Fair Compromise?: Allocation of Re-letting Costs in Commercial Leases - ABA YLD 101 Practice Series

By David J. Weiner

When negotiating commercial leases, one of the most hotly contested issues is the scope of remedies available to the landlord. Typically, landlords have much greater bargaining power than tenants when negotiating these provisions. As a result, the landlord's remedies have the potential to be extraordinarily cumbersome to a defaulting tenant. Even when the tenant is a national chain retailer (who typically has much more bargaining power with landlords eager to secure a large, dependable tenant), oftentimes the greatest concession such a tenant can get from the landlord is an increase in the cure periods, a reduction in the default interest rate, and a limited duty to mitigate damages. Office leases (especially for Class A buildings) can be even more rigid in favor of landlords.

Landlord remedies may include the right for landlord to do any one or more of the following: (i) terminate the lease and collect the amount by which all future rent under the lease exceeds the fair market rental value of the leased premises over the remainder of the lease term, discounted to present value; (ii) terminate the tenant's right of possession yet continue to charge the expelled tenant for rent as and when it comes due (less any amounts obtained by re-letting the leased premises); (iii) enter the leased premises and remove the tenant's fixtures and personal property; (iv) store or otherwise dispose of the tenant's fixtures and personal property at the tenant's expense (subject to any UCC standards); (v) cure any tenant default and charge the tenant for such costs plus a service fee; (vi) require reimbursement of the unamortized portion of any tenant improvement allowance; (vii) change the locks to the leased premises; or (viii) re-let the leased premises and charge the tenant for all costs and expenses associated with such re-letting. This list is far from all-inclusive. And most leases expressly state that all landlord remedies are cumulative ( i.e., that such remedies may be combined).

While many of these remedies are objectively reasonable (assuming that, in each case, the landlord has a duty to mitigate its damages, which may be derived from contract or applicable state law), the landlord's right to reimbursement for all re-letting costs can be a burden too great for the defaulting tenant to bear; and oftentimes this remedy results in a windfall for the landlord. Re-letting costs can include costs of repairs, redecorating, alterations and additions to the leased premises, the landlord's expenses for marketing and showing the leased premises, the landlord's attorneys' fees for negotiating a lease with the new tenant, brokers' commissions associated with the new lease, and the monetary value of any other lease concessions made under the new lease. The burden for the tenant to cover these costs is exacerbated by the fact that, as long as the defaulting tenant has the financial wherewithal to pay, the landlord has little incentive to keep these costs down. Also, these costs are all expenses that the landlord would nevertheless incur once the tenant's lease had expired and the tenant vacated the leased premises.

In some states, the landlord has a duty to mitigate its damages, whether by statute or under common law; and that duty may not be waivable. However, the lease may spell out the nature of the mitigation, imposing certain limitations on what steps the landlord must take in order to be deemed to have mitigated its damages. With respect to a landlord passing along excessive re-letting costs to a defaulting tenant, the landlord may take the position that its willingness to re-let the leased premises to begin with is mitigation enough.

The inequity of the common practice regarding the landlord's right to full reimbursement of re-letting costs can be explained in the following example:

A retailer tenant ("Tenant") signs a ten- (10) year lease (the "Lease") with a shopping center owner ("Landlord") covering approximately 2,000 square feet of rentable space in one of Landlord's multi-tenant out-parcels (the "Leased Premises"). Since Tenant is not an anchor tenant for the shopping center, Tenant has little bargaining power in lease negotiations with Landlord and must acquiesce in the inclusion of a provision allowing Landlord the right to full reimbursement of re-letting costs. At the midpoint of Year 9 of the Lease term, Tenant defaults, and Landlord decides to terminate Tenant's right of possession. Landlord then re-lets the Leased Premises to a more upscale retailer tenant ("New Tenant"). As part of this re-letting process, Landlord agrees to a twenty- (20) year lease (the "New Lease") with New Tenant. Pursuant to the terms of the New Lease, Landlord will pay New Tenant a $120,000 tenant improvement allowance for substantial redecoration and alterations to the Leased Premises; Landlord will pay New Tenant's broker a six percent (6%) commission covering all rent under the New Lease; and, as a concession to New Tenant, Landlord will pay all of New Tenant's attorneys' fees in the negotiation of the New Lease. All of these costs, along with any other costs incurred by Landlord for the marketing of the Leased Premises and for Landlord's attorneys' fees, would likely be included within the re-letting costs owed by Tenant.

The result of the above example would be that Tenant is stuck with the bill for substantial re-letting costs, even though there were only eighteen (18) months remaining on the Lease term and Landlord would have nevertheless had to incur those same costs the following year had Tenant not defaulted and subsequently vacated the Leased Premises after the expiration of the Lease term.

The need for a fair and equitable approach to handling re-letting costs has been largely overlooked by commercial landlords and tenants (and their counsel). However, many tenant attorneys have been offering (and some landlord attorneys have been willing to accept) what appears to be an appropriate compromise in lease negotiations on this issue. This compromise involves the allocation of re-letting costs between the tenant and the landlord based on (a) the time remaining on the defaulting tenant's lease term (the "Remainder Term") and (b) the length of the term of the lease that the landlord signs with a new tenant (the "New Lease Term"). The re-letting costs would be "hypothetically amortized" over the New Lease Term, with the tenant being responsible for its proportionate share based on the number of months in the Remainder Term and in the New Lease Term.

If this allocation approach was applied to the earlier example, a much more equitable result would be reached. For purposes of this example, suppose that the total amount of all re-letting costs was $200,000. If this amount was amortized over the life of the New Lease Term, the "per year" amount of re-letting costs would be $10,000 (ignoring interest). Since the Remainder Term was only eighteen (18) months, Tenant would be liable to Landlord for $15,000 as its proportionate share of re-letting costs. By using this approach, Tenant is relieved of the undue burden of paying up to $200,000 in re-letting costs despite its default occurring late in the Lease term. Meanwhile, Landlord still receives the benefit of essentially having its re-letting costs - which Landlord would nevertheless have had to incur eighteen (18) months later had there been no default - subsidized by its defaulting tenant. Also note that Landlord would still be entitled to its other monetary remedies under the Lease, including its right to any shortfall in rent and other amounts otherwise owed by Tenant.

The allocation of re-letting costs is not the most well-publicized issue in landlord-tenant negotiations. However, this approach can prove quite useful in alleviating the burden to tenants of otherwise onerous landlord remedies; and it can serve landlords well as a good faith concession in lease negotiations.

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About the Author

David J. Weiner, an associate at Liskow & Lewis, A Professional Law Corporation in Houston Texas and practices in the areas of commercial leasing and real estate, lending and general commercial transactions. He has authored and co-authored presentations on sale and purchase agreements, title insurance issues and commercial real estate loan transactions.

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