COMMERCIAL LEASE DEFINITIONS PRIMER
Commercial leases contain terms that many people don’t know and definitions would help them. Some commercial leases are the subject of complex, lengthy, and intense negotiations. To be proficient at such negotiations, one must be familiar with certain basic concepts and be able to anticipate and protect one’s client from problems that may occur during the term of the lease. This post addresses definitiions of some of the principal legal and financial terms applicable to commercial leases. The most important legal and financial terms in commercial leases include the following:
Rent, including base rent, percentage rent, increases in rent, taxes, and operating expenses, and rent abatement;
- Renewals or extensions of the lease;
- Security deposits;
- Promotional funds;
- Uplift allowances;
- The condition of the premises;
- Lease term;
- Options to terminate;
- Options to purchase;
- Casualty and condemnation;
- Maintenance and repairs;
- Defaults (landlord as well as tenant);
- Attorneys’ fees;
- Guaranties of lease;
- Assignment and subleasing;
- Americans with Disabilities Act provisions;
- Entry by landlord;
- Environmental issues;
- Anticompetition clauses;
- Landlord limitation of liability;
- Substitution of premises;
- Mandatory remodeling;
- Rights to lease adjacent space;
- Landlord’s lien; and
Rules and regulations of landlord
Charges for office building, warehouse, and shopping center space are often calculated as “triple-net,” which means that the rent the landlord receives does not include charges for taxes, operating expenses, and insurance. Tenants are billed separately by the landlord for their share of these charges, which is based upon the square footage leased by the tenant.
With single-tenant buildings or ground leases, charges may be computed as a “gross” lease with a rent charge only. The rent charge includes all expenses, including taxes, insurance, and operating expenses. Oftentimes ground leases are negotiated so that the tenant pays rent to the landlord and pays taxes, insurance, and utilities directly to those creditors.
Most square footage leased is computed based upon the concept of the “rentable” square foot. Rentable square footage is the total area of space leased to the tenant and includes columns, projections, lobbies, utility rooms, and bathrooms. In contrast, the usable square footage is the area that will actually be occupied by the tenant, a lesser total than the rentable square footage. If the usable square footage were used instead of the rentable square footage, portions of the leased premises would be exempt and not covered by tenant payments. The distinction in usable versus rentable area is often explained as the area for which tenant buys carpet versus the area that gathers dust. The rentable square foot concept is used in calculating rent and expense charges so that the totality of the leased premises is allocated amongst the tenants in a building.
Depending upon the interests and leverage of the parties to a lease, almost any lease term is subject to negotiation. Some of the provisions that may be negotiated include the following:
The amount of rent paid by a tenant is calculated based upon market conditions, type of building (office vs. shopping center), quality of building (an A type building vs. a C type building), profit margin sought by the landlord, and leverage of the tenant (anchor tenant vs. tenant with small square footage, or first tenant in new space vs. last tenant in space).
In determining the amount to charge a tenant for rent, the landlord makes certain assumptions about the charges it will incur for taxes, expenses, management fees, and insurance. These assumptions should be made after investigating the actual cost of such expenses for similar properties. A figure for debt service must also be included, as well as a percentage of profit margin for the landlord. All expenses must be calculated carefully. If expenses are underestimated, the profit margin of the landlord may be affected adversely.
Base rent is a set amount of rent per square foot of the space leased. Calculations of base rent must be sufficient to recoup all of the landlord’s expenses with a gross lease, and all of the landlord’s expenses, except for net items, with a triple-net lease.
Retail tenants may pay base rent, and percentage rent based upon a percentage of their sales. Percentage rent may be based upon a percentage of the amount of sales in excess of the gross sales breakpoint. Once a tenant reaches its gross sales breakpoint, the landlord receives a percentage of all sales in excess of this figure. In some situations, this may enable a tenant to pay less base rent, with a larger portion of its costs being paid under the lease based upon future sales. A definition of gross sales must be included in the lease with exceptions noted for items that are not included. The landlord should require that the tenant maintain its sales receipts, and provide landlord a right to audit such receipts to ensure correct payment of percentage rent.
Increases in Rent, Taxes, and Operating Expenses
Increases in rent, taxes, and operating expenses are often based upon Consumer Price Index (“CPI”) increases. Oftentimes tenants will seek to cap such increases by requiring that the increases cannot exceed, for example, five per cent of the amount paid the previous lease year for such expenses.
Tenants may negotiate a rent abatement for a portion of the lease–generally, one to three months. Where leased space remains in low demand, or where leasing to a particular tenant is particularly desirable to a landlord, rent abatements have become very common. Rent abatements are especially useful for a tenant who needs an opportunity to get in its space, conduct business for a few months, and then begin paying rent.
Renewals or Extensions
Rent during renewal terms may be established as a set amount, or calculated based upon:
· Increases in the CPI;
· Market rates at the time of the renewal; or
· A certain percentage increase agreed upon by the parties.
If the terms of a right to renew are vague, or left to later resolution by the parties, the right to renew may arguably be void. All conditions of a right to renew should be addressed, including rent, term, space leased, expenses, and whether the remaining lease terms continue to apply.
Tenants are often required to pay a share of the expenses required to operate the common areas of a building, and to conduct the maintenance of the landlord. With multitenant buildings, operating expenses may be based upon the tenant’s proportionate share of the building. With gross leases, the landlord may bear a certain portion of the expenses up to a set dollar amount which is called a “stop.” Any amounts incurred in excess of this stop are borne by the tenant, and assessed by the Landlord as additional rent. Some leases will reference a base year, and provide that after the first lease year under the lease, any increases over the amounts paid by the tenant in the base year shall be borne by the tenant as additional rent payments.
Payments by tenants of taxes generally follow the same manner as payment of operating expenses. Single-tenant buildings may seek the right to contest taxes on behalf of the landlord. Taxes should be defined to specify what types of taxes, charges, and assessments are included. The tenant may seek a right to contest the amount of the taxes, especially in single-tenant buildings.
Payment by tenants of insurance generally follows the same manner as payment of taxes and operating expenses. Tenants may seek to negotiate the types and amounts of insurance coverage; the manner, timing, and incidence of repair; and the reconstruction of a building in the event of casualty or condemnation. A waiver of subrogation should be included for both landlord and tenant by the other party, and each party should seek evidence of the other party’s insurance.
Tenants may seek to audit a landlord’s charges for taxes, insurance, and common area expenses to verify the types of charges included in the calculation and the basis for apportioning the charges amongst all tenants. Tenants should ensure that estimates of such charges and actual amounts are reconciled by the landlord within a certain period of the end of the landlord’s calendar year. Landlords should reconcile such amounts promptly to ensure that the tenants do not have a right to argue that the landlord has waived its right to collect such charges.
Where space is not in great demand or the landlord is comfortable with the financial capacity of the tenant, a landlord may waive the requirement of a security deposit. When deposits are required, they are generally in the amount of one month’s rent. Without a deposit, a landlord may have little recourse if a tenant vacates and abandons its premises. Applicable state law should be examined to determine whether a security deposit with a commercial lease must be placed in an escrow account.
Shopping center tenants are often required to contribute to a fund for advertising at the shopping center. The amount required from each tenant is based upon its proportionate share of space leased. Exceptions may be made by landlords for large tenants where it would be unfair to require that the tenant pay into a promotional fund based upon its total square footage, or for small tenants who may be unable to afford payments for a marketing fund.
The amount of upfit allowance provided to a tenant can be nothing or a complete upfit, depending upon the leverage of the tenant and the interest of the landlord in leasing to the tenant. Landlords will attempt to recoup the upfit allowance from the rent paid by the tenant over the initial years of the term of the lease. Often provisions are incorporated into a lease requiring that a tenant pay a certain portion of the upfit costs to the landlord if the tenant seeks an early termination of the lease. This amount would decrease the longer the tenant remains in its space.
Condition of Premises
Landlords seek to lease premises on an “as is” condition. This limits the cost incurred by the landlord if it does not provide upfit allowances or perform upfit for the tenant. The landlord will seek to avoid providing representations to the tenant regarding the condition of the premises or the suitability of the premises for use by the tenant, to limit the liability of the landlord for the condition of the premises. Tenants should use their leverage to obtain representations from the landlord on the present condition of the premises, the manner in which upfit will be performed, and warranties about the upfit performed.
Landlords seek to have long terms in leases while tenants seek shorter terms. The typical term in an office building is from three to five years. The typical ground lease is at a minimum 30 to 40 years, and often 99 years. Many tenants will seek to negotiate options to renew or extend their terms as part of their original lease. Provision should be made for rent and expenses when the tenant holds over beyond the initial term, without the right to renew the term of the lease.
Options To Terminate
Shopping center tenants and at times office tenants may seek the right to terminate their leases. The shopping center tenant may seek this right if other tenants vacate, adversely affecting its business, and the presence of the other tenant was an inducement to or condition of the tenant executing a lease, or if its business is not as successful as the landlord had suggested or the tenant had envisioned.
From a landlord’s perspective, all such rights should be conditioned upon there being no event of default by the tenant under the lease at the time the right is exercised. Many such rights are conditioned upon the payment by the tenant of a buy-out fee to reimburse the landlord for upfit monies expended or other monetary concessions such as rent abatements. This fee may be graduated depending upon the time of the exercise of the termination.
Options To Purchase
Ground lease or other large tenants may be provided rights of first refusal to purchase their building. Such rights must be clearly stated, including the manner of determining the purchase price. Some states have time limitations on the exercise of such rights that if not included in the lease will void the option to purchase. Arguably if any conditions to the exercise of such rights are unclear or omitted, the rights may be unenforceable. Tenants may seek this right to have a measure of control over who continues as the landlord under a lease.
Casualty and Condemnation
Lease provisions concerning what happens to the lease once a casualty or condemnation has occurred are often negotiated. The issues concern:
· Whether the lease terminates;
· Who has the right to terminate the lease (the landlord, the tenant, or both);
· How long a period of time the landlord has to rebuild if he is required to do so;
· What property the landlord is responsible for repairing and replacing; and
· What proportion of the building or property must be damaged or taken to trigger these provisions.
Maintenance and Repairs
Maintenance and repair obligations must be delegated clearly so that issues will not arise later about who is responsible for the repair. With ground leases, the tenant may be wholly responsible for all repairs and maintenance, while under a multitenant building or shopping center, the tenant may be responsible only for disposing of its refuse. Who bears the responsibility for these items will affect operating expense calculations.
Leases executed in a commercial setting today generally contain even-handed indemnities of each party to the other unless the parties have agreed to forgo indemnities, waive claims against each other, and seek recourse from each party’s insurer. See the discussion in Robert K. Hagan, Using Waivers and Indemnities in Commercial Leases, The Practical Real Estate Lawyer (September 1993) regarding the use of waivers and indemnities.
Tenants may seek to have notice, in writing, and a period of time before a default becoming an event of default. Landlords must consider the administrative requirements that they must comply with before declaring an event of default, and ensure that such requirements are not too cumbersome to effectuate. Landlords may agree to provide written notice of a default but condition such notice on the requirement that it only be provided a certain number of times each lease year. Landlords should not waive any of their remedies upon the occurrence of an event of default, and should assert that all remedies available at law or in equity are available to the landlord. Tenants may seek to have written notice provided before the exercise of certain remedies. Landlords should avoid such provisions. What may seem a small and amicable resolution during lease negotiations can become a large problem once the lease is in default.
Landlords generally seek to recover their attorneys’ fees for enforcing lease provisions. Tenants should seek instead to have a prevailing party provision inserted in the lease so that both parties have a right to recoup attorneys’ fees. Landlords may also include provisions for late fees and interest for late payments. Tenants should seek to limit the amount of these fees.
Guaranties of Leases
If at all possible, landlords should seek guaranties with corporate and partnership tenants. This assists them in seeking recourse upon a default under the lease. The procurement of a guaranty is often a question of the leverage of the parties, the financial capacity of the tenant, and the demand for the leased space. The landlord should seek to have any debt of the tenant to the guarantor subordinated to the lease obligations. The landlord should also require that the guarantor waive any rights under applicable law to require that the landlord first pursue the tenant for a default under the lease, if permitted under applicable state laws.
Assignment and Subleasing
In many states, based upon the current economic climate and the availability of leased space, it is difficult for a landlord to refuse to allow a tenant some rights to assign its lease. These rights are conditioned typically upon a requirement that the landlord must consent to the assignment, but that its consent cannot be unreasonably withheld. In determining whether an assignee is suitable, the landlord will examine the business of the assignee and its financial capacity. Landlords may also require that the tenant continue to remain liable under the lease despite its having assigned the lease unless the landlord can obtain sufficient assurances of the financial capacity of the new tenant, and have the new tenant assume any continuing obligations of the former tenant. The lease should provide clearly what constitutes an assignment, for example, whether a change in the ownership structure of the tenant would effect an assignment. The definition of an assignment is important to prevent the tenant from modifying its ownership structure in such a manner that it has assigned the lease by operation of law but such a modification is not defined as an assignment under the lease. Applicable state laws will affect the ability of the tenant to assign its lease and the interpretation of the language in the lease governing this right.
The Americans with Disabilities Act (the “ADA”)
A provision regarding the ADA is the most recent addition to most leases. The ADA requires, among other things, certain architectural compliance by buildings to ensure access by the disabled. A lease may be used by the landlord and the tenant to delegate responsibility for this compliance.
Tenants often seek to have a provision included covering the default of the landlord, grace periods allowable, and the remedies of the tenant. The insertion of such provisions has increased in frequency. Such provisions are useful since an issue important to the tenant is addressed and clarified. These provisions can be used to meet the issue of the landlord’s default and can be tailored to the benefit of the landlord.
Entry by Landlord
Landlords should ensure that they have a right to enter upon the premises to inspect the same, to conduct repairs to the premises, and to show the premises to prospective tenants during the last portion of the term. Tenants will want to ensure that such inspections are conducted upon notice, if at all possible, and in a manner that does not disrupt the operations of the tenant.
Most commercial leases contain a provision concerning environmental matters where both landlord and tenant represent to each other their knowledge of their environmental usage, and agree to indemnify each other. These provisions may be negotiated as to the breadth and completeness of the parties’ knowledge and the indemnities provided. Landlords must do sufficient due diligence, including environmental audits, to provide their representations. Some landlords seek lists from their tenants of the hazardous materials used by them in the premises.
Restrictions on Business of Tenants or Landlord
Shopping center and certain office tenants may seek exclusive-use provisions or require that the landlord covenant regarding the other tenants who will be allowed to lease space in the building to ensure that they will not have direct competition within the premises. Landlords may seek to protect other tenants in the building by limiting the usage to be made by a tenant of its space. Without such provisions in a shopping center lease, it may prove difficult to attract certain types of tenants. Landlords must use care in agreeing to such provisions since they may agree to an exclusive-use provision now that later may cause them to be unable to attract a certain type of tenant. In addition, for a landlord to monitor such provisions in a large shopping center can be time-consuming and problematic. Care should be used with such covenants as antitrust issues may arise with their use.
Limitation of Liability of Landlord
Landlords seek to insert clauses in their leases limiting their liability to a tenant to the interest of the landlord in the building. The enforceability of such clauses in all cases has been questioned but they do provide a level of comfort to the landlord. Tenants may question such clauses when the landlord has little, if any, equity in the building and the building is mortgaged to a third party. Such clauses may be of little comfort with environmental liability situations that might quickly exhaust any interest of the landlord in the building. Tenants may obtain some comfort by ensuring that the landlord has substantial amounts of liability and environmental insurance.
Substitution of Premises
With multitenant buildings or shopping centers, landlords may include provisions allowing them to substitute other premises for that of the tenant. This allows the landlord flexibility in placing new tenants. Some tenants may strongly object to the possibility that they may be moved, and may refuse such provisions, or require that the landlord reimburse them for their costs, including moving, telephone, stationery, and inconvenience.
Shopping center leases may include provisions requiring the tenants to remodel their premises after a certain period of time. This ensures that the premises are kept in good order and repair, and of a “like-new” condition. This is especially important to provide retail space that is aesthetically pleasing to consumers. Tenants may object to such provisions for various reasons, including the cost to a tenant that may not be recouped by any benefit to the tenant if the lease term is not of sufficient duration.
Rights to Lease Adjacent Space
Tenants may seek the right to lease adjacent space to help them plan for future growth and expansion. In providing such rights, the landlord must keep in mind and notify the tenant of any tenants that have rights prior to those of the tenant. Such a provision is beneficial to a tenant but may provide headaches for the landlord. The landlord will need to contact the tenant when others express an interest in adjacent space and ensure that a correct accounting is maintained of each tenant’s priority in the adjacent space.
Landlords often seek a lien upon the personal property of the tenant located on the leased premises. Such a lien is sought by the landlord to assist it in recouping its losses in the event of a default by the tenant under the lease. Tenants may refuse to agree to such a lien because their personal property secures an operating line of credit or other financing and they have agreed not to further encumber their personal property, or they may wish to seek such financing in the future and not wish at that time to encumber their personal property. If a lease provides for a lien by the landlord, local law must be complied with to perfect a security interest in such a lien. In addition to obtaining and perfecting a security interest in the personal property of the tenant pursuant to agreement under the lease, a landlord may have certain rights under applicable law to a statutory lien on the personal property of the tenant.
Rules and Regulations
Many leases contain detailed rules and regulations for all tenants. Such rules and regulations may be updated by the landlord periodically. Tenants should ensure that the rules and regulations are reasonable in form and are enforced uniformly. Notice should be provided to tenants of new rules and regulations before their becoming effective.
A lease is a complicated legal document. Most of the leases I’ve seen in Anchorage are old leases cribbed from leases that someone pulled out of a prior tenants lease file. It appears that many landlords and tenants don’t spend anything for lease preparation and everything on the agent’s commission for bringing the two parties together. Some think that lease negotiations may be conducted less expensively by laypersons or brokers. It is useful, however, when problems arise during the term of a lease to have had legal representation to anticipate and protect one’s interests. With the myriad of legal issues that a lease presents, it is helpful to have an attorney skilled in lease negotiations to help one sort through the maze.
If you are looking at drafting a commercial lease, you owe it to yourself to engage a lawyer experienced in commercial leases. Call 907-375-9226 to talk with us about your lease.