Negotiating Commercial Leases
By David Weisman, Esq.
Board Certified Real Estate Lawyer
Relationships between contracting parties must be carefully created so that when difficulties arise, resolutions will be simple
A “lease” is defined by Black’s Law Dictionary as a “contract for exclusive possession of lands or tenements for determinate period!’ An older definition appears as: “A contract in writing, under seal, whereby a person having a legal estate in hereditaments, corporeal or incorporeal, conveys a portion of his interest to another, in consideration of a certain, annual rent or render, or other recompense.” While the latter definition is somewhat antiquated, it is a reminder that a lease transfers an interest in real property to another, which is more than a simple contract. Therefore, the negotiations of the terms and conditions of a lease should not be taken lightly.
More importantly than the textbook definitions, the lease is a device which is used to transfer ownership and control of property to another, and creates a relationship between the contracting parties that will continue for a term of years. That term varies, but the minimum term of a commercial lease is from three to five years, and more often leases today are longer. Through the use of renewal options, a lease term can extend for 20 years or more. Thus, the relationship must be carefully created so that when difficulties arise, the resolution of that difficulty will be simple.
An article in the Journal is too brief to discuss all of the intricacies of commercial lease provisions, but a few Important concepts are set forth here as a guide to the general practitioner.
The most basic fact to determine before the negotiation starts, is the identity of the parties. One must be wary of trade names, such as Main Street Associates. Entities shown at the heading of the lease must actually exist. It is important to verify the ownership of the property and the authority of the persons negotiating and signing the lease.
Each party must beware of a “shell corporation” formed only last week for the sole purpose of entering into the lease. The landlord must be certain that the tenant has the financial ability to make the lease payments. Since many new businesses are started with minimal capitalization, a landlord can protect itself by requesting a personal guarantee from individuals involved in the venture. Principals of the tenant will resist the personal guarantee because they are only willing to risk a certain amount of capital. As a compromise, a limited guarantee can be negotiated, such as rent for the first year of the lease or a dollar amount which will accomplish the purposes of both parties.
An attorney must be certain that the person who negotiates the lease has the authority to do so. Many landlords today are using leasing agents, some of whom may be lawyers who were smart enough to get out of the day-to-day practice of law. These agents may not have the authority to bind the landlord. Certain key points of the deal, especially rent agreements, may not have been properly documented or communicated.
While it may seem straight-forward, another important task is defining the “premises”. In a retail or office lease, it is not uncommon for the landlord to use a “load factor,” an amount by which the useable square footage is multiplied in order to arrive at rentable square footage. This procedure allows the landlord to collect rent for the common areas of the building which are not demised to any specific tenant.
In a lease of an entire building, the definition of the demised premises focuses more on the area surrounding the building than the number of square feet within the building. In a setting such as an office park or warehouse complex, the tenant must be certain that the demised premises include a sufficient amount of parking, ingress, and egress so that the tenant will be able to reach its space.
Once the who and the what have been determined, the focus shifts to when the lease begins. The commencement of the lease term is not the same as the commencement of the obligation of the tenant to pay rent. Most commercial leases provide for a rent abatement period so that the tenant can improve the space or have time for the business to begin producing revenue. The lease should commence immediately upon the tenant being granted any rights to enter the premises, so that the contractual provisions regarding insurance, indemnity, and other rights and obligations of the parties take effect. If the space is available at the time the lease is executed, the commencement date can be easily ascertained. If the project is under construction, then the commencement date should be defined by an external event, such as the issuance of a certificate of occupancy. However, the commencement of the lease should be acknowledged in writing, to provide an ascertainable commencement of the lease, and make the computations of the termination date, the end of the rent abatement, and the right to exercise options free from argument in the future.
Following the who, what, and when is the how (much). The rent is the heart of the business negotiation. Determining the base rent is a relatively simple function of the market—where the property is located, and the success of the project. The factors which are open to negotiation are rent abatement, rent increases, and additional rental charges.
Almost every commercial lease negotiation results in the landlord giving a period of free or reduced rent. Besides being a financial incentive for the tenant to sign the lease, this gives a new business a start-up period which may be necessary in order for the business to get on its feet and become successful. Rent abatements from six to 12 months are not uncommon, and these allowances are often granted in addition to contributions for tenant improvements. The amounts of each are entirely dependent upon market conditions at any given time.
Rent abatements can be structured in several ways. The most common way is for the tenant not to pay any rent for the first six months of the lease. This structure benefits the tenant, but may place a financial burden on the landlord by limiting cash flow. A better way for the landlord to structure the rent abatement is to double the length of time and cut the abatement amount in half; that is, require the tenant to pay 50% of the rent for 12 months, rather than no rent for six months. This gives the landlord some cash flow to make mortgage payments or meet other expenses, and it gives the tenant the desired reduced operating costs for the initial period of his or her business.
What rent is abated? It may seem fairly simple to say that the tenant will be entitled to free rent for a period of six to 12 months, but to the tenant this may mean that no payments whatsoever are due during the abatement period. The landlord, conversely, may be of the opinion that the rent abatement applies only to base minimum rent, the flat dollar amount which is payable for the use of the demised premises. Most commercial leases today contain provisions for payment of real estate taxes, insurance, and common area maintenance. Are these items being abated together with base minimum rent? This must be considered, both in the financial negotiation and in examining the clauses which deal with a rent abatement in the event of condemnation or destruction of the premises.
Besides base minimum rent, the landlord’s revenue can be increased by “additional rent.” The most common add-on is found in the retail lease: percentage rent. This clause provides that the tenant will pay to landlord a stated percentage of the tenant’s gross sales, once the tenant has reached a minimum sales level. If this is required, the tenant should be certain that the break-even point for the payment of this percentage rent is at least as much as the base minimum rent, and that this is adjusted if there are any adjustments in the amount of base minimum rent, such as a consumer price index adjustment.
Another type of additional rent is “common area maintenance,” the landlord’s carte blanche for recovering whatever expenses may be incurred in the operation of the property. The tenant should be cautious to except capital improvements or repairs to premises which belong exclusively to any one tenant.
Base rent is also subject to adjustment. Even in a short-term lease, absent an unusual circumstance such as a near-empty building, a tenant cannot expect the rent to remain fixed for several years. The rent can be adjusted either based upon an ascertainable index such as the consumer price index, or based upon a flat annual increase which is negotiated at the outset of the lease. If the consumer price index is used, the tenant will argue that the annual increases should be capped at a reasonable percentage, and the landlord will argue that a minimum increase should be allowed. Each of these propositions is reasonable from the perspective of the different parties, but the numbers have to be worked out carefully to avoid either the landlord’s property being burdened with a low-yield lease, or the tenant from being driven out of business by exorbitant increases.
After the negotiations have been completed and the parties are happily enjoying the relationship of landlord and tenant, what happens when the tenant receives an offer he cannot refuse: the offer to buy the business and give the tenant the opportunity to retire to a condominium on the beach?
The tenant looks to the lease that was so carefully negotiated and finds that assignment and subletting are not permitted without the prior consent of the landlord. If those are the only words which appear in the lease, the landlord must be “reasonable”. Under current case law, absent additional language granting the landlord the right to be arbitrary and capricious, a landlord must be commercially reasonable in deciding whether to approve a new tenant under an assignment or subletting clause which provides for the landlord to consent. Fernandez v. Vasquez, 397 So.2d 1177 (Fla. 3d DCA 1981). Among the factors which the courts examine in determining commercial reasonableness are the financial strength of the proposed assignee, the proposed assignee’s experience in the business which existed in the premises, or the proposed assignee’s use of the premises. The use to be made of the premises is governed by the use clause, and a careful landlord’s draftsman should not permit too broad a use clause.
Since landlords do not like to be reasonable, if the assignment clause states clearly that the consent will be in landlord’s sole and absolute discretion, or that the landlord shall have the right to withhold consent without providing any explanation whatsoever, or similar language, the landlord then is not bound by the case law and can deal with its property freely.
The tenant may wish to provide for the right to sell the business, and if this is the case, the tenant should negotiate into the initial drafting of the lease a provision which allows for an assignment in connection with the sale of the business, and should provide for certain standards which, if met, mandate the landlord’s consent. An example of such standards would be a net worth figure, financial strength equal or greater than that of the existing tenant, or some similar ascertainable standard.
Should the tenant be permitted to profit from the assignment of the lease? The landlord should consider a provision that the landlord will receive 100% of the consideration for the assignment, if the tenant is not selling the business as a going entity. If the tenant has negotiated a below-market lease, or the tenant has taken advantage of generous improvement allowances and rent abatements, the tenant should not then be in a position to profit from the landlord’s initial negotiations, and the landlord should be entitled to recoup some of that initial investment.
In the case of subletting, the landlord should prohibit the tenant from profiting or competing with the landlord in the real estate business, particularly if the tenant has a below-market lease. Theoretically, the tenant could profit from earlier negotiations by subletting at a profit and depriving the landlord of a tenant for other vacant space at a market rent. The only circumstance where the landlord should be more liberal regarding the subletting is a case in which the tenant’s business is in jeopardy. By allowing the tenant to sublet a portion of the premises, the landlord enables the tenant to remain in business and continue paying rent.
Another financial incentive which a landlord offers a tenant to sign a lease is a tenant-improvement allowance, which allows the tenant to construct or renovate the demised premises prior to taking occupancy. The amount depends on the market conditions, the same as any other financial negotiation. In some markets, it is not uncommon to find the landlord contributing the equivalent of one year of rent to construct the tenant’s improvements.
The landlord’s allowance may not be sufficient to build out the premises to the tenant’s satisfaction, and the tenant must contribute additional funds to complete the improvements. The landlord must be certain that the tenant has sufficient funds to complete the improvements to avoid being left with a partially finished premises that might be more expensive to demolish than the value of the entire tenant improvement allowance. The landlord can be protected by requiring a cash bond or a letter of credit, by relying upon the tenant’s financing commitment from a construction lender who will be providing the dollars to do the construction, or by loaning the money to the tenant and increasing the amount of base minimum rent to amortize (presumably at a market interest rate) the loan. Whatever method is used, a smart landlord will require the tenant’s dollars to go into the construction first. This way, when the tenant runs out of money, the landlord’s improvement allowance can be used to complete the premises.
Who should do the construction? If the tenant is sophisticated, it may choose its own architects and contractors, but all plans and specifications should be subject to the landlord’s approval to be certain that the premises are constructed in accordance with the overall scheme of development, and in a workmanlike manner. In a new construction setting, the landlord has already engaged a contractor who will be building the shell of the building and whose construction personnel are familiar with the premises. It may be wiser for the tenant to use the landlord’s contractor to do the finish work as well as the shell construction. This may avoid an argument over who causes a delay in construction. Subsequent renovations should be subject to the same considerations as the initial improvements.
At the termination of the lease, the tenant improvements should, usually, remain on the premises and become the property of the landlord, who will have an easier time re-letting an improved space than one which is bare and in need of complete renovation prior to occupancy. The alternative is to require the tenant to remove the improvements and alterations at the termination of the lease. The disadvantage to this provision is that the tenant has no incentive to do a thorough job restoring the premises to their “original condition!’ As a compromise, the landlord should reserve an option to decide whether the improvements should be abandoned or removed at the termination of the lease. From the tenant’s perspective, the words “restored to its original condition” should either be avoided entirely or defined as to whether the original condition means the condition of the premises as a shell, or after the original tenant improvements were completed.
It is the best of arrangements: the transfer of the obligations relating to real property in exchange for money, without permanently parting with the ownership of the property. It is the worst of all possible situations: the loss of control of something owned. Leases are a fact of commercial life which, if carefully negotiated and drafted, can be an excellent financial package for both landlord and tenant. Carefully viewed as a long-term relationship, the concept works for everyone; casually done, it is a disaster. This article may be of help as a starting point for successful commercial lease negotiations.