This article sets out certain key provisions in a commercial office lease that are and should be negotiable, explains both the ramifications of the typical provisions and workable alternatives to those provisions, and identifies key tenant rights that should be added or addressed.
In a commercial lease negotiation, the landlord’s counsel will supply the initial draft of the lease, which will usually be very landlord friendly. For instance, counsel will find that there will be no concept of landlord default and few provisions, if any, imposing obligations upon the landlord. The lease document will obligate the tenant to pay rent, come hell or high water, often specifically without exception for any failure of the landlord to perform. Any relief for events of force majeure will be entirely one-sided and will never excuse the tenant’s payment of rent, but will excuse any performance by the landlord. Even the failure of the landlord to deliver the premises on time or in the agreed-upon condition (which the lease often states as being “as-is”) or the failure of the landlord to provide essential services, utilities, or access often will not trigger any rights for the tenant. Commonly, the lease document will be lengthy and will contain numerous provisions for the benefit of the landlord. In representing a commercial tenant, the attorney’s task as tenant’s counsel is often to figure out what is missing from that document, including landlord obligations and tenant remedies, and to confirm that all of the terms of the letter of intent have been included.
Counsel should not consider the commercial lease document to be a contract of adhesion. A commercial lease is negotiable. All provisions should be considered mere starting points, and counsel will want to negotiate more even-handed provisions for the benefit of its tenant client. In the current economic environment, a landlord’s counsel can no longer insist on inequitable provisions merely because the landlord “has never agreed to” anything else or because this is the landlord’s “form of lease.”
The negotiation of a commercial lease generally begins with a letter of intent (LOI) between the landlord and tenant, which is often drafted by the brokers for the parties. Although the LOI will provide that it is nonbinding, the parties will find themselves bound by any business terms set forth in the letter of intent, and any matters that the attorney’s client feels are essential to the transaction should be addressed in the letter of intent. Counsel should review the letter of intent for its client and discuss the terms with the client before it is executed. This is the time to address the client’s specific needs, such as timing of delivery, any specific requirements (such as electrical capacity, supplemental air conditioning, space-sharing arrangements with affiliates or “friends of the company,” and required amenities), and establishing all of the financial terms of the transaction.
The date of delivery of the premises is often a critical concern for both the landlord and the tenant. The landlord typically seeks the delivery of the premises to occur as early as possible so that rent will commence. The tenant may not want the delivery to occur earlier than the date on which the tenant needs the space (including to begin its build-out, if applicable). Certainly, the tenant will not want any longer overlap in the lease terms than is necessary and will not want to be paying rent in two leased spaces at the same time. On the other hand, the tenant may require the delivery by a specific date to avoid a holdover situation at its current location.
The landlord’s lease document may provide that the term of the lease will commence on a date certain, or on the date on which the landlord delivers the premises to the tenant, and often in its then “as-is” condition, thereby affording the landlord the option to deliver the space to the tenant when it suits the landlord. The lease should contain clear deadlines for the delivery of the space and should specify in detail the “delivery condition” in which the landlord must deliver the space. Although the lease may state the delivery condition is “as-is,” there are usually certain criteria that must be met for the delivery to take place.
For example, not only does the landlord’s work need to be substantially completed, but also the premises and building should be in compliance with all laws as of the commencement date (including the Americans with Disabilities Act and environmental laws), all permits and certificates of occupancy should be issued so the tenant can take immediate occupancy and start its business operations, and all systems should be in good working order. The delivery of the premises (i.e., the commencement date) should occur only after all the conditions are met. Furthermore, the lease must provide remedies or penalties for the landlord’s failure to perform in this regard.
Feasible meaningful remedies include affording the tenant an additional abatement under the terms of the lease (that is, an abatement that runs consecutively with the market abatement that tenants typically receive at the beginning of any lease term), usually on a day-for-day basis, for the duration of any delay. Any trigger of the commencement of the lease term, which often ties in to triggering the commencement of the obligation to pay rent, also should be tied to the date upon which the landlord actually delivers to the tenant possession of the premises free and clear of any other occupancies, and in the required condition, rather than being tied to any anticipated delivery date or other fixed date; note that the effect of this edit will effectively push both the commencement date and the expiration date of the lease, effectively shifting the term of the lease. Depending upon the timing constraints of the client, the tenant also may need the right to terminate the lease if the foregoing delivery conditions are sufficiently late in being met.
In commercial office leases where the tenant is constructing its own space, the tenant will be afforded an allowance, a “tenant improvement allowance,” which will be funded by the landlord or its lender, to pay for the hard and soft costs of this construction, as well as for certain expenses for furniture, fixtures, equipment, and even moving expenses. The tenant will be required to allocate a large portion of the allowance to the costs of construction to ensure the funds are spent primarily to improve the space.
The allowance should be funded monthly, as the construction work progresses, subject to the tenant’s compliance with requirements typical in the funding of any construction process, including the submission of itemized draw requests and lien waivers. The tenant should be permitted, at its election, to direct the payment of these amounts directly to its general contractor, rather than either having to receive the funds and then advance them to its contractor or, worse, having to pay the contractor and then seek reimbursement from the landlord.
The tenant should have the right to use a portion of the allowance—perhaps up to 20 percent or 30 percent—for items such as furniture, fixtures, equipment, and moving expenses. The lease often will provide that the tenant is not entitled to the allowance if the tenant is in default. Understand that the cost of this allowance is one of the metrics used in calculating the rent, and an amount for the amortization of the tenant improvement allowance has been used to calculate and increase the base rent payable, such that the tenant effectively pays the landlord back for the allowance through the payment of its base rent over the term of the lease, in much the same way one pays a mortgage.
If the lease is terminated because of a tenant default, the allowance paid would constitute a measure of the landlord’s damages. Otherwise, if the tenant defaults, and the default is cured or waived and the lease continues, the tenant, through its base rent, will continue making payments that include an amount to reimburse the landlord for the allowance. Therefore, forfeiture of the allowance because of a minor default is inequitable and results in a windfall to the landlord.
In contrast, the landlord has a valid objection to funding an allowance to a tenant while that tenant is in default. A workable compromise is to have the landlord’s obligation to fund the allowance toll during any tenant default, resuming when the default has been remedied. Separately, the tenant should have a stated remedy for the landlord’s failure to fund the allowance.
Typical lease language will obligate the tenant to pay rent in full, without offset or deduction for any reason. Accordingly, counsel will need to add an express right in the lease for the tenant to offset any due and unpaid allowance against rent payable, with interest accruing on the unpaid amount until paid in full. Given that a typical lease structure will provide for the abatement of rent at the beginning of the lease term—often for a year or more—it should be noted that it will take a considerable amount of time for a tenant to recoup the tenant improvement allowance through the offset of its rent.
Recognize that the right to offset the allowance against rent is a meaningful remedy for the client only if the client has sufficient liquidity to fund its construction costs out of pocket, which may not be the case. If the landlord’s failure to fund the tenant improvement allowance in a timely manner would be a material hardship for the client, counsel should consider having the landlord’s parent company provide a guaranty for the funding obligation or having the funds escrowed. We also advise making sure the client’s landlord’s lender recognizes these rights under a subordination, nondisturbance, and attornment agreement, as discussed further below.
As mentioned above, the tenant improvement allowance is typically expressed as a fixed amount payable by the landlord per square foot of the premises. It is the maximum amount of money the landlord will pay for the tenant to improve the space. For example, if the commercial space is 15,000 square feet and the allowance is $25 per square foot, the landlord has agreed to reimburse the tenant up to $375,000 for the construction work.
The landlord may require the improvements to be completed by a certain date, usually a number of months from the commencement date, and the tenant’s request for reimbursement along with all documentation to be submitted within a certain time period, usually between nine and 12 months from the construction completion date. Keep in mind that certain events can delay the completion of the construction or the request for reimbursement, thereby risking the tenant’s ability to receive the full tenant improvement allowance. The period within which the client should be allowed to submit requests for reimbursement should be subject to extension for force majeure.
A typical office lease will initially provide for the commencement of rent either upon a date certain, which is often presumed by the parties to be the date on which the landlord will have delivered the premises to the tenant, or a date that is some specified period after that delivery date. The problem with this construct is that it is often the case that the landlord will not deliver on the specified date, and the typical landlord’s form lease will not provide any relief for the tenant in this regard.
The authors recommend that the rent commencement date be tied to the date upon which the premises are delivered to the tenant in the required condition. Market terms will dictate that a commercial tenant will be afforded a lengthy rent abatement period, often structured as a period commencing after the commencement date, which, as discussed, should be either the date on which the landlord delivers the premises to the tenant in the required condition or a later date, after the period afforded to the tenant to complete its build-out of its space.
In the current economic market, office tenants are often afforded an abatement of one to two years of fixed rent and of the obligation to pay pass-throughs for operating expenses and real estate taxes, depending upon the lease term and local market conditions. This period during which no rent is payable, notwithstanding that the obligation to pay rent under the lease has otherwise commenced, is called the “abatement period.” The landlord will often condition the tenant’s right to this abatement on the tenant’s not being in default during the abatement period or, worse and more rarely, will try to give itself the ability to recapture the abated rent if the tenant defaults at any point during the lease term.
As with the tenant improvement allowance, discussed above, the fixed or “base” rent payable by the tenant is calculated assuming the abatement to which the tenant is entitled is pursuant to the terms of the lease; that is, the landlord has calculated the economic benefit of the lease assuming only the rent (and pass-throughs) that is payable by the tenant, assuming that no rent will be paid during the abatement period (and, similarly, your client will have built this abatement period into its fiscal calculations).
Assume first that the tenant defaults. Assume further that the default is ultimately cured and the term of the lease continued. Finally, assume that the landlord was in that instance to avail itself of some right to withhold the abatement. Under that set of facts, the landlord would receive a windfall by receiving more rent over the term of the lease than the rent bargained for. Of course, if the tenant were to default and the landlord instead were to terminate the lease because of the default, the landlord would have a claim for recoupment of any unrecovered inducements, such as rental abatements and tenant improvement allowances. As with the tenant improvement allowance, discussed above, a more equitable remedy for the tenant’s default is for the tenant’s right to the abatement to toll if the tenant defaults during the abatement period. If the tenant defaults later in the term, and as a result the landlord terminates the lease, then the landlord should only be entitled to recoup (as to the abatement) the then-unamortized portion of the abatement as of such termination.
Given that the landlord will have certain delivery and construction obligations, it may wish to protect itself by giving itself the right to claim the excuse of force majeure. To the extent that the client will be relying upon the delivery of the premises by a certain date, the landlord’s ability to claim relief from performance due to force majeure should be limited, and counsel should consider whether, given the timing the landlord has agreed to with regard to the delivery of the premises (which often includes a great deal of temporal cushion), the landlord should be able to avail itself of the excuse of force majeure at all. Certainly, the excuse of force majeure should not apply to the financial obligations of either party. A sample provision follows:
If either party is delayed or prevented from performing any obligation hereunder due to any cause beyond such party’s reasonable control, including, without limit, fire, weather, act of God, governmental act or failure to act, strike, labor dispute, inability to procure materials, supply chain interruptions, or pandemic or other health emergency (such delay, a “Force Majeure Delay”), then the time for performance of such obligation shall be excused for the period of such delay or prevention and extended for a period equal to the period of such delay or prevention, provided that the party claiming such permitted delay promptly notifies the other of such delay and provided, further, that any delay deemed a Force Majeure Delay hereunder shall be subject to a cap of sixty (60) days, except for any delay due to permitting, so long as the party claiming such permitting delay shall have timely submitted, and thereafter diligently pursued, all applications with respect thereto. No Force Majeure Delay shall (i) extend the deadlines for Landlord’s delivery of the Premises in the delivery condition or the deadlines for restoration of the Building in connection with any casualty, (ii) extend the date by which the tenant is required to surrender the Premises upon the expiration of the term of this Lease, or (iii) excuse the timely payment of any amounts payable by Landlord or Tenant hereunder.
A full-service office lease typically will provide that in addition to paying base (or fixed) rent, the tenant will pay the landlord pass-throughs for operating expenses and real estate taxes, often above the amounts incurred by the landlord for such amounts in a “base year,” which is a specified calendar year, often the first full calendar year during the term. As with the tenant improvement allowance, as a part of the economics of the deal, the landlord will have estimated the operating expenses and real estate taxes for the base year and included that amount in its calculation of base rent. To help protect against fluctuations in operating expenses and real estate taxes based upon fluctuations in occupancy, the lease should provide that these amounts will be “grossed up” both for the base year and for each comparison year, which methodology provides a mechanism for fairly modifying the included amounts to account for vacancies.
Simply put, if the property is not fully occupied in the base year, expenses that fluctuate with occupancy (such as janitorial expenses and utilities but not, for instance, insurance) will be increased to the amount that they would have been had the building been fully occupied. This mechanism should burden the landlord, rather than the tenant, with the portion of any expenses that do not fluctuate with occupancy that are allocable to unleased portions of the building, yet allow the landlord to divide the costs that rightfully fluctuate with occupancy among only those tenants leasing space in the building. Although the lease should be grossed up based on 100 percent occupancy, the parties typically agree to a 95 percent gross-up, recognizing that there is usually some vacancy in the building.
The attorney also will want to negotiate limits on the types of expenses that can be passed through to the tenant. For instance, the landlord’s ability to pass through items such as capital expenditures should be limited to new laws enacted after the commencement date, capital expenditures that will reduce operating expenses (not to exceed the amount of the savings), and amounts amortized over the useful life of the improvements, and the landlord should be prohibited from passing through costs of compliance with legal requirements that were in effect prior to the lease term, because to permit the landlord to pass along those costs would be tantamount to requiring the tenants to pay for the cost of constructing and retrofitting the building.
Similarly, certain costs, such as ground lease payments and financing costs (including debt service), costs incurred by the landlord for buildout of tenant space, tenant improvement allowances, and brokerage commissions, as well as costs incurred by the landlord in completing the construction of amenity space, should be excluded altogether and borne entirely by the landlord. Other customary exclusions to limit the expenses passed on to the client would include any repairs and restoration covered by insurance (excluding the deductible), income and franchise taxes of the landlord, financing costs (including interest and depreciation), salaries and fringe benefits of any personnel above the level of building manager, any cost that would be the responsibility of an individual tenant, and management fees above a market cap (customary caps range from three to five percent of gross rents).
The client may wish to negotiate the right to terminate the lease before the expiration of the term. These rights are typically granted only (i) as of a date certain (such as at the beginning of the eighth lease year), (ii) upon significant advanced notice (such as one year’s notice), and (iii) upon payment to the landlord of the landlord’s then-unamortized expenses incurred in securing the lease, such as the tenant improvement allowance, brokerage commissions, and legal fees.
Although the abatement discussed above is an inducement or landlord expense, the sum of the abatement should not be included in this calculation if the unamortized portion of these expenses is calculated over the portion of the term that has lapsed exclusive of the abatement period. The termination payment will not be minimal, but it should be less than the rent that otherwise would be payable for the remainder of the term, and the availability of this option will afford the client more flexibility if it later determines that it needs to relocate for any number of reasons.
The real estate industry is experiencing what many have touted as a “flight to amenities,” in both the commercial and residential (multifamily) markets. These amenities can include anything from rooftop features such as decks and conference centers to fitness facilities, bike storage facilities, cafés, and courtyards. Counsel should ensure the lease includes a covenant for the landlord to provide those amenities (that are important to the client) throughout the term of the lease, including that the amenities continue to be, for instance, located on the roof of the building (rather than being relocated to a basement or “mezzanine” or “concourse” level) and that they continue to generally be at least of a quality commensurate with that either promised or existing at the commencement of the lease term.
It is not uncommon for a landlord to market a building as having amenities that do not yet exist, intending to construct those amenities later with available rents or loan proceeds, or intending to construct those amenities once there is a sufficient tenant population in the building to warrant the expenditure. Counsel should obligate the landlord to construct these amenities, including specifying the date by which such construction should be completed. Akin to remedies for the landlord’s failure to timely deliver the premises, as discussed above, counsel should include remedies, such as rent abatement, if the landlord does not meet its obligations in this regard. As discussed above, the cost of completing these amenities should not be passed along to the tenant as operating expenses.
The lease should obligate the landlord to maintain the building throughout the term commensurate with an appropriate standard, such as that of Class A office buildings in the central business district of the applicable city or metropolitan area. The generality of this requirement may help protect against unforeseen changes in the operational protocols for the building. As with amenities, if there are criteria that are important to your client, such as ensuring that the landlord provides janitorial services after a certain hour or that the building be patrolled by one or more security guards, you should add these particular requirements.
The landlord should generally be responsible for ensuring that the building, as well as all structural elements, common areas, base building systems, and life safety systems, are in compliance with applicable laws in effect from time to time. There may be legitimate exceptions to this rule, such as compliance that is triggered only by something unique to the client as a user, rather than something applicable to commercial office tenants generally. For instance, if the client has a particularly dense occupancy profile, applicable regulations might mandate additional restrooms to serve those occupants, the cost of which might rightfully fall upon the tenant.
A typical lease will contain an express waiver of any liability for any interruption in services or utilities. Although the tenant can protect itself to some extent through insurance, such as business interruption insurance, the landlord also has rent insurance protection, and it is important for the lease to contain incentives for the landlord to actively seek to avoid permitting any such interruption. A workable incentive is to provide for the abatement of the tenant’s rent for any interruption that continues beyond a minimum period, which abatement often will be conditioned upon the tenant not using the space during that period. Larger tenants may insist upon the right to terminate a lease for interruptions that continue for an unreasonably long period.
As a general rule, the client’s rights as a tenant will be subordinate to the lien rights of any mortgagee of record before the date of the lease. A typical lease also will provide for the subordination of the rights of the tenant under the lease to the lien rights of future mortgagees. The ability to negotiate favorable terms requiring a mortgagee to recognize the rights of the tenant will depend on the size of the tenant and the lease term, with larger tenants having the leverage to require the mortgagee to recognize rights such as setoffs, self-help, and other tenant-negotiated provisions. The full negotiation of subordination, nondisturbance, and attornment rights as between tenants and the landlord’s mortgagees is beyond the scope of this article, but suffice it to say that in the current economic environment, one should be mindful of the ramifications of a foreclosure or other transfer of the property for then-client’s rights.
To the extent feasible, counsel should be sure that any subordination of the lease is only to the lien of the mortgage, rather than to the terms, conditions, and operation of the mortgage (as a contract), and that the tenant is granted the right to have its tenancy remain undisturbed, notwithstanding a foreclosure or similar action, so long as the tenant is not in default.
The tenant’s focus in the early lease negotiations is typically on the buildout and delivery date, and rarely does it consider the need for an exit strategy during the lease term. Unless an early termination right is negotiated into the lease form, as discussed above, most leases will not have a mechanism for permitting the tenant to terminate the lease before the expiration of the term; accordingly, the tenant may look to either assign the lease or sublet the premises as an exit strategy. As the trend of employees working from home persists, more and more tenants are seeking to reduce their office space, which may mean subletting a portion of their space or relocating to smaller premises.
A typical office lease will contain limited, if any, rights for the tenant to transfer the lease or sublet the premises, and any right to transfer will be subject to restrictions and conditions. It is important to understand the differences between assigning and subletting. Under an assignment, the original tenant transfers all of its interest in the lease to a new tenant (i.e., assignee) but usually is not released from the lease obligations. The assignee assumes all of the lease obligations, usually from and after the date of the assignment. The assignee will have a direct contractual relationship with the landlord. If the assignee were to default under the lease, the landlord would be able to exercise its remedies against the assignee, or the tenant, or both. Because the tenant no longer retains any rights under the lease, it cannot exercise the lease remedies against the assignee, nor can it terminate the assignment or evict the assignee.
Under a sublease, the original tenant (i.e., sublandlord) transfers its interest in all or a portion of the premises, but not its interest in the lease. The tenant remains liable to the landlord, and the subtenant takes its rights of possession from the tenant without any privity of contract with the landlord. The subtenant communicates directly with the tenant on all matters relating to the subleased premises. The economic terms and rights in a sublease can vary from the lease. In this structure, the tenant continues to pay its rent to the landlord, and unlike in the assignment, if the subtenant defaults, the tenant can exercise remedies against the subtenant, including taking back possession of the premises.
At the commencement of the lease term, the client may not know what may be needed during the term; therefore, it is important to negotiate flexibility in the assignment and sublet provisions. Standard assignment and subletting provisions will favor the landlord and will require the landlord’s consent to a transfer, which may include assignments by operation of law (e.g., by court order, statute, etc.), transfers of the majority of the tenant’s corporate stock, and changes of control of the tenant. Although the landlord’s consent will be required, the lease should provide that the landlord’s consent shall not be unreasonably withheld, conditioned, or delayed.
Note that if no requirement of reasonableness is imposed, most state laws will not otherwise impose upon the landlord the obligation to be reasonable. If the landlord agrees to be reasonable, it often will want to include a list of criteria for consent that it may impose without being deemed to be unreasonable. One such requirement often involves the financial wherewithal of the proposed assignee or subtenant; this standard should be tied to the economics of the lease, and not merely by comparison to the financial wherewithal of the tenant. For instance, if the tenant were a multimillion-dollar company leasing only a small office, then the demand for the new tenant to meet or exceed the original tenant’s net worth would not be reasonable. In this instance, it would be more appropriate to have the criterion tied to the rent, such as requiring that the new tenant have a net worth of at least five or 10 times the annual rent.
The lease should specify the timing within which the landlord must respond to any such request for consent. The landlord may insist on having to recapture the space, rather than consenting.
Notwithstanding the restrictions discussed above, certain transfers should be permitted as of right and not be subject to the landlord’s consent or recapture. “Permitted transfers” would include transfers by merger, consolidation, or a sale of substantially all the tenant’s assets. Although these transfers may be permitted, the resulting tenant may need to evidence a financial net worth at least equal to or greater than the net worth of the original tenant. Other transfers that should be recognized as of right by a tenant are IPOs, the sale of stock on a recognized stock exchange, and transfers to affiliates. The client may want the right to allow “desk sharing” or to license a portion of the space without the landlord’s consent.
Further, landlords often prohibit transfers to an existing tenant in the building, as they do not want competition in leasing space to an existing tenant. Any such limitation should apply only so long as there is comparable space available in the building within the next few months. The foregoing are only a few of the exclusions that a landlord may impose. Each restriction or condition placed on the tenant’s right to assign or sublet should be considered in the context of the specific transaction and negotiated to give the client flexibility to exit the lease.
The goal of this article is to help attorneys to identify the types of scenarios that will need to be addressed to adequately represent a commercial office tenant in a lease negotiation; certainly, it is not comprehensive. For more assistance on these topics, please feel free to reach out to the authors at [email protected] and [email protected].
