General Practice, Solo & Small Firm DivisionMagazine
Volume 17, Number 6
REAL ESTATE LAW
HOW ALLIGATORS HIDDEN IN LEASES CAN EAT A CLIENT'S BOTTOM LINE
By Patrick T. Sharkey
Boilerplate clauses might well be referred to as "alligator clauses" because issues left unaddressed in them could eat up the economic benefits of a lease transaction. Some of those provisions concern the condition of the leased premises if a fire or other casualty occurs, the allocation of maintenance responsibilities, and the payment of operating expenses.
Damage and Destruction Provisions. A party that has assumed the obligation to repair or rebuild will try to limit the obligation with a right to terminate the lease or relax the reconstruction provisions to eliminate any deadline for beginning and completing the restoration. Lease termination clauses usually consider whether: the damage to the premises is substantial; the peril causing the damage is one that is insurable under the insurance policy required under the lease; the damage is near the end of the lease term; the insurance proceeds are unavailable or insufficient because of an election by the landlord’s lender to apply the proceeds to its mortgage debt; and the damage is to portions of the building other than the premises.
The conditions under which either or both parties may want the right to terminate the lease will usually depend on who is ultimately obligated to repair or restore the premises. That obligation generally depends on the type of lease. In the case of a full net lease of a freestanding, single-tenant building, the tenant may be obligated to repair and restore the premises and continue paying rent without abatement. But in a gross lease of the same type of structure, the landlord may have the obligation to restore the premises, and the fire clause will usually provide for the abatement of rent.
A landlord’s lease that places the restoration obligation on the landlord is usually general about the restoration procedure, providing that the landlord will proceed to repair or rebuild "with reasonable diligence." The lease should not be open ended with respect to the deadlines for beginning and completing the restoration. Even if the tenant has not been able to negotiate its own right of termination, the tenant should be able to negotiate an outside date by which the landlord must complete its restoration. The lease should state that the outside date will not be subject to the general force majeure clause of the lease.Maintenance, Alterations, and Compliance with Laws. Generally, the outcome of allocating maintenance responsibilities depends on the type of lease, the negotiating strengths of the parties, and the lease term. Lawyers should keep in mind the distinction between the obligation to perform maintenance and the obligation to pay for maintenance. With a development ground lease, the ground lessee is usually charged with the obligation of constructing a building and maintaining it during the lease term. With a freestanding, single-tenant structure, it is common for the structure to be leased on a full net basis, with the tenant having the obligation to maintain the leased premises and improvements, both structural and nonstructural. The parties may agree that the landlord will maintain and pay for maintenance of the structural portions of the improvements.
The lease usually provides that, except for the maintenance obligations that are specifically allocated to the landlord, the tenant will maintain the premises and make all other repairs. The tenant may request a representation and warranty that the items the tenant is expected to maintain will be in good condition. Alternatively, the lease may be a full net lease with the tenant ultimately paying for the cost of all maintenance. Regardless of how the parties allocate maintenance and repair obligations, the lease should provide that the destruction and condemnation provisions will override them.
The lease usually provides that alterations, additions, and im-provements will remain on the premises at the expiration or earlier termination of the lease and will become the property of the landlord. The landlord should make sure that the lease gives the landlord the option to require that the tenant remove these alterations and restore the premises to the same condition in which they existed before the alterations.
A commercial lease usually provides that the tenant will comply with all laws, ordinances, and regulations affecting the premises. The tenant should request a warranty that, on the commencement date, the premises will comply with all laws, ordinances, governmental regulations, restrictive covenants, and other restrictions applicable to the premises, and that no laws or restrictions will limit the use of the premises and any common areas for their intended purposes. Operating Expense Increases. Operating expenses, or increases in the expenses, for the building or project in which the premises are situated are sometimes called "pass-throughs" because they are passed through to the tenant. Some leases have an operating expense escalation provision that passes through increases in operating expenses to the tenant, and a CPI escalation provision that adjusts some other component of the rent to account for inflation. When negotiating the escalation clause, the lawyer’s objectives should be to identify ways to calculate rent escalations under the operating expense clause; identify the tenant’s share of increases in those costs; identify which expenses are included in, and excluded from, the operating expense definition; and make sure the operating expense clause operates fairly for both parties. Two types of operating expense escalation methods are the "base year" method and the "expense stop" method.
Under the base year method, the parties choose an initial calendar year as the "base year," and the tenant pays its proportionate share of increases in operating expenses in each succeeding calendar year (usually called a "comparison year"). Generally, the tenant makes a lump-sum payment following the end of each comparison year. Beginning with the next year (sometimes called an "adjustment year"), the tenant pays monthly installments of its proportionate share of anticipated increases for the adjustment year, based on increases for the comparison year, with a final settlement for the calendar year in which the lease ends. This method will not result in a rent increase until after the expiration of the second year.
Under the expense stop method, the initial rent includes an expense component (sometimes called the "expense stop"), with the tenant required to pay its proportionate share of operating expenses each year to the extent those expenses exceed the expense stop. The adjustment occurs at the end of the first year. First-year rent is based on an expense component of a stated amount. At the conclusion of the first year, the expenses for that year can be calculated and compared with the expense stop to determine any resulting rent escalation. The partial occupancy problem noted in connection with the base year method applies equally to the expense stop method and can be dealt with by the same gross-up clause. The lack of a gross-up clause works to the landlord’s disadvantage. The landlord has chosen an expense stop that, if correct, would equal the actual expenses for a fully leased, fully occupied building. To place the comparison of operating expenses for later years on the same basis as the one used for establishing the expense stop, the operating expenses for later years must be adjusted under the gross-up clause; otherwise, operating expenses for those later years will be artificially low if the building is only partially occupied.
Patrick T. Sharkey is a member of Jenkins & Gilchrist, a P.C. in Houston, Texas.
This article is an abridged and edited version of one that originally appeared on pages 41,45, and 49 of Probate and Property, March/April 2000 (14:2).