options, be sure your prospective landlord addresses your concern in its term sheet. Although a term sheet is not binding and landlords sometimes retract an offer, experience has shown that the term sheet is a useful negotiating tool. Landlords realize that their ability to lease space can be adversely affected in the long term if they earn a reputation for retracting or renegotiating term sheets.
The time it takes to negotiate a lease. Many tenants mistakenly believe that the deal is all but done after the term sheet has been agreed upon. Unfortunately, this is often far from true. A well-negotiated term sheet can certainly streamline the process, but a term sheet cannot address all of the issues that arise under a lease. Moreover, the lack of specificity in a term sheet can often result in ambiguities that must be resolved during lease negotiations. This takes time and patience. The good news is that with experienced counsel on both sides of the transaction, this time can often be reduced.
The location. Almost everyone has heard that in real estate the three most importance factors are “location, location and location.” Although many tenants understand this concept, they fail to address in their lease the conditions that make the location so desirable. For retail tenants, visibility and access can be of critical importance. Yet tenants fail to address this issue in their lease. Sometimes, to their dismay, they are left with little recourse when trees or signage obscure visibility, a fast-food restaurant is built on an out-parcel that is immediately in front of their storefront, or the curb cuts in the parking lot are changed in a manner that impedes access to their store. Perhaps the store was initially in an attractive location in the mall, but visibility has been diminished due to the landlord’s installation of a fountain or a redevelopment of the mall that directs foot traffic away from the store. For an office tenant, perhaps the key points are the amenities and condition of the property. Office tenants would be well advised to require landlords to maintain the property to a condition and provide services to a standard that are consistent with the condition and level of service that made the location desirable to the tenant. Tenants are sometimes surprised to find that in many leases the landlord has reserved the right to relocate the tenant to a different space in the building or shopping center. Although it is preferable to delete this provision, this is not always possible. Nonetheless, a tenant can often address the provision in other ways. Perhaps the tenant will be provided with a termination right if it is dissatisfied with the relocated space, or the number of relocations can be limited. Sometimes the area of the relocation can be limited. For example, the lease could provide that the relocated space must be on one of the top five floors of the building.
Understanding the nature of the rent obligation. Many clients focus solely on the base rent rate and fail to understand the many other components that can affect the total rent obligation. For example, the manner and method by which a landlord measures the space will affect the amount of rent you pay. Rent is typically calculated on the basis of rentable square feet in the leased space. There is a real difference between rentable square feet and usable square feet, particularly in office buildings where the common areas on multi-tenant floors are allocated and included in the calculation of rentable square footage. Some landlords are more aggressive in the manner in which they calculate rentable square footage, which ultimately results in higher rent. In addition, unless you have a true “gross lease,” the base rent is but one component of the total rent expense. Typically, the tenant is also responsible for its pro rata share of operating charges, which can include a share of the real estate taxes, common area maintenance expenses and insurance expenses. Sometimes the total of these charges is billed to the tenants, and sometimes it is billed only if and to the extent the total costs exceed a base amount, which is typically the total of such charges in the first year of the lease. These additional pass-through charges can be substantial and can represent a significant rent expense. When comparing locations, a prospective tenant needs to consider these expenses and the manner in which the prospective landlord addresses them. A gross lease rate of $30 per square foot might compare quite favorably with a net lease rate of $22 per square foot plus operating charges. Also, consider the meaning of any “free rent periods.” More than one tenant has been surprised to find that the landlord’s offer of “free rent” did not extend to operating charges.
Understanding the nature of the lease term. Few tenants are so naive as to believe that they can simply surrender the leased space to the landlord before the end of the term of the lease and walk away from the lease without consequence. Nonetheless, many tenants fail to anticipate the need for flexibility on both the lease term and amount of space, or to address the methods for dealing with them. Some tenants, upon finding an attractive location, are inclined to tie it up by signing a long-term lease. Although this strategy can make sense in some situations, in other situations it may make more sense to sign a shorter term lease with fixed-rate renewal options. If a long-term lease is preferable, it may still make sense to negotiate early termination rights in case circumstances change. For example, a retail tenant may wish to negotiate an early termination right if its gross sales fall below a given level, or if the shopping center fails to maintain suitable anchor tenants. An office tenant may wish to provide for an option to expand or reduce its premises in future years. Although these rights can be negotiated later in the lease term when circumstances so dictate, the tenant is rarely in as good a negotiating posture as it is when initially negotiating the lease.
The repair and maintenance obligations. Who is responsible for what repairs? Leases differ widely on this issue. In a “triple net” lease, the entire obligations for repair and maintenance are shifted to the tenant. In a full-service office lease, most repairs are performed by the landlord, although the landlord typically charges the tenant for alterations or improvements such as new carpet or repairs that arise due to an act or omission of the tenant. Many tenants are surprised by the repair provisions of their leases, and first become aware of them when a major repair is required. In a retail lease it is not uncommon for the tenant to be responsible for the maintenance, repair and, if necessary, the replacement of the HVAC unit serving its space. This can be quite a shock and expense for an unsuspecting tenant. Although it may not be possible to shift these obligations to the landlord, a prospective tenant should have the premises and its mechanical systems inspected so it is better informed as to the likely costs it can expect to incur for maintenance and repair. The tenant must also remember that shifting the responsibility for maintenance and repair to the landlord may not absolve the tenant from financial responsibility if the costs for such maintenance and repair are included in operating expenses that are charged back to the tenant as additional rent. For example, a landlord may be responsible for the maintenance and repair of the roof and the parking lot, but if such costs are passed on to the tenants, then the tenants are really bearing the financial burden. Accordingly, in order to have a complete understanding of the maintenance and repair obligations, and the financial burdens they entail, the maintenance and repair sections of the lease must be carefully reviewed in conjunction with the lease provisions dealing with operating charges.
Understanding the assignment and subletting provisions. Most leases provide that the tenant may not assign or sublet without the landlord’s consent and that the landlord may withhold its consent for any reason or no reason. In addition, many leases provide that an assignment includes by definition a change of control in the equity or management of the tenant. These provisions can have a major impact on a tenant’s ability to engage in corporate transactions or exit a location for an alternative site. Many tenants are surprised that landlords, and particularly retail landlords, are often resistant to a request that their consent to assignment or subletting not be unreasonably withheld. The landlord will often take the position that it should be the sole judge as to the suitability of a proposed subtenant or assignee. However, when pushed, most landlords will at a minimum set forth the requirements and parameters which will be used to judge the suitability of a proposed subtenant or assignee. These parameters may include, for example, suitable financial statements, reputation and experience. For the retail lease it is also important to remember that the permitted use provisions can have a direct impact on the assignment and subletting provision. For example, if the lease allows the premises to be used solely for a hair salon, then any assignment or subletting would have to be for the same use unless the lease provided otherwise. Most tenants would prefer the flexibility of being able to assign or sublet for a use that is different from their own. Most landlords would prefer to limit this flexibility.
The common pitfalls that are listed above are but a few of the problems that can be encountered in a typical commercial lease. Leases are negotiated documents that represent the written culmination of a negotiated transaction. Although there are obvious similarities between many lease transactions, each transaction is unique and accordingly each lease is different. There is no “standard form” lease that is appropriate for all situations. Having a lawyer who is familiar with the leasing process, lease documents and their hidden traps is the best way of ensuring that your transaction will go as smoothly as possible and that the lease accurately represents your understanding and expectations, and protects your interests.