June 29, 2017

Representing the Landlord in Commercial Lease Negotiations and Disputes

This article provides a brief overview of commercial leasing from the landlord’s attorney’s perspective. Our goal is to introduce and survey significant and common aspects of leases prevalent among all properties, locales, and tenant businesses. One could easily devote entire articles to each topic and subsection below. Similarly, variations among the leasing of offices, stores, or warehouses, between urban and suburban locales, and among assorted tenant businesses can each be delved into more deeply as stand-alone topics of discussion. We provide here a brief introductory overview of commercial leasing.

General Considerations

Prior to drafting the lease, an in-depth understanding of the client’s property, as well as the tenant’s business, is crucial because each directly impacts the lease. For example, restaurants’ or dental offices’ utility needs may be significantly greater than those of retail stores or business offices. Suburban office parks may assign parking spaces that city office towers lack. Office buildings’ electrical capacity may be inadequate to sustain manufacturing uses.

Landlords are generally guided by several core principles that are at the heart of every lease negotiation. These include receiving ongoing returns on investments in their property; ensuring the structural integrity and safety of the property and its systems; managing the property’s use and by whom it is used; maintaining the property’s character; and having tenants bear as much risk and responsibility as possible in connection with their occupancies. Landlord-side leases are designed to embody these principles.

Ideally, the attorney’s approach in the negotiation and drafting process is to produce comprehensive leases while being as efficient as possible in negotiations and building or improving positive working relationships between the parties. At the same time, understanding landlord-client perspectives in detail and protecting clients’ most significant concerns is paramount.

Essential Lease Terms

Depending on the type of property, locale, lease value, and nature of the tenant, lease terms will vary. However, clauses addressing each of the following terms should be found in virtually every lease:

Description of the premises. Specify exactly what space the tenant will occupy. This can be done with a measurement of square footage, a suite or store number, a diagram, or preferably some combination of these. A precise description of the leased space clarifies tenant obligations and often impacts the tenant’s share of expenses that the landlord will recoup.

Use. Define the tenant’s permitted use of the premises narrowly in most cases other than general office use. Landlords want to retain control over their property by defining tenants’ permitted business activities clearly. This prevents undue stress on the building’s systems and overcrowding the property, ensures that tenants’ businesses remain compatible with the building’s character, and, in retail settings, prevents undue competition with neighboring tenants.

Base rent. Calculate base rent as a set price, often valued on a per-square-foot basis, with a fixed annual percentage increase, thus allowing landlords to realize returns on their investments. Shopping mall owners may choose to calculate rent as percentages of tenant revenues in order to maximize their returns on investment in implementing retail strategies that drive customers to each store.

Additional rents. Shift maintenance cost burdens by recouping operating costs from tenants. Additional rents fall into two categories. First are landlord ownership and maintenance costs, including among others, common area utility costs, property insurance, real estate taxes, and compensation costs for building personnel, security, and workpeople. Landlords typically divide each property based on the amount of space occupied by each tenant, and each tenant pays its share of these carrying costs. Often, the initial year’s proportionate share is factored into the base rent, and the tenants’ shares of the increase above that are paid in subsequent years.

The second category covers tenant-specific expenses incurred by landlords, including any utilities landlords provide for specific tenant spaces and expenses landlords incur as direct results of each tenant’s occupancy. In any lease, it is essential to provide that all payments tenants owe their landlords other than base rent are deemed additional rent, and that landlords retain all remedies available against tenants for nonpayment of additional rent as for base rent.

Security deposits, letters of credit, and guarantees. Require tenants to deposit funds to be held throughout the lease term to protect against costs arising from tenant defaults that may arise, and have a principal or corporate parent guarantee the tenant’s rent payments. Security deposits must be replenished if drawn upon. Both devices shift the financial risk of tenant defaults away from the landlord and onto the tenant.

Depending on the situation, standby letters of credit may be preferable to cash security deposits. These instruments provide bank guarantees for tenant financial obligations. Upon a landlord’s presentment of a demand to the issuing bank, in accordance with the terms of the letter of credit, the bank promptly renders payment to the landlord without tenant involvement. One advantage of using letters of credit is to avoid the loss of cash security in the event of a tenant bankruptcy. The specific language of a letter of credit is negotiable with the issuing bank, and the landlord’s attorney should always insist on eliminating any language in the letter of credit requiring the landlord to specify the nature of any default, or any notice to the tenant, when drawing on the letter of credit.

Guarantees provide landlords with secondary payment sources in the event tenants fail to pay. These come in a variety of forms ranging from the full personal guaranty that tenant principals provide, which guarantees all rents and lease obligations and is unlimited as to scope and duration; to good-guy guarantees that guarantee the rents and whatever other financial obligations landlords require, through the date the tenant vacates the premises. Landlords will demand different types of guarantees for different types of tenants, spaces, and business climates. A similar guaranty from a corporate parent is also important in situations where a subsidiary entity is formed for the sole purpose of holding the lease.

Repairs. Insist that tenants repair any damage that arises to the property as a result of their use, but restrict tenants from altering structural elements of the property or building systems in the process. Such requirements shift some maintenance burdens to tenants while simultaneously enabling landlords to control core aspects of their property. To the extent possible, where repairs require contact with structural elements or building systems, reserve landlords’ right to perform repairs, and require tenants to reimburse landlords’ costs for doing so.

Alterations. Ensure that any physical changes the tenants make are structurally sound, do not damage the property or conflict with its general character, and comply with all applicable laws in terms of use and construction process. Landlords maintain control over changes made to the property by requiring that tenants request permission to make alterations. Tenants must present detailed plans for any proposed work and obtain landlord approval of tenant contractors. Tenants retain responsibility to obtain all governmental permits required for alterations and to ensure that all open permits are properly approved and closed. Tenants must also bear the risk of adequately insuring the work and promptly bonding or discharging mechanics’ liens arising from it. Landlords also may retain control by determining when work can be performed, thereby minimizing interference with other tenants’ activities.

Insurance. Require tenants to indemnify landlords against any and all losses arising from tenant acts or omissions during the entire lease term, and obligate tenants to carry adequate insurance. Insurance coverages vary substantially, and landlord risk management departments or insurance agents must be consulted as to which specific coverages landlords should require tenants to maintain. Generally, tenants should be required to carry commercial general liability insurance, commercial property coverage, and workers’ compensation (depending on state law). Landlords must be named and maintained annually as additional insureds or loss payees on tenant policies, as applicable. The nature and location of the property and tenant business will factor into determining the appropriate policy limits and coverage lines.

Casualty. Should a casualty preclude use of the premises, prevent tenants from canceling their leases but permit landlords to cancel if the property will not be restored to its pre-casualty use. Upon destruction of the premises, most leases suspend tenant obligations to pay rent. However, landlords must retain the ability to choose between continuing the leases if casualty damage is repaired or discontinuing the lease at no cost if a better opportunity comes along for the space and the property will not be restored to its former use. This protects landlord investment by preventing occupancy gaps on the one hand while affording flexibility to repurpose the property, if desirable.

Eminent domain. Reserve condemnation awards for landlords only. Mechanics of eminent domain proceedings are beyond the scope of this article. However, note that the landlord is losing its property while the tenant will have an ability to reestablish itself elsewhere without the financial obligations of its current lease. Thus, landlords should not be obligated to partner with their tenants in such situations and lose any portion of condemnation award proceeds.

Assignment and subleasing. Require landlord consent to any lease assignments or subleases; enable landlords to increase the rent and security deposit upon doing so; and where applicable, secure for landlords a share in the benefit of tenants’ bargain for minimizing or eliminating their lease obligations. This enables landlords to continue controlling use of their property and by whom it is occupied, benefit from changing market and business conditions as tenants benefit, and hedge against losing the opportunity to benefit from increased rents. Because the law generally disfavors restraints on alienation of real estate, absolute prohibitions on assignment or subleasing are often difficult to enforce. However, nothing prevents landlords from requiring the right to approve assignments or subleases. Other than assignments incident to tenant mergers or acquisitions, when tenants assign or sublease, landlords often lose the benefits of their initial bargains for the space. Leases should require landlord approval of all proposed assignees’ or subtenants’ financial conditions and natures of their business. Because assignments and subleases diminish landlord control over selecting tenants, leases will often enable landlords to raise rents to prevailing market rates upon landlord approval of the transfers.

Surrender of premises. Require tenants to surrender the premises, and do so in the conditions in which they were received. Surrender occurs at the end of the lease term, whether as fixed in the lease or earlier based on the tenant’s default or a termination right exercisable by either party. This often-overlooked obligation both protects landlord investment by empowering landlords to re-rent their spaces at prevailing rates and also allocates restoration burdens to outgoing tenants. Exceptions exist for tenant-installed alterations that add value to the property, such as a restaurant kitchen designed to fit a particular space or new wall display system for a retail space.

Conclusion

Our overview is a basic primer on the landlord attorney’s view of fundamental lease clauses, and it is by no means an exhaustive analysis. Given the variables and complexities involved, drafting and negotiating commercial leases should always account for the particular nuances of each situation. Although the ultimate goal of representing parties to transactions is to close each deal, understanding how landlord perspectives affect basic lease terms is critical to effectively protecting landlord interests and achieving landlord objectives.