GPSolo Magazine - April/May 2004
Negotiating a First-Rate Lease
A business client renting new space has asked you to draft and negotiate the lease. Sounds simple, but the reality may be daunting. Many issues await the attorney representing a landlord or tenant client: how to efficiently assess the transaction and obtain the best possible terms for your client, what factors to consider other than the usual lease provisions, which technical experts to involve. This article provides practical suggestions on lease drafting and negotiating and then suggests ways to address the frequently competing interests of landlords and tenants.
Letter of intent. Initially the parties must accurately inform respective counsel of the business terms that will govern the lease, generally in a letter of intent (LOI). Some clients try to save legal fees by negotiating and drafting the LOI themselves, but this is often a shortsighted move. The LOI provides the foundation for smooth negotiations. An ambiguous or insufficiently detailed LOI can be a great hindrance to the attorney trying to prepare a proper lease. Advise your clients to involve you early and to face any major lease issues at the LOI stage—they’ll have to be resolved at some point, and it’s more cost effective to do so early on.
The LOI should provide all of the basic elements of the deal: accurate description of the premises, term, extension or renewal options, base rent, percentage rent, taxes, escalations, operating expenses, security deposit, rent commencement date, exclusivity clauses, construction and improvements, assignment and subletting, maintenance and repair, telecommunications, parking, signage, and special requirements of either party.
The LOI also should specify which lease form will be used. Using a solid form is extremely important and will save your client money; insist on this point. Landlords usually prefer to use their standard lease, but if your tenant client has enough clout, you may be able to switch forms or at least negotiate many of the landlord’s boilerplate provisions. A less imposing client may have to agree to the landlord’s form and live with most of the lease provisions. In any case, the LOI should state that it is nonbinding on either party and that no contractual obligation is intended or will be created until the parties have a fully executed lease.
Educate the client. As soon as possible, discuss with your client the extent of lease review and negotiation you anticipate considering the size and nature of the transaction. Unsophisticated clients often vastly underestimate the time necessary to adequately draft and negotiate a good lease. It’s not uncommon for a prospective tenant to give the lawyer a 30-page landlord-oriented form with the instruction, “Just give it a quick review—don’t spend more than a couple of hours on it.” It’s the lawyer’s duty to educate clients about legal work—about the necessity for a careful and thorough review. Depending on your relationship with the client and to avoid later misunderstandings, you may want to draft an engagement letter before you begin the work, or require a retainer. In any event, be clear that your fees are due whether or not the lease is consummated.
Communicate with the client. Don’t try to work the deal in a vacuum. Good communication with your client is paramount and will help you focus on your client’s objectives. Do you know the client’s long-term goals and its time frame for the transaction? What are the key lease points? Is there a deal breaker? How extensively should you negotiate? Are there items that may be negotiated more successfully by the parties themselves rather than by counsel? What is your client’s view of the market? Discuss these issues at the outset to establish the drafting and negotiating parameters. If your client has unrealistic expectations, it is your responsibility to say so.
Be realistic. Before entering into negotiations with the other side, assess the strength of your client’s position. A tenant who proposes to lease 1,500 square feet of retail space in a shopping center will not have the clout of an anchor tenant. On the other hand, the importance to a landlord of a specific deal may outweigh its size. If the landlord is looking for a certain tenant mix or must satisfy square-footage requirements for financing, even a small tenant may have unexpected leverage.
Know the other side. Look at the issues driving the deal from the perspective of the other side. Researching its prior deals, deal structures, and legal representation may give you an edge in the negotiation or influence which decisions are better negotiated by the lawyers or by the principals.
Be a role model. The negotiating process can be as pleasant or unpleasant as the parties and their counsel make it. Lawyers can and should model appropriate and ethical behaviors for clients—the parties will have to live with the lease, and each other, for an extended period of time. Establish a rapport with the opposing attorney and remember that you’re not in a courtroom. To facilitate a win-win resolution, negotiate in a spirit of mutual respect, flexibility, and fairness.
Consult technical experts. Early in the process and with the client’s approval, involve technical experts as required. These may include an accountant, architect, risk-management consultant, environmental engineer, attorney, and technology specialist. Don’t wait until the last minute to bring in the experts.
Consider the timetable. If the deal must be signed as quickly as possible, provide quick turnaround of lease drafts and comments and prepare checklists for face-to-face negotiations. Always consider your client’s goals and get creative to provide solutions.
Anticipate Competing Interests
The most common conflicting interests of landlords and tenants in commercial lease transactions involve the tension between stability and flexibility. Landlords are primarily concerned with control and predictability and want financially secure, reputable tenants. Tenants want some degree of flexibility because future circumstances may require more or less space, merger with another company, or a different location.
The following are just a few examples of the dozens of potential issues that may need to be negotiated in a commercial lease. The actual issues in any case depend on many variables, including size of the transaction, market conditions, the client’s business, strength of the parties, and timing.
The Lease Term
Delivery of premises. Occupancy is scheduled for a specific date. Because the premises may not be ready for reasons outside the landlord’s control, landlords typically reject liability for failure to render the premises on that date. Tenants, however, generally want the right to terminate if the premises are not delivered by an outside date and want the lease to provide that such termination will not affect the landlord’s liability for damages. Tip: Consider the possibility that the previous tenant may refuse to leave, and include a provision that either party has the right to terminate upon failure of that tenant to vacate.
Substantial completion. If the landlord is building out tenant improvements, the landlord may suggest that “substantial completion” be satisfied by a temporary certificate of occupancy. From the tenant’s perspective, however, “substantial completion” occurs with a permanent certificate of occupancy. Tenants must be certain that the premises are fully completed and all services required for the business operation are functioning. Tip: Provide that the lease commences upon delivery of the premises and acceptance of the premises by the tenant. Acceptance by the tenant is satisfied when the landlord and tenant execute a written notice of delivery and acceptance of the premises on the date referenced.
Renewal or Extension Options
Grant of option. Granting a tenant the right to renew or extend the lease term generally doesn’t benefit the landlord, who may instead prefer the longest possible lease term, with adequate rent increases to protect against inflation. Agreeing to grant the option generally implies a short renewal or extension term that gives the landlord the option of acquiring a more attractive tenant. Tenants usually want a renewal option to avoid the time and costs involved in relocating if the present location is successful. Tip: When representing a landlord, condition the option upon the tenant not being in default on the exercise date and on the effective date. Also ensure that the landlord will have the same due diligence rights (including review of the tenant’s financials and other evidence of creditworthiness) at renewal or extension as existed before the lease was executed.
Rent. For a renewal or extension term, the landlord will want to apply the higher of the previous fixed rent (floor) or the fair market value, while the tenant is concerned that the floor by that time may be well above market. Tip: For the benefit of both parties, agree on a definition of “fair market value” for the renewal or extension term. Another option is to provide a dispute resolution mechanism (usually arbitration) for negotiating the fair market value provision at that time.
Timing. How much notice is enough notice? The landlord wants ample time to find a new tenant if necessary, and the tenant wants to postpone the decision until the last possible moment to scout all available locations and reduce the risk of committing to an unprofitable one. Tip: In general and for a relatively long-term lease, compromise on a reasonable 12 months before the lease expiration date.
Responsibility. Landlords may insist that the tenant bear the burden of remembering when to exercise the option, which allows the landlord to waive the option limitation if no other tenant shows up. A tenant with sufficient leverage may be able to shift the burden and require the landlord to send a reminder of the coming deadline; if the landlord neglects to do so, the option exercise period is tolled. Tip: Provide that when the tenant exercises its option to renew or extend the lease, the parties will execute a written memorandum evidencing this and including applicable dates and rental rate.
Term. The landlord will want the same lease term for the expansion space that would apply to a third party. The tenant, however, will want the term for the expansion space to be coterminous with the lease and any option periods for existing space. Tip: The outcome likely will depend upon the relative bargaining strengths of the parties. If the tenant exercises the option, the parties should furnish notice with a supplement to the existing lease detailing the applicability of the lease to the expansion space.
Right of first refusal. The landlord may want to provide that the tenant’s rights are extinguished if it declines any space offered. The tenant will want the right to arise each time space becomes vacant. Tip: C ompromise by offering to provide that rights are extinguished for only a specified number of months if the tenant declines to exercise its right of first refusal.
Option to Contract Space
Landlords generally want control over any space returned by the tenant, whose primary concern in such a situation is keeping its current space contiguous, with unchanged ingress and egress. Tip: Negotiate a fallback position in which the tenant retains a broad right to sublet excess space if it is not needed for the tenant’s business.
Option to Terminate
Landlords want a predictable income stream and thus push to eliminate contingencies that allow tenants to terminate leases. Tenants want at least the option to terminate upon material changes caused by damage and destruction or condemnation, and in retail centers, percentage of vacancy or loss of an anchor tenant. Tip: The landlord may compromise and agree to extinguish the operating covenant or to abate the tenant’s rent on a pro-rata basis in such an event.
Assignment and Subletting
Landlords prefer that the tenant’s right to assign or sublet the demised premises be subject to the landlord’s consent, in its sole discretion; tenants want a broad right to assign or sublet without the landlord’s consent. Tip: The most common compromise is to specify that the landlord’s consent shall not be unreasonably withheld, conditioned, or delayed. If your client is a corporate tenant, remember that a transfer of a majority of its stock is deemed an assignment that would constitute a default in the absence of written consent from the landlord (unless otherwise addressed in the lease). Negotiate a provision permitting the lease to be assigned, without the landlord’s consent, to a corporate affiliate or an acquiring corporation. The landlord may require such an assignee to have a net worth equal to the tenant’s.
In retail space, the landlord will be concerned about tenant mix, seeking to maximize the sales of the overall complex. In leasing office space, landlords generally want the right to specify the exact nature of the tenant’s office use. Tenants, on the other hand, prefer to remain as general as possible; e.g., “Tenant may use and occupy the premises for any lawful use.” Tip: Circumstances at some point may require the tenant to modify the nature of its business or to sublet a portion of the space to a somewhat different business. A restrictive-use clause can be a serious detriment to the tenant’s future business.
Attention to your client’s goals, meticulous preparation, and an attitude of cooperation and trust will lead to successful negotiations and long-term relationships, for both the parties and their counsel.