Commercial Leases

Vol. 1, No. 6

James P. McAndrews was formerly a partner with a partner with the law firm of Benesch, Friedlander, Coplan & Aronoff. He currently resides in Fairfax, Virginia.

 

From The Commercial Real Estate Practice Manual With Forms

  • Learn the key provisions of a commercial lease.
  • Learn the differences between office leases and office-warehouse leases.

A lease delineates the rights and responsibilities of the landlord and the tenant with respect to the leased premises. To accomplish this, a lease must contain certain key provisions, which are discussed in this chapter. Understanding the purpose and scope of such provisions plays a large part (along with the parties’ respective bargaining power) in determining how a lease evolves through negotiation. While the discussion to follow will focus primarily on office leases, notable differences between office leases and office-warehouse leases will be highlighted.

 

Letter of Intent

Many times a prospective landlord and a prospective tenant will enter into a Letter of Intent prior to actually finalizing the lease. The letter at times will include a “non-shop” provision. The landlord likes this provision in order to keep the tenant from looking at other space while the negotiations are in progress. The tenant wants it because it stops the landlord from offering the space to other prospective tenants while the lease terms are being negotiated. In OfficeMax, Inc. v. Gerald L. Sapp,1 the prospective tenant brought an action against the owner of the real property, claiming the prospective landlord violated the non-shop clause by negotiating with and actually renting the space to Staples, a competitor of OfficeMax. The non-shop provision provided that the landlord would not initiate negotiations with third parties or respond to solicitation by third parties and that the landlord agreed that it would be legally bound by the provisions. There was no time limit in the provision. The court declared that the Letter of Intent was not binding, since it did not contain all the essential provisions for the lease. It pointed out that OfficeMax, in the draft of the lease, wanted to add many restrictions. It noted also that the non-shop provision would not be enforceable because OfficeMax did not agree that it would not look at other properties during the negotiations, and it did not pay any independent consideration for the non-shop provision.2 Finally, the court noted that there was no time period in the provision, thereby making it revocable at will.

 

Leased Premises

A lease must adequately describe the location and size of the leased premises. Identification can be in the form of a metes and bounds legal description of the leased premises, or a copy of the site plan can be attached as an exhibit to the lease. For recording purposes, however, it is preferable to have a legal description of the real property in which the leased premises are located made a part of the lease, with a site plan to show the exact location of the leased premises.

Precise identification of the leased premises is important, because without it, a court may find the lease void for indefiniteness. While courts have implied reasonable rent where rent is omitted or indefinite under a lease, they will not imply identification of the leased area. Therefore, a lease that does not sufficiently identify the leased premises will be unenforceable. If the leased premises cannot be described adequately because the building is under construction, the lease should provide that the location and size of the leased premises will be set forth in an amendment to the lease as soon as a sufficiently precise description can be determined.

 

Rentable v. Usable Space

The lease should specify the total usable square footage of the leased premises and the total rentable square footage on which tenant will be charged rent. The difference between “usable” space (the space the tenant may actually use) and “rentable” space (the space on which the tenant will be charged rent) is a product of local real estate custom3 or is negotiated by the parties.

Rentable space usually includes a tenant’s pro rata share of space in the office building deemed “beneficial” to the tenant even though tenant does not have exclusive possession of the space. This beneficial space usually includes some or all of the building’s common areas and nonrentable space such as mechanical areas, lavatories, and staircases. The square footage of tenant’s pro rata share of these beneficial areas is added to the square footage of tenant’s usable space to determine the tenant’s total rentable space. Prior to the execution of a lease, a tenant should be permitted to confirm the accuracy of all space measurements.

In an office-warehouse, the lease usually provides one square footage measurement for the office area and another similar measurement for the warehouse.

 

Term of the Lease

The period of time in which a tenant has the exclusive right to possession of the leased premises, and usually the corresponding obligation to pay rent, is called the lease term, although there might be an “inducement period” at the beginning of the lease term when the tenant is not liable for any fixed rent. The provisions governing the commencement and termination of the lease term should be clear and unambiguous. A lease that has an uncertain termination date may be found unenforceable as a term of years and converted into a tenancy at will. Moreover, ambiguity about the commencement date of a lease can provide a tenant with grounds to delay paying rent.

 

Commencement Date

In many leases, the commencement date coincides with the date of the lease, thus leaving no room for ambiguity. Under some leases, however, the commencement date is contingent on the completion of certain improvements or some other event. In these cases, the lease should require that a supplement or amendment to the lease be executed documenting the exact commencement date.

If another tenant currently occupies the leased premises, the landlord and the proposed tenant should bargain for protection against failure of the old tenant to vacate. The lease should condition the tenant’s possession and obligation to pay rent upon such vacancy and provide a cutoff date after which either party may terminate if the current tenant remains.

When a commencement date of the term is postponed for a period of time in order to give the tenant an opportunity to install improvements, the period should be limited to a certain number of days—for example, 90 days or 120 days—after the execution of the lease but not later than the date the certificate of occupancy is issued or when the tenant enters into occupancy and commences business operations. Some tenants do not want the construction period time to start to run until the plans are approved by the landlord and the building permit is obtained from the appropriate governmental agency. Even in this situation, there should be an outside date for obtaining the approval and permit.

Generally, tenants do not want the lease to commence before they install their equipment and inventory and make all necessary renovations. As a result, the commencement date (or at least the rent period commencement date) usually is tied to the tenant’s occupancy of the leased premises, but with a limitation to the effect that the commencement date shall not be later than 90 days (or some other agreed upon period) after the leasehold improvements are completed and the certificate of occupancy (if required) is obtained.

If the landlord is responsible for renovating the leased premises, the lease may allow the landlord to postpone the commencement date, and the tenant to postpone paying rent, until the landlord completes the work in the event renovations are not completed on a timely basis. The lease may also provide a “drop-dead date” after which the tenant may cancel the lease without any further obligation to the landlord if the landlord’s renovations are not finished by such date.

Most leases limit a landlord’s liability for delay in delivering the leased premises to a tenant to mere postponement of the start date of the lease, although some leases do give a tenant the right to terminate the lease or to require the landlord to reimburse the tenant for any additional rent the tenant is required to pay as a holdover tenant in its present space. In any case, the landlord generally is not liable under the lease for the tenant’s professional service expenses and/or lost revenues resulting from the landlord’s delays.

 

Duration of Lease

The duration of an office lease varies depending on the tenant’s size, but most office leases are for a term of five years. The lease term is generally a function of the landlord’s and the tenant’s plans with respect to the leased premises. As a practical matter, however, a landlord generally wants to lock in a substantial tenant for a long term provided the lease contains provisions that guard against the effects of inflation. Tenants who finance their own improvements also require long-term leases so they may recover their investment in such improvements.

In most jurisdictions, the statute of frauds permits enforcement of an oral lease agreement as long as the term is less than a defined period. The most common maximum period for oral leases is one year; however, in some jurisdictions an oral lease for three years may be enforced. In Ohio, if the tenant is in possession under a parol lease of three years or less, such lease will be exempt from the operation of the statute of frauds.4 One consequence of such enforcement is the potential for a claim for breach of an oral lease by a disappointed party should lease negotiations break down or should either party want to terminate after the tenant enters into occupancy. Accordingly, essential lease terms should be put in writing as early as possible.

 

Renewal Terms

A lease may provide that a tenant can extend the term of the lease for one or more renewal terms provided the tenant is not in default. Renewal provisions should provide the mechanics for exercising the renewal provision, the date by which notice of renewal must be given, and the amount of rent due during the renewal term. If the rent is left for future agreement between the parties and the parties do not agree, the renewal provisions will not be enforced or considered valid unless there is an additional provision that states that if the parties fail to agree, the rental shall be the fair market rental as determined by an appraiser or some other agreed person.

Landlords should consider requiring special renewal provisions that pertain to financial covenants affected by inflation, such as the level of required insurance coverage. Because office leases generally contain detailed allocations of maintenance costs, taxes, assessments, and insurance coverage, the impact of these allocations in the future should be considered in drafting the renewal provision.

Otherwise, the lease should provide that renewal is on the same terms and conditions in force during the original term except for the renewal terms then exercised. This is particularly important where the lease contains unusual provisions or provisions not favored by law, such as a confession of judgment.

 

Termination

The lease may expire or terminate in accordance with the terms of the lease, or a trustee or debtor in possession may disaffirm it in bankruptcy pursuant to their respective powers to disaffirm executory contracts under the Federal Bankruptcy Code.5

When the lease term ends for any reason, the tenant’s right of possession and its obligation to pay rent accruing after the termination date also end. A lease should require that, upon termination or expiration, the tenant must remove its property from the leased premises. The landlord should have the right to remove and store the property at the tenant’s expense, and the right to dispose of it after a certain specified period of time, if the tenant fails to do so. In the event a tenant defaults, leases generally give landlords the right to terminate the lease, regain possession of the premises, and accelerate the rent for the balance of the term. Landlords should use care, however, in exercising these remedies, as they may be mutually exclusive. Tenants will want to impose some limit on the amount of accelerated rent or discount it to present value.

In general, a landlord may not have possession of the leased premises and receive rent. Therefore, if a landlord terminates a lease, removes the tenant, and takes possession of the leased premises, the landlord cannot sue for rent accruing after the date of termination. On the other hand, if a landlord accelerates a tenant’s rent and obtains a judgment for the accelerated rent balance, the tenant might acquire the right of possession of the leased premises for the balance of the term, thereby making it difficult for the landlord to re-let, unless the tenant agreed in the lease that the landlord has such rights and that they are cumulative. The lease also can provide that the landlord, at its option after default, may obtain possession of the leased premises and, without terminating the lease, re-let the leased premises for tenant’s benefit on whatever terms landlord deems proper.

 

Rent

The most important provision in a lease, of course, is the rent provision. The rent that a tenant agrees to pay, however, is usually only one of several expenses the tenant may be obligated to pay during the lease term. Rent is generally defined as a base or minimum rent plus operating expense pass-throughs. Usually, however, any amounts payable under a lease are classified as rent or additional rent so that, in the event of default, the landlord has summary proceedings available. In the absence of agreement, rent is payable on the last day of the period and not in advance.

 

Escalator or Pass-through Provisions

Most leases contain several provisions that escalate base rent during the lease term. These provisions protect landlords from unanticipated and/or extraordinary costs that could adversely affect the investment value of the lease during the lease term.

 

Step-up Charges

Step-up charges are periodic, fixed adjustments of the base rent at certain stages of the lease. They typically represent the landlord’s estimate of what the market value of the leased premises will be at a particular point in time during the lease. Fixed increases in the base rent give both parties sufficient indication of what the tenant’s space cost and the landlord’s income stream will be during the term of the lease, and they give the landlord a certain hedge or protection against inflation. From a tenant’s viewpoint, however, these increases create the potential for rent increases if the value of the building and/or the character of the area declines.

 

Adjustments

CPI-based adjustments, porter’s wage adjustments or other similar bases for adjustments escalate rent based on the movement of different predetermined indices. These provisions allow landlords to keep pace with inflation by increasing the tenant’s share of the building’s operating expenses and taxes. Banks and mortgage holders favor such provisions because they allow the landlord to cover operating costs without disrupting debt service or eroding cash flow.

 

Common-Area Charges

The general rule is that only those costs that are “directly related to a building’s operation and which benefit all tenants in general” are included in a lease operating expense pass-through. These costs typically include those associated with heat and light, cleaning costs, maintenance, minor repairs, and materials and supplies used in operating and maintaining the building. General costs associated with marketing or advertising space in the building or those incurred by a landlord with respect to a particular tenant or lease (for example, legal fees for evicting a tenant) generally are not passed through to all tenants.

A tenant is usually required to pay such common-area charges either from dollar one or from a base amount agreed upon by the landlord and tenant at the time of execution of the lease. If a landlord generates fees or rentals from common-area spaces or similar beneficial areas upon which tenants pay rent, however, such tenants should receive a credit against their pass-through expenses for their pro rata share of any such revenues. Sometimes tenants are able to negotiate caps on the increase in common-area charges.

 

Taxes

The real estate taxes applicable to the leased premises could increase over the term of the lease and cause the landlord’s return from the leased premises to be reduced if protection against such increases is not included in the lease. Therefore, landlords usually require a pass-through similar to that of common-area charges whereby tenant agrees to pay its pro rata share of real estate taxes either from dollar one or from a predetermined basis tax amount.

 

Late Payment

Leases generally provide tenants with a reasonable grace period to cure delinquent rent payments before the landlord has a right to charge either a late fee or a penalty. This opportunity to cure, usually after notice, protects tenants, to some extent, against the harsh effects of the rent acceleration clauses typically found in leases.

In reviewing the late payment provisions of a lease, tenants should determine whether there are duplicate penalties for late rent. Typically, a late fee will be charged along with the interest expense incurred by the landlord as a result of the late payment. While a landlord is justified in wanting to be reimbursed for its out-of-pocket expense in paying its debt service while rent is late, the tenant should not have to pay a double penalty if rent is a few days late. Thus, tenants should attempt to negotiate an arrangement whereby the tenant has to pay either a late charge or interest fees—but not both—unless a tenant’s late rent payments become habitual or the rent is late for more than a specified period of time.

 

Endnotes

1. 132 F. Supp. 2d 1079 (M.D. Ga. 2001).

2. The result may have been different in other states that have enacted a law, sometimes referred to as the Uniform Written Obligations Law, that provides: “A written release or promise hereafter made and signed by a person releasing or promising, shall not be invalid or unenforceable for lack of consideration, if the writing also contains an additional express statement, in any form of language, that the signer intends to be legally bound.”

3. Under the New York method, a tenant’s gross rent is computed by increasing the actual space occupied by a factor reflecting both the common areas on the floor to be occupied and a share of the building’s utility space. The Building Owners and Managers Association International (BOMA) method is similar to the New York method but does not include common areas as part of the rentable space. The Washington Board of Realtors (WBR) method of measurement determines rentable space by employing detailed definitions to key terms (e.g., “finish surface,” “building walls,” etc.) used in measuring space.

4. Wilber v. Paine, 1 Ohio 251 (Ohio 1824); Gillespie v. Citizens Bldg. of Cleveland, 16 Ohio Supp. 82 (Ohio Com. Pl. 1945).

5. 11 U.S.C. § 365; see Countryman, Executory Contracts in Bankruptcy, 57 Minn. L. Rev. 439 at 460 (1973).

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Did you find this article helpful? Do you think more information like this would help you? More information is available. This material is excerpted from pages 103–110 of The Commercial Real Estate Practice Manual with Forms, 2009, by James P. McAndrews, published by the American Bar Association Solo, Small Firm & General Practice Division. Copyright © 2009 by the American Bar Association. Reprinted with permission. All rights reserved. This information or any or portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. GP/Solo members can click here to purchase this book at a discount.

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