Some Key Considerations in Negotiating a Commercial Lease

This article, written by attorneys Eric Kilchenstein and Christopher Candon, was originally published by the NH Bar News and can be found here (page 36).

The considerations involved in the drafting and negotiating of a commercial lease are extensive. Landlords and tenants have different motivations, but ultimately this is a business relationship that is intended to endure for many years, and may represent significant revenue to the landlord and, conversely, the largest expense to the tenant. To avoid future misunderstandings, the landlord and tenant must consider numerous items and draft a lease that meets their expectations. Base rent and initial term may initially frame the structure of the lease, but many other considerations will arise in the lease negotiation.

Additional Rent; Determination of Operating Expenses
Payment obligations under the lease tend to draw the most attention and typically have the most influence over whether the landlord and tenant are able to reach an agreement. In most leases, the base rent is clearly identified and usually has some measure of escalation during the term. However, the base rent may only be a portion of the overall rental obligations in a lease. In most commercial leases, the tenant will also be responsible for the costs and expenses of operating, maintaining and managing the property or the “operating expenses.”

The determination of what is included in operating expenses may have significant financial implications in the lease. While the landlord  will seek a broad definition of operating expenses, the tenant will seek to limit the inclusion to reasonable expenses and negotiate a number of exclusions. Embedded in these negotiations, among other things, is the treatment of capital expenditures. The parties will need to identify whether any limitations on the pass through of capital costs will exist. The tenant may seek to limit these  capital expenses only to those that reduce operating expenses. Whatever is ultimately included should be subject to amortization over the useful life of the expenditure.

Key aspects of the operating expense negotiation may also include whether a gross-up provision (landlord’s ability to increase expenses based on building occupancy) will be included or whether the tenant will have an audit  rights to examine whether the charges are fair.

The Buildout Process
Even in the best scenarios, finding a rental space that meets the needs of the business will likely require some amount of renovation. This buildout requires a negotiation between the landlord and  tenant to determine the financial responsibilities for each party. Depending on the circumstances, the parties may prefer a “turnkey” arrangement, whereby the parties agree on a buildout plan that the landlord pays for and completes. Issues that might arise typically relate to the “ownership” of the project. The tenant is ceding most of the control on execution of the buildout plan, including contractors, materials and timing, so agreeing on the condition and timing of the delivery of the property is crucial.

An alternative to the turnkey process is a tenant improvement buildout that is largely controlled by the tenant. The landlord often gives the tenant a payment or a discount on rent to offset the improvement costs. In lease negotiations, the tenant should be prepared with a preliminary construction budget to guide the amount of the tenant improvement allowance and to identify the costs that it may ultimately need to complete the project if the allowance is not sufficient.

Extension Options; Determination of Rental Amount for an Extension Period
The lease should clearly set forth whether the tenant has the option to extend the lease and the terms and mechanics of an extension.

Commercial leases that are drafted by non-lawyers often include extension provisions but fail to address notice. Notice is extremely important with commercial leasing. Aside from clear provisions in the lease as to how and to whom notice should be delivered and received, the timeframe of a notice to exercise an extension needs to be carefully considered with your client. Generally, commercial tenancies require a match between the unique needs of a business and the limited number of properties that are suitable for those needs. This means that because the pool  of commercial tenants and suitable properties is limited both landlords and tenants need to ensure that there is adequate time, in the event of non-extension to a) if a landlord, market
the property and find a new tenant and b) if a tenant, find a new and suitable space. Typically, landlords will seek a longer notice of extension period and tenants will seek the flexibility of a shorter one.

The Extension provisions themselves most often mirror the initial term of the lease in length and the term of an extension period is not disputed in negotiation. The rental amount in an extension period is obviously one of the most negotiated terms of a lease and there are several ways that it can be calculated but it should be specific. Often commercial leases link extension term rental amounts to changes in a consumer price index (CPI). While this may be deemed fair to the parties to a lease, there is very low correlation between CPI and the commercial rental market or the needs of the parties. More commonly, landlords and tenants establish the extension rental amount based on negotiation at the time of negotiating the lease or include a provision liking extension rental amounts to fair market value. If left to fair market value, the lease should provide a clear amount of time for the landlord to notify the tenant of the new rental amount and an arbitration and an appraisal or arbitration process should be included in the event of disagreement.

Including an Option to Purchase, Right of First Refusal or Right of First Offer
It is often in the interest of the tenant to include an Option to Purchase, Right of First Refusal (ROFR) or a Right of First Offer (ROFO) in a commercial lease. An Option to Purchase is generally narrowly drafted to give the tenant the opportunity to purchase a property on or after a certain date. Specificity is needed regarding the terms which should include an appraisal process if the price is not predetermined. A ROFR and a ROFO can be drafted to include the purchase of the property or simply the renting of other space that the landlord may own. A ROFR is generally triggered when the property owner receives an acceptable offer to purchase, or lease, the property and gives the holder of the ROFR (the tenant) the right to either purchase or lease the property upon the same terms or upon other terms listed in the ROFR. A ROFO is triggered when the landlord decides to sell or lease additional property and gives the holder (the tenant) the right to make a first offer. All three types of provisions should include as much detail as possible and if representing the landlord could be drafted to be linked to the tenant’s performance under the lease.

The above represents only a few of the key provisions in a typical commercial lease. Given that the property represents an asset to the landlord and is critical to the future business of the tenant,  engaging in a fulsome review and negotiation of the lease is a critical business item that warrants special attention by the landlord and tenant.