Look Before You Lease Protecting Your Business From Unexpected Costs

Leasing commercial space for a business can be an expensive proposition. So, when most business owners shop for space, they do so with a clear budget in mind for rent and other leasing expenses. Eventually, when a deal is struck, a term sheet is signed by the parties. But term sheets are brief and only serve to outline key topics such as the rent, the lease term, the tenant improvement allowance and perhaps a few other key issues. The details are left for the lease. And as we all know, the devil is in the details. Therefore, business owners should spend the time and effort, in concert with their attorney, to ensure that the lease will allow the business to thrive and not be blindsided with unanticipated costs.

While some landlords use short, standardized forms for smaller spaces and tolerate little negotiation, this is the exception in the commercial leasing market. Most landlords expect some negotiation and employ attorneys to draft lengthy, one-sided leases. So, in almost every case, there is room to improve the lease and to make it more even handed. Some of the key issues to negotiate are as follows:

Restoring Space to Original Condition.  Many leases require that the tenant, at landlord’s option, remove all improvements made to the space. If the space started out as shell space with nothing inside the wall studs, the restoration could be quite expensive. While it is reasonable to require a tenant to remove a specialty item that a future tenant will not likely use and which the landlord would have to incur extra cost to restore (e.g., an interior staircase between two floors, or a computer room with special cooling equipment serving it), it is unreasonable to require the tenant to remove other improvements or to perform other restorations. The failure to address these issues can expose the tenant to a huge liability at the end of the lease term.

Extension Term Rent.  Where a landlord agrees to permit the tenant to extend the lease for one or more extension terms, it is important that the tenant either negotiate a firm rent number for the extension term(s) or a method by which parties will determine fair market. The first draft of a lease sometimes provides that the landlord will set the extension term rent unilaterally, leaving the tenant in a position where it has to accept the new rent or waive its right to an extension. Moving to a new business location is time consuming, disruptive and expensive, and should not happen because the lease gave the landlord total control over extension term rent.

Assignment/Subletting.  Many leases state that the tenant must have the landlord’s consent before assigning or subletting the lease, but prohibit the landlord from unreasonably withholding consent. This is fairly customary, so when a lease omits language requiring a landlord to not unreasonably withhold consent, the tenant should push back hard. A tenant cannot predict what its circumstances will be in the future, so there should be some flexibility in the lease to permit the tenant to find a subtenant or assignee of the lease in the event the tenant requires more space or needs to downsize. In addition, if the tenant desires to sell its business, it should not have to go hat in hand to seek the consent of the landlord to transfer the lease to the buyer.  Generally, under these circumstances, landlords will agree that no consent will be required, but may impose restrictions on the financial net worth of the buyer.

Operating or Common Area Maintenance Costs.  Most leases charge or “pass through” some or all of the landlord’s costs to operate and maintain the building tenant. These are known as “net” leases, with “triple net” meaning a lease that passes through all or substantially all costs, such as utilities, real estate taxes, insurance, and certain maintenance costs including capital expenditures. This is a key area for negotiation and often consumes a significant portion of the discussions between landlord and tenant.

From the landlord’s perspective, all costs of management, operation, and maintenance should be reimbursed by tenants, so that no costs eat into the base rent. From the tenant’s perspective, certain costs incurred by the landlord are just part of ownership costs and so should not be passed onto tenants.

Usually, a middle ground gets hammered out. Often, the lease starts out with far too many costs being passed through to tenant, such as charging all capital expenditures to tenant regardless of the type of cost. However, in many Class A office buildings, given the high rent, landlords are willing to take a more balanced approach and will limit capital expenditure charges to improvements that make the building more energy efficient or improvements required by changes in the law that occur after the lease begins:  All other costs are borne by the landlord.

In contrast, the owners of industrial buildings and smaller office buildings will often try to pass through all capital expenditures to tenant. There is a sliding scale that needs to be thought through in each case, and the right balance of cost sharing depends on many factors including the property type, the rental rate, and the length of the lease term. Sometimes, the landlord will agree to be responsible for its roof and the structural elements of the building, but will pass through the cost of repairs or replacements to systems. However, where capital expenditures are passed through, a landlord usually agrees to charge the amortized cost of such repair.

Repair Obligations.  The tenant’s obligation to maintain its space or adjacent common areas or systems is also a key area of negotiation and is closely related to the operating expense pass through provisions. If landlord is responsible for repair or maintenance, the tenant only has to pay its pro rata share of expenses, whereas if tenant is responsible for repair or maintenance, it will bear 100% of the cost. Accordingly, the tenant should fight to push as much as it can over to the landlord, limiting its responsibilities. The biggest tug of war occurs over who is responsible for repairing systems in the building. If the lease is not well negotiated, the tenant can find itself with large repair bills that it never anticipated.

Interruption of Services or Use.  In almost every lease, there is a clause that protects the landlord from interruptions to tenant’s use of the space due to utility service failure or the landlord’s repairs to the building or tenant’s space. In each case, there should be some protection for the tenant in the event such conditions last more than a few days. Rent abatement is the most common remedy, and this is generally an adequate remedy for most short term problems. But if this issue is not negotiated up front, the tenant could find itself paying rent without the ability to use the space. In that case, it will be all the more critical to have adequate business interruption insurance in place.

SNDA.   In most cases, tenant should obtain a Subordination Non-Disturbance and Attornment Agreement, otherwise known as an “SNDA”. An SNDA protects the lease from termination if a lender forecloses on the mortgage that was obtained prior to the lease’s execution. While this may be a relief to a tenant that has an above market lease, most tenants find it comforting to have an SNDA, especially where the lease is entered into in a low rent environment or where the tenant has invested significant funds into the build-out of its space.

Acceleration of Rent.  If a tenant defaults under a lease, the remedy sections are usually fairly similar, generally providing for landlord’s right to terminate the lease, collect back rent and either pursue tenant periodically for rent that would be due if the lease had not been terminated, or collect damages in an amount equal to the difference between rent that would be due until the expiration of the lease and the current market rent that would be due through the lease’s end-date.

However, some leases contain onerous acceleration clauses, providing landlords with the option of accelerating tenant’s rent through the expiration of the lease term. In most circumstances, rent acceleration is unwarranted and should be stricken from the lease. However, where a landlord refuses to remove such a provision, tenant should push hard to limit the claim to a more reasonable estimate of damages that could be incurred by a landlord.

The above issues are just some of the more typical traps for the unwary. Every business owner is well-advised to be mindful of the details that may be buried in the fine print of leases. Using a team approach with legal counsel, the tenant can negotiate a lease that avoids costly surprises, allows the tenant to thrive in its space, and provides tenant the freedom to make key business decisions without unreasonable restraints from the landlord.