10 pitfalls of commercial real estate lease agreements
- Richard Murillo
- Aug 24, 2018
- 9 min read
No matter how small a space nor how short a term, a lease can trap a tenant into unexpected and significant liabilities. The following are traps for the unwary tenant.
1. Construction, Renovation, Repair, and Remediation Obligations
A lease may impose tenant maintenance, repair, construction, and remediation obligations that are out of line given the nature of the lease. A three-year tenant, for example, should not have to perform upgrades required by the Americans with Disabilities Act or the fire or building code unless such alterations are required by some unusual tenant use. Check the following clauses closely: maintenance and repair beyond ordinary maintenance and repair of the premises, such as the building’s roof, heating, ventilation, and air conditioning system, other building systems, and common areas; compliance with laws (for code compliance upgrades, retrofits or other construction requirements, or possible capital expenses); environmental compliance (for remediation obligations for existing environmental conditions or contamination not caused by the tenant); and casualty loss and condemnation (for restoration obligations).
2. Overly Broad Indemnity Obligations
Study the indemnity provisions very carefully to be sure the tenant is not inappropriately assuming liabilities. Confirm that the tenant can obtain insurance coverage (contractually assumed obligations coverage) for the entire insurable scope of its indemnification obligations. Generally, the indemnification should be limited to anything that happens in the premises and anything the tenant and its agents, employees, contractors, and invitees do outside of the premises, and without consequential, special, or indirect damages, if possible. Be sure the tenant’s indemnification obligation (and the exculpation or release of landlord provision) excludes actions and negligence (or at least gross negligence) of the landlord and its agents, employees, and contractors.
3. Waiver of Subrogation
Confirm that the lease contains the mutual waiver between the landlord and the tenant to support an insurer’s consent to a waiver of subrogation. Confirm that the landlord’s and the tenant’s insurance policies each allow such a waiver.
4. Relocation and Re-measurement Rights
Landlords often reserve the right to move the tenant to other space in the building to accommodate a future tenant that needs, for example, a full floor or a large portion of a floor. In such a case, the lease should limit the locations to which the original tenant can be moved and compensate that tenant for moving-related costs. The landlord also might reserve the right to re-measure the premises or the building, both of which the tenant should resist. Area measurement can affect the base rent or the percentage share of expenses the tenant is required to pay. Obviously, a landlord is going to exercise the right to re-measure only if it benefits the landlord. Re-measurement not only includes changes in the square footage of the premises, but also can change the way the space is measured (for example, to the outside glass rather than to the baseboard) and the allocation of common area to the premises. The new widely used Building Owners and Managers Association International (BOMA) standards increase the “rentable area” of office space by a substantial amount over “rentable area” determined under the 1996 standard. Office Buildings: Standard Methods of Measurement (ANSI/BOMA Z65.1—2010).
5. Subordination Without Nondisturbance, Quiet Enjoyment
Unless the lease provides that the tenant’s occupancy will not be disturbed if the landlord’s lender forecloses on the building, most leases subordinate the lease to an existing or future lender’s lien and provide that the lender may terminate the tenant’s lease in a foreclosure. Although a tenant whose lease is likely to add value to the building (usually a large, credit-worthy tenant) may be more successful in obtaining a nondisturbance clause for future lenders and an SNDA from the existing lender, every tenant should ask for nondisturbance protection in the lease and agree to an SNDA if needed to get it. Does the lease otherwise require the landlord to protect the tenant’s quiet enjoyment and possession?
6. Changes to Common Areas
Landlords often retain the unfettered right to change common areas. If the tenant’s access, visibility (especially for retail tenants), parking, or other important amenities are part of the common area, the tenant will want to limit changes to those common area amenities.
7. No or Limited Cure Periods
Default provisions can really hurt a tenant. They also are difficult to negotiate because the landlord’s typical response (not completely meritless) is “don’t default.” The most common default clause traps are no notice of the default from the landlord, no cure period, and both interest and penalties for late payments. Ideally, the tenant should have a cure period after notice from the landlord that a payment is late, which protects the tenant if there is a snafu in making the payment of which the tenant is unaware. For nonmonetary defaults, the practical ideal is a 30-day cure period following notice from the landlord that is extended for the reasonable time necessary for the tenant to actually effect a cure.
8. Damage Penalties—Making the Landlord More Than Whole
Remedies provisions are similarly difficult to negotiate, but sometimes they simply are unreasonable as presented to the tenant. Common overreaching provisions include (a) high liquidated damages for a breach; (b) excessive default rates of interest; (c) double recoveries (for example, recovery of full rent, plus a separate recovery of the full amount of any free rent, tenant finish allowance, or other allowances, all of which are amortized over the lease term and are thus already recovered if the landlord recovers the full rent); (d) unreasonable restrictions on mitigating damages (for example, a long list of types of tenants the landlord need not consider as a replacement tenant, often including the landlord’s existing and prospective tenants); (e) excessive costs to restore or alter the premises for the next tenant; (f) very low rates of interest (for example, Treasury rates or less) for discounting the future rent to present value; and (g) landlord’s liens (perfected as a UCC security interest) covering all of the tenant’s property (which could include the tenant’s proprietary information and assets it may need as collateral for business loans). Is each party entitled to payment of its attorney’s fees if it is the prevailing party in any dispute?
9. Extensive Removal Obligations on Surrender of the Premises
A tenant may want to limit its restoration obligations when surrendering the premises so it is not obligated to remove (a) tenant finish that existed when the tenant took occupancy; (b) tenant finish or alterations made during the lease term with the landlord’s approval (unless the landlord told the tenant before the alteration was installed that it would need to be removed); and (c) telecom cabling that the tenant did not install. Does the tenant have trade fixtures to install? Make sure they are approved and that the tenant can remove them at the end of the term.
10. Unclear Work Letter Obligations
Work letters or clauses (the lease provisions or addenda that define the tenant finish work to be accomplished before the tenant moves in) are often cursory and fail to clearly define (a) exactly what work will be done, or what the step-by-step procedure will be for defining the scope of such work, as well as the procedure for approving space plans and construction drawings; (b) who will do the work; (c) who will pay for the work; (d) when the work will be completed and whether the tenant has any remedy for late completion; (e) a procedure for inspecting the work, creating a “punch list” of unfinished items, and a schedule and procedure for completing those items; and (f) a warranty for the work. The tenant should ensure that the consequences of delay are spelled out and that the tenant does not bear the responsibility or burden for the landlord’s delay. Ideally, the work letter or clauses will address the landlord’s responsibility for latent defects. Also, if the landlord is performing the work, watch out for provisions that trigger rent commencement before the premises are completed and the tenant can move in.
Ten Tips
1. Keep Your Eye on the Money
Pay careful attention to, and point out to the client, all the clauses in the lease that require the tenant to pay money. Also consider each clause of the lease in terms of the economic consequences to the tenant. Encourage the tenant to review the lease with its accountant, including any financial consequences under the new Financial Accounting Standards Board (FASB) lease accounting rules, if and when adopted.
2. Know the Market
Negotiating changes in a lease depends largely on the tenant’s strength in the market. A landlord can stiff-arm even a large public company in lease negotiations in a low-vacancy market. And even a small, shaky tenant’s requests will get a hearing after a real estate crash. Knowing the tenant’s position in the market helps make the negotiation process more efficient and, often, more successful for the tenant. The tenant and the lawyer will know better how hard to push for lease changes and what to let drop. Knowing the market not only includes understanding the market generally but also the specific market for the type of space, type of use, and type of tenant in the specific location of the premises. A good leasing broker can help the tenant and the attorney in this regard. See also tip no. 8 below.
3. Look for Inconsistencies
Common inconsistencies in a lease include those between (a) the commencement of the term, the commencement of rent, and the delivery of possession provisions and the work letter; (b) the casualty loss provisions and the insurance provisions (for example, landlord and tenant each insure the same property; the landlord carries the property insurance for the tenant finish, but the tenant is required to replace the tenant finish at its cost on a casualty loss); (c) the indemnity provision, the exculpation clause, the insurance requirements, and the waiver of subrogation provisions; (d) the alterations clause, repair and maintenance provisions, the casualty loss provisions, the insurance requirements, the condemnation clause, and the surrender clause (for example, inconsistencies in who owns and insures the tenant improvements; requirement to restore without access to insurance proceeds and a surrender clause inconsistent with ownership of the tenant improvements); (e) the term provision and renewal rights (for example, sometimes the “term” is defined to include a renewal term and sometimes not); (f) the landlord’s and the tenant’s respective maintenance and repair obligations (for example, gaps and overlaps); (g) operating expense inclusions and exclusions (for example, exclusions that are not really excluded; exclusions from exclusions that fall into “no-man’s land”; exclusions without an obligation to perform); and (h) rules and regulations inconsistent with other lease provisions.
4. Read the Boilerplate
Important provisions are sometimes hidden in the “miscellaneous” section or elsewhere, appearing as boilerplate. It is unwise to review a lease, and certainly unwise for the client to sign one, unless you and the client have read every word of it—including the boilerplate.
5. Assign Risks to the “Least Cost Avoider”
Every lease allocates risks between the landlord and tenant. A good principle to use in negotiating risk allocation is to assign the risk to the party with the greatest incentive to reduce costs or mitigate risks and that has the most control over the matter, as it will be the party best positioned to manage the risk.
6. Consider Both Short-Term and Long-Term Issues
Clients are often overly focused on short-term issues in the lease, such as the completion of tenant work and the moving-in process. Encourage those clients to consider longer-term issues with equal attention.
7. Educate an Inexperienced, Naive, or Unsophisticated Client
If your client is not experienced in leasing matters, or is naive or unsophisticated, be prepared to give real life, practical examples of how troublesome lease provisions can hurt the tenant. Making a good decision on whether to take a risk requires a good understanding of the risk. Use true stories and examples to communicate, in practical terms, the nature and relative importance of the risks.
8. Be Reasonable in Your Requestfor Changes
A 3,000-square-foot tenant in a 100,000-square-foot office building or retail center is not going to get a lot of changes to the landlord’s standard lease. Asking for unreasonable changes reduces your credibility and can backfire. Knowing what changes are reasonable is part of the value an experienced, knowledgeable attorney brings to a lease negotiation.
9. If You Don’t Understand It,Don’t Let Your Client Sign It
Some leases are just plain awful. Sentences don’t make sense. Subjects, verbs, or objects are missing. Arcane language is used as though it conveys some ancient truths. Definitions are missing or used inconsistently. Generally, clients do not want their lawyers to rewrite a lease for style, but a minimum standard is appropriate. You at least ought to know what each provision means.
10. Choose Your Landlord Carefully
Some landlords are harder to deal with than others. Always consider the financial viability of the landlord. And life is too short to deal with some landlords, if you can avoid it. A slumlord with a history of bad tenants and bad experiences may deal with your client differently from a landlord more accustomed to dealing with good tenants. Out-of-state landlords sometimes are harder to negotiate with than local landlords. And some landlords are just plain tough. A tenant who has a good relationship with its landlord will be a lot happier in the long run. Lease negotiations sometimes reveal what the tenant can expect from the long-term relationship.
Conclusion
Agreeing to perform a quick review of a lease is not without risk for the attorney and client. In an ideal world, the client would appreciate that entering into a lease without benefit of a thorough review is a recipe for remorse. In the world most of us live in, however, approaching a lease review by asking and answering key questions, looking for traps (which can create expensive mistakes for the unwary), and then applying the tips can help make reviewing the lease a more manageable, efficient exercise. In the best of circumstances, the process of spotlighting a few unpleasant traps with the client will lead the client to request (and understand the need for) the more thorough review that leases typically merit.
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