San Diego Business Lawyer Blog

In today's business world, with so much focus on the bottom line, most individuals and companies are looking for a way to cut operating expenses or at least pass them on to someone else.  For this reason, most commercial leases these days include provisions which require the tenant to pay all or part of the landlord's cost of operating, maintaining, insuring and furnishing utilities for the building (Common Area Operating Expenses).
 
Depending on the type of lease, the tenant may bear all or only a portion of the landlord's expenses.  In a "triple net lease," all of the landlord's operating expenses are passed on to the tenant.  A lease may, however, contain an "expense stop" which establishes a point at which expenses begin to be passed on to the tenant.  In this type of lease, expenses for a "base year" are determined - the expense stop.  Thereafter, the landlord pays expenses equal to the base year and the tenant pays its pro rata share of the rest.  For example, if a lease contained an expense stop at $10,000 ("base year" expenses), and the landlord's operating expenses were actually $11,000, the tenant would pay the $1,000 over the expense stop.

It has become more common in recent years for office leases to contain what's referred to as a "gross up" provision.  Gross up provisions permit landlords to "gross-up", or overstate, operating expenses to simulate the building being at full capacity.
 
Here's how a gross up provision would work in the real world:

Assume the gross up provision states that common area maintenance expenses will be calculated for each tenant as if the building was fully occupied, or at 100% capacity.  Further assume the building is currently only at 50% occupancy.

Under this set of facts, a $1,000 expense to the landlord would be multiplied by a gross up factor of 2 (100% (the markup rate) / 50% (the level of occupancy)).  $1,000 x 2 = $2,000 (the grossed up operating expense).  The tenant is required to pay a pro rata share based on the percentage of space it occupies - let's assume 20%.  In this scenario, the tenant's total grossed up obligation would be $400.   

So, what exactly are the advantages and disadvantages of including gross up provisions in a commercial lease?
 
From the landlord's perspective, the most obvious benefit of a gross up provision is being able to pass on the expenses resulting from building vacancies to the tenants.  Gross up provisions are generally viewed as reasonable for certain expenses, such as utilities that are not separately metered, because the landlord will bear that expense for the entire building even though it is only partially leased.  These expenses do not vary by occupancy levels.  
 
Although a gross up provision may seem disadvantageous to a tenant on its face, it can actually benefit the tenant under certain circumstances.  For example, referring back to the lease which includes an expense stop - if a building is not fully occupied during the base year, a gross up provision overstates the expenses based on full occupancy.  This protects tenants from sudden increases in operating expenses when the building becomes fully occupied later.  Essentially, the gross up provision for a property not fully occupied results in a higher expense stop.  In the absence of a gross up provision and less than full occupancy, the tenant's expense stop will be lower resulting in higher increases in future years when the building becomes fully occupied.
 
As demonstrated by the above discussion, gross up provisions can drastically impact the terms of a commercial lease agreement.  Prior to entering into a commercial lease agreement, make sure to consult with a San Diego commercial lease attorney.

It is common for commercial landlords and tenants to have disputes over needed repairs.  Most commercial leases require tenants to make needed repairs to the leased premises while repair and maintenance to the structural elements of the commercial center and its common areas are left to the landlord.  Moreover, even though the landlord maintains the structural elements of the center, those costs are most often passed on to the tenant as common area maintenance expenses (CAMs).   

Problems arise where either the landlord or the tenant misconstrue respective responsibilities.  When this happens, commercial tenants are tempted to make the needed repairs and simply deduct the cost from their monthly rent.  Unfortunately, this commonly referred to "repair and deduct" remedy is not available to commercial tenants unless the remedy is specifically provided for in the lease.  Even if the repair and deduct remedy is provided for under the lease, commercial tenants need to be careful about what repairs the landlord is legitimately responsible for under the terms of the lease.  Commercial tenants that mistakenly withhold rent for repairs that weren't the landlord's responsibility or where the lease doesn't specifically provide for the "repair and deduct" remedy risk being evicted (unlawful detainer).  

Where a landlord clearly breaches the lease by failing to make repairs it is obligated to make under the express terms of the lease and there is no "repair and deduct" clause in the lease, commercial tenants are left with the unfortunate and expensive task of suing the landlord seeking declaratory relief (an order forcing the landlord to perform) or damages to compensate the commercial tenant for losses associated with the breach.  See Realities of Pursuing Breach of Contract Actions.  Ideally, San Diego business owners will negotiate with their landlords and look to resolve any outstanding issues amicably.  Otherwise, the costs of battling a commercial landlord in court can be extensive.  

Before making any decisions, the commercial tenant should carefully review its lease regarding the parties' respective obligations and determine whether a "repair and deduct" clause is included.  Understanding the terms of the lease is the best way to ensure that a proper remedy to is sought. Ultimately, consulting with a San Diego commercial lease lawyer is best.

Under California law, a commercial tenant's options when a landlord fails to perform under a lease are generally limited by the terms of the commercial lease.  San Diego businesses often find themselves without a practical legal remedy because the terms they originally agreed to prevent them from withholding rent or terminating the lease.  Tenant's are forced in these circumstances to seek a remedy through litigation which is of course costly and time consuming.  

Those tenants that entered into leases without review or who were unable to negotiate better terms often find themselves dealing with landlord breaches.  Some withhold rent immediately not realizing that they might be held in breach of contract.   Others just abandon the premises and end up getting sued afterward.  Whether or not a commercial tenant can do these things for the most part depends upon the actual terms of the lease.  Is it silent as to landlord's defaults?  Does it allow the tenant to make needed repairs and then deduct the cost from rent (repair and deduct)?  Or does it have specific language limiting the tenant's remedies to court action.  For instance, a lease clause might state, "in no event shall the tenant have the right to terminate this lease as a result of landlord's default and tenant's remedy shall be limited to damages and/or an injunction."  

The best way to avoid this peril is to negotiate better terms in the first place.  However, negotiating better terms is dependent on a party's bargaining power.  In most cases, San Diego businesses have little bargaining power because they are new or unknown entities.  In addition, competing businesses are willing to enter into a lease with the landlord under any terms, leaving the more savvy entrepreneurs a difficult tight rope to walk.  Many landlords approach lease negotiation from a "take it or leave it" perspective. This does not mean that San Diego businesses have absolutely no bargaining power, but landlords typically stand strong when it comes to limiting a tenant's remedies.  Nonetheless, a prospective tenant should never shy away from negotiation better lease terms no matter how limited their bargaining power.  Every landlord is different, and the issues that are important to one landlord may not be as important to another.

Ideally, those tenants currently facing landlord defaults which cannot be resolved through informal discussions will consult a commercial lease lawyer.  Of course, paying for an attorney is not always practical.  In such cases, the first step is to review the operative lease and its amendments carefully.  Look for language that limits, or relates to in any way, tenant's remedies upon landlord breaches including language limiting the tenant's ability to terminate the lease, seek consequential damages, seek declaratory relief, withhold rent or any other limitations on tenant's remedies.  Once the tenant has gained a basic understanding of its limitations, it can determine whether seeking legal assistance is necessary.  If there are limitations, consulting a commercial lease lawyer is highly recommended.

Continue reading "Tenant's Options After Landlord Breach of Commercial Lease" »

At first glance, the differences between triple net leases (NNN), gross leases and modified gross leases seem complicated. Many of the definitions found on the internet are convoluted and even experienced real estate professionals have trouble figuring out what some bloggers are trying to say. The differences, however, are not that complicated. In the simplest terms, commercial leases can be separated into two major categories: those where the tenants pay all of the property's expenses (NNN leases) and those where the landlords pay all of the property's expenses (gross leases). A base year lease, or modified gross lease, calls for existing expenses to be paid by the landlord, but any annual increases in expenses to be assumed by tenants. A base year lease is somewhere in between the NNN lease and the gross lease.

Most retail leases are triple net leases and the common area maintenance expenses (CAM expenses) that the tenants pay for include just about every imaginable cost for the operation of the property including in most cases property taxes, utilities, maintenance, insurance and management fees. Each tenant is responsible for its pro rata share of the CAM expenses. The actual terms in NNN leases vary widely from lease to lease and how favorable the terms are to the tenant depend on the tenant's negotiating power. Gross leases are less common but still used today. This is largely because landlords are reluctant to take on the risk of increased costs over time. A base year lease or modified gross lease eliminates this problem by transferring the risk of increased costs to the tenants. The base year lease provides landlords security by passing on increased costs to tenants.

Most office leases are some variant of a base year lease. In a base year lease, a base year is selected (usually the first year of the lease). The landlord agrees to pay the property's expenses for the base year. The landlord continues to pay the property expenses at the base year level and the tenant agrees to pay its pro rata share of any increases in property expenses. If the property expenses for the base year (say 2010) are $40,000 and the expenses increase to $50,000 for the year 2011, a tenant with 20% of the square footage would pay $2,000 (20% of the $10,000 increase) in 2011 in addition to the tenant's base rent (with a NNN lease, the tenant would pay its pro rata share of the entire $50,000 in 2011 or $10,000 in addition to the base rent). Each year thereafter, the tenant pays its pro rata share of the property's expenses but only to the extent that those expenses exceed the $40,000 established in the base year. In most cases, the annual increase in expenses is estimated at the start of each year and tenants pay monthly to spread out the cost over the year. In the above example, if at the beginning of 2011 the landlord over estimated the increase in property expenses at $12,000, the tenant would pay monthly payments of $200 (20% of 12,000 divided by 12 months) totaling $2,400. The tenant thus overpays $400. At the end of 2011, the landlord would perform an expense reconciliation resulting in the extra $400 being credited back to the tenant.

Continue reading "Office Leases and the Base Year" »

Most San Diego business owners know that commercial landlords typically pass on real estate taxes, including property taxes, to their tenants. Whether it's a triple net lease requiring commercial tenants to pay their pro rata share of all property taxes due including property tax reassessments or a base year lease (common for office buildings) where tenants are responsible for property tax increases only, property tax reassessments can have a devastating effect on unsuspecting San Diego tenants. The problem stems from California's Proposition 13 which limits property tax reassessments to 2% annually, but allows for full tax reassessments upon the transfer of ownership. Unwary prospective tenants may not realize that an attractive property has not been reassessed under Proposition 13 for years, if not decades. If the property is sold, or ownership is transferred in any number of ways, the property tax reassessment can be significant.

For example, consider a property that has not changed ownership in ten years (meaning it has not been reassessed for Proposition 13 purposes in ten years). In 1994, at the time the property last changed ownership, its value was assessed at $10,000.000.00. Assuming maximum Proposition 13 increases annually of 2%, in 2003 the Proposition 13 tax basis for the property would be $12,189,944. At a tax rate of 1.5%, the tax on the property in 2003 would be $182,849.00 (12,189,944 X .015). A new tenant in 2003 with a 10% pro rat share of property expenses under a triple net lease would owe $18,285 in taxes for 2003. Typically, these taxes are anticipated and paid by tenants as part their monthly Common Area Maintenance (CAM) expenses. However, in 2004, if the property is sold to an investor for $20,000,000.00, it triggers a Proposition 13 reassessment. The Proposition 13 reassessment is based on the new $20,000,000 price tag resulting in a property tax of $3,000,000.00 (20,000,000 X .15%). The new tenant's pro rata share for 2004 is virtually doubled to $30,000.00. In most cases, the tenant will continue to pay the same monthly CAM payment for 2004 and will be billed for the difference upon reconciliation in early 2005 (approximately $11,350 assuming the 2004 CAM calculations accounted for an anticipated 2% Prop 13 tax increase). This can place a significant burden on a new or growing business especially when the business owners do not see it coming. In some cases, the amount owed can be staggering. This is a highly simplified example, but the outcomes are similar in just about any scenario so long as property values are appreciating faster than the 2% maximum allowed under Proposition 13. Of course, the problem is less common in San Diego's current down market, but it is a climate where large appreciations can be expected in the future.

The simple solution for tenants is to seek Prop 13 protection (a clause in the lease that excludes from tenant's expenses any increase in property taxes resulting from reassessments or at least those increases directly attributed to a transfer of ownership). This is not always a practical solution, especially for tenants with less leverage. Nonetheless, it should always be the subject of negotiation. The potential harm can devastate a business. If complete Proposition 13 protection is not possible, tenants should consider seeking a cap (say 5%) on annual property tax increases or an advance agreement to spread out the lump sum tax payment that would be due upon reconciliation. If these concessions prove impossible which is often the case, a new tenant needs to know when the property was last reassessed for Proposition 13 purposes, what its assessed value was at the time and what its assessed value is today in order to forecast the potential losses due to a transfer of ownership. The longer it's been since the last reassessment, the greater the tenant's exposure to extreme property tax increases.

The property tax increase isn't a one-time burden. The new tax basis remains until the property is again reassessed and will not decrease unless property values decrease. It's understandable then that landlords seek to pass the burden onto tenants. In fact, a commercial property is harder to sell (has less value) if its tenants have Proposition 13 protection. Either way, blindly entering into a commercial lease without understanding how property taxes are apportioned is unwise for tenants and landlords alike. Consultation with a San Diego Commercial Lease Lawyer is the best way to avoid pitfalls like this.

Almost every San Diego business owner has had to negotiate a commercial lease at one time or another. Whether with the assistance of a San Diego lease lawyer or on their own, they are presented with a myriad of confusing terms and conditions. Business owners typically focus on the major terms of the commercial lease (rent, common area maintenance expenses, term of the lease and options to extend), and let their attorneys sort out the rest. While it is good practice to consult with an attorney before entering into any contract, business owners benefit from a basic understanding of the commercial lease as a whole and how its terms interrelate. This article takes a brief look at one common clause - the recapture clause.

A recapture clause allows a landlord to terminate the lease and take back possession of the premises upon the occurrence of certain conditions. It is usually associated with complex "assignment and subletting" clauses that allow tenants, upon landlord's approval, to assign their lease or to sublet a part of the leased premises to a third party. Landlords like to include "recapture clauses" that are triggered by a tenant's mere request for the approval of an assignment or subletting.

The "recapture clause" issue arises because landlords know that tenants' desires to assign or sublet are usually motivated by profit. When the commercial real estate market is hot, tenants can assign their lease at rental rates above what they are currently paying or sublet a portion of the premises at exceptional rates. Recapture clauses allow landlords to step in and take the profits for themselves. In essence, landlords are able terminate the less profitable lease. Tenants then are better off without such clauses and existing tenants need to carefully review their leases before requesting approval of an assignment or sublease.

As with all commercial lease terms, favorable language for either side will depend on the parties' relative bargaining power. Landlords want recapture clauses. They provide an out when existing leases are under performing compared to the current market. The fewer conditions the better. Ideally, from the landlord's perspective, the recapture clause will be triggered on any request for the approval of an assignment or sublease. However, given the complex nature of assignment and subletting clauses in commercial leases, it is most often productive for landlords to agree to more flexible language. Tenants, on the other hand, should ask that recapture clauses be omitted in their entirety although this is not a practical expectation for most small businesses. If the recapture clause cannot be negotiated away, tenants should insist on clear triggering language. For instance, landlord's recapture rights may only be triggered upon a request for a complete assignment or a request that more than 50% of the premises be sublet. This allows tenants to sublet portions of the premises without risking termination of the lease. There are other options equally appealing to both landlords and tenants. Most notably, language may be included in the lease that addresses the division of profits from an assignment or sublease omitting any sort of recapture clause.

In the end, commercial landlords and tenants have to weigh the value of these issues against all the other lease terms being negotiated. It may be that a tenant has little concern over future assignments and would much rather spend its bargaining power on other important concerns such as reduced annual rental increases. The practical result of recapture clauses after they are triggered will be the subject of another article. Consult a San Diego commercial lease attorney for further guidance.

Triple net leases dominate today's San Diego commercial lease market and virtually every landlord is faced with the annual burden of reconciling common area maintenance expenses (CAM expenses). Challenges to CAM expenses often spiral out of control. Tenants, ever weary of the unseen profit center, want to ensure that they are being billed correctly and are willing to share their frustration with other tenants. The management of CAM expenses begins with the initial lease negotiation which in the ideal results in lease terms that clearly set forth each CAM expense and how each expense will be calculated and apportioned. Experienced commercial managers and lease lawyers understand the need for clarity and comprehensiveness and strive for consistency among tenants while simultaneously negotiating the best possible terms. Unfortunately, the result is most often imperfect. National chains and anchor tenants' demands are given greater weight in negotiation and smaller tenants are finding themselves with increased bargaining power due to the current downturn. Regardless of the economic climate, landlords can and should take care in managing and accounting for CAM expenses. The goal is to reduce tenant frustration and avoid future problems and associated costs.

The best first step towards improved management of CAM expenses is for property managers to simply pay attention. Supervision of maintenance operations ensures that waste is kept to a minimum. If or when a tenant does question a specific expense, the landlord will be prepared to produce relevant invoices and explain why the expenses were necessary. This is especially important for anchor tenants who typically have the resources to challenge landlords' accountings. Too often property managers ignore potential problems hoping that the tenant will either forget about it or accept an evasive answer for fear of creating conflict. What property managers tend to overlook is that tenants have long memories. If later problems arise or if business starts to decline (for whatever reason), tenants inevitably latch onto the older seemingly innocuous issues and the landlord/tenant relationship can deteriorate rapidly. Regardless of the tenant's size, experienced property managers know the headaches this can create.

In addition to supervising maintenance operations, it's best to know what allowable CAM expenses are for each tenant. That is of course why consistency in tenant leases is so important. Knowing that all of the tenants are billed the same way for all expenses makes for simpler calculations. Because perfect consistency is virtually impossible, it is particularly important that property managers know where the differences lay. Misunderstandings can be costly. It may seem that a parking lot improvement is simple enough. Putting aside that the anchor tenant may not be required to share in the expense (reverting a large share of the cost back to the landlord), it may be that another tenant previously negotiated for the specific use of some of the parking spaces being torn out. 

Continue reading "Landlord Management of Common Area Maintenance (CAM) Expenses" »

Continued from Part Two.

Paragraph 6 - Security Deposit: From the landlord perspective, it is a good idea to include lease language wherein the tenant waives its rights under Civil Code §1950.7 allowing the landlord to apply security deposits toward future rent.

Paragraph 7.4(b) - Removal and Surrender: Under the AIR lease, landlords may require tenants to remove alterations and utility installations by providing notice between 30 and 90 days before the end of the lease term. To avoid unanticipated costs, tenants should seek language requiring landlords to provide notice of landlord's requirement of removal before the alterations or utility installations are made. This way, tenants can calculate the costs of removal in deciding whether the improvements are economically feasible.

Paragraph 12 - Assignment and Subletting: The AIR lease does not address circumstances where an assignment results in net profit to the tenant. Landlords and tenants should work with their attorneys to include lease language that defines profits in such situations and how those profits are to be divided.

Paragraph 20 - Limitation of Liability: Paragraph 20 limits a tenant's rights to recover damages from the premises assets for the satisfaction of any liability of the landlord with respect to the lease. This language is common in commercial leasing. However, where possible, tenants should seek to eliminate the provision. If they cannot, one alternative is to better define the assets tenants may go after including rents, profits, and other income from the commercial property.

Paragraph 47 - Waiver of Jury Trial: Under Paragraph 47 of the AIR standard commercial lease, the parties waive their rights to a jury trial. Such clauses are unenforceable in California. Commercial landlords continue to include them in their leases probably in the hope that someday the law might change. Because tenants typically do not benefit from such a waiver and because the clause is unenforceable anyway, the clause should be omitted.

Paragraph 49 - Americans with Disabilities Act (ADA): The AIR lease places the burden on the tenant to ensure that the leased space is ADA compliant. Tenants should seek removal of this clause, or at the very least seek amendment of the language to require landlord to warranty that the property is presently ADA compliant or will be by the commencement date.

Brokers: The AIR standard commercial lease contains several clauses pertaining to brokers. Because these clauses do not relate to the landlord/tenant relationship, the parties should consider eliminating the language. If brokers are involved in the transaction, landlords might consider a separate agreement.

These are of course general issues that arise in negotiation. The discussion is not intended to include an exhaustive list of important issues for landlords and tenants to consider when entering into an AIR standard commercial lease. San Diego businesses should review each and every clause in the lease and consult with an attorney before entering into an agreement. Significantly, it is important that each side recognize their respective bargaining positions. A major department store that anchors a shopping center will have much greater success when it comes to negotiating more favorable tenant terms. Smaller businesses in a big pond need to be careful that they don't negotiate themselves out of a desirable lease. Consultation with an experienced commercial lease attorney is the best way to balance these concerns.

Continued from Part One.

Paragraph 4.2 - Common Area Operating Expenses: The AIR lease includes a comprehensive list of common area operating expenses which tenants are responsible for. The list includes property management fees. While property management fees are common in commercial leases, the AIR lease does not set any limits on the amount landlords can expense or define how such fees are assessed. Tenants should seek a limit on management fees and seek clarification of how administrative and management fees are calculated. See Understanding Your Lease - Common Area Expenses. Administrative and management fees should not be a source of additional income for landlords. The AIR list of common area operating expenses also includes reserves set aside for property maintenance. If the lessor is unwilling to remove this language, at least ask that the procedures for determining the reserves and the amounts reserved are set forth in the lease and/or an addendum to the lease.

Paragraph 4.2(a)(ix) passes on the costs of capital improvements to the tenants. This is also common in commercial leases. The AIR lease calls for the costs to be amortized over 12 years reducing the tenants' monthly burden. However, this burden may still be significant depending on the size of the commercial property and the particular premises leased. This can be especially problematic for smaller businesses leasing space in a smaller commercial property. If the business leases 25% of the space from a 50,000 square foot strip mall and the lessor decides to completely remodel the property at a cost of $500,000.00 , the business' monthly obligation increases an additional $868.00 not including any additional property tax passed on to tenants. This can be disastrous for new or growing small business. This clause essentially passes on the costs of discretionary capital improvements to tenants. Capital improvements ultimately benefit both the landlord and its tenants. As such, passing on a portion of the cost is reasonable. However, tenants need to be acutely aware of this potential expense. Ideally, tenants will negotiate for the elimination of this clause. Alternatively, tenants should seek a cap on the capital improvement costs that may be passed on to the tenant during the term of the lease. From the landlord perspective, agreeing to a cap might be a reasonable compromise, but the landlord should clarify that the cap only applies to discretionary capital improvements. Compliance with applicable laws is dealt with comprehensibly by the AIR standard lease and California law.

It appears that the AIR list of operating expenses is not intended to be exclusive. To ensure that there are no uncertainties, prospective tenants should ask their attorneys to negotiate for the inclusion of language that sets forth specific exclusions. To avoid confusion, Landlords will want to ensure that its lists of inclusions and exclusions are consistent for all tenants.

Finally, the AIR standard commercial lease does not include a provision granting tenants the right to audit landlord's books with respect to common area operating expenses. To incentivize proper accounting methods and efficiency, tenants should seek the right to audit landlord's books at least once a year. Landlords benefit from an audit clause that includes language that sets forth the timing and specific methods for conducting the audit.

Continued in Part Three.

In the San Diego commercial real estate market, these days it is relatively common for landlords to ask prospective tenants to enter into a standard AIR (American Industrial Real Estate) commercial lease.  The AIR standard lease was drafted by the AIR Commercial Real Estate Association with the intention of balancing the interests of commercial landlords and tenants in an effort to expedite the negotiation process.  While the standard lease provides a framework for landlords and tenants to work from in negotiating lease terms, it's important that they avoid arbitrary acceptance.  Every lessor/lessee relationship is different and it is important that individual landlords and tenants examine the AIR lease with an eye towards their particular circumstance.  Consultation with an experienced commercial lease attorney is the best way to ensure that a business' interests are protected.  This article examines some general issues with specific attention directed to the Standard Industrial/Commercial Multi-Tenant Lease - Net:
 
In general:  The parties to a commercial lease should always be acutely aware of important terms and definitions such as Premises, Common Areas, Common Area Operating Expenses, Commencement Date, Parking, Use, Warranties, Rent, Maintenance, Utilities, Trade Fixtures, Alterations, Insurance, Property Taxes and Renovations.  This list is not exhaustive, but it is a good representation of lease language that requires specific attention by both the lessor and lessee.  The ultimate terms will depend on the tenant's business and the layout of and landlord's vision for the property.  The standard AIR lease language is typical for commercial net leases.  Landlord's who repeatedly use the AIR lease have practical experience relying on its terms, and aren't necessarily concerned with changing the status quo.  However, finding and keeping good tenants provides a significant benefit to landlords, and working with new tenants to achieve lease terms that are practical and economically feasible for new tenants is a good long term business practice.  New tenants have much to learn about the "triple net" lease and common area operating expenses.  It's important that they understand clearly what their rights and obligations will be under the new lease regardless of whether they are able to negotiate more favorable terms. 

Paragraph 3.3 - Delay In Possession:  The lessor is required to use its best commercially reasonable efforts to deliver possession of the premises by the "commencement date", and lessees have little recourse against the landlord for delayed delivery.  Under Paragraph 3.3, lessors are not liable in any way for delayed delivery.  At best lessees may terminate the lease if possession isn't delivered by the 60th day.   If delivery is delayed beyond six months, the lease automatically terminates under Paragraph 3.3.  Termination of the lease is an untenable option for most new tenants who have made commitments to lenders, contractors, suppliers, franchisors and/or customers.  As such, lessees are at the mercy of the lessors' "commercially reasonable efforts" without legal recourse for the damages delayed delivery cause.  This does not mean that landlords are out looking to take advantage of new tenants.  However, tenants should ask their attorneys to try and negotiate better terms with respect to delayed possession to increase the landlord's incentive to be diligent and efficient, including a provision for damages for delayed possession. 

Continued in Part Two.

Common Area Expenses (or CAM expenses) are nothing new in the commercial leasing business. However, new business owners are often caught off guard by the thought of the additional expense that sometimes is as high as the base rent itself, especially where there is so little control over how the expenses are managed. Leases that require tenants to pay common area expenses (including property taxes and insurance) are called triple net leases. It is common these days for landlords to pass on every imaginable expense to its tenants. So long as the landlord is passing on legitimate expenses that are necessary for the operation and maintenance of the common areas, there is nothing inherently wrong with the practice. However, prospective tenants should work closely with their attorney to carefully review the proposed lease terms to ensure they have a complete picture of the potential liability and that the landlord isn't using the CAM charges as an additional source of revenue. Ideally, tenants will negotiate for a gross lease that is inclusive of all landlord expenses. However, in most cases negotiating for a gross lease is difficult (if not impossible). Where a net lease is your only option, the following is a list of important considerations:

Pro Rata Share: A tenant's pro rata share of common area expenses should be determined based on the tenant's leased square footage compared to the commercial property's gross leasable space, not "leased" space. In other words, the pro rata share is determined based on 100% occupancy. Landlords often seek to defer costs associated with empty space and will try and include lease language that calls for CAM charges to be calculated based on the square footage of "leased" space rather than "leasable" space. Tenants should seek to amend such language so that the landlord absorbs the expenses associated with empty space.

Audit Rights: Tenants should try and negotiate for the right, upon reasonable notice, to audit the landlord's accounting records. Such clauses are common in commercial leases and allow tenants to ensure that the common area expenses are calculated correctly. Look closely at the lease language as these clauses typically set forth specific procedures for examination of records and for resolution of disputes. Sometimes leases limit the frequency of tenant audits. The more often you are allowed to audit, the better. At the very least, tenants should have the right to audit accounting records once a year within six months of reconciliation (the time landlords reconcile actual expenses with estimated expenses).

Management Fees: Management fees are common, especially in the retail setting. The practice is prevalent and prospective tenants should ensure that the lease clearly defines what the management fees are and how they will be calculated. Management fees should not exceed three percent of the property's gross receipts, and shouldn't include expenses for off-site personnel and overhead. In some cases, landlords seek both administrative and management fees. While this may be appropriate in some circumstances (i.e. landlord hires a separate management company to manage the property), it's important to clearly understand exactly how these fees are delineated and to make sure that the landlord isn't double dipping. Try and negotiate for limits on management fees. 

Clearly Defined Expenses: Ensure that the common area expenses are clearly defined in the lease. Vague and ambiguous language that doesn't spell out precisely what expenses will be included in CAMs leave tenants open to excess costs.

Continue reading "Understanding Your Lease - Common Area Expenses" »

As the San Diego commercial real estate market continues to struggle, foreclosures are becoming more and more common.  The prevailing wisdom is that it's going to get worse before it gets better.  While this writer cautiously takes a more optimistic view, there can be little doubt that many San Diego businesses are being and will be confronted with landlord foreclosures.  Businesses invest more than just lease payments in the premises they occupy.  They make tenant improvements, invest in advertisements and marketing materials using the premises address, build customer loyalty and benefit from a well known and popular location.  Under these circumstances, being forced out as a result of a landlord's default would be disastrous.
 
So what does happen to a business when a landlord defaults on its loan?  The answer depends on the terms of the lease, when it was executed and whether or not it was recorded.  Senior commercial leases will generally survive foreclosure sales, especially where the commercial lease is recorded prior to the recordation of the third party encumbrance.  Tenant possession of the premises may also serve as constructive notice of the senior lease to third party encumbrancers.  However, where a trust deed or other encumbrance is recorded prior to the execution of the lease, the lease is subordinate to the trust deed.  In such circumstances, a foreclosure will extinguish the lease.  A foreclosure purchaser may then evict the tenant as an unlawful occupant.
 
Experienced commercial landlords and tenants, savvy business owners and those represented by commercial lease attorneys look to address these potential consequences before entering into long term leases.  Whatever the terms, it is sound business practice to record all leases including amendments and other related instruments.  If the parties are concerned with confidential terms, they may record a "memorandum of lease" which identifies the unrecorded lease, the parties, the property and the lease term.

Continue reading "Understanding Your Lease - What Happens to Your San Diego Business After Landlord Foreclosure?" »

Commercial leases often appear daunting, especially to new and growing San Diego businesses. After negotiating the rent, business owners often feel they have little choice but to accept the remaining terms if they want to move forward. It is always advisable to consult with a commercial lease lawyer, but the thought of additional costs turn many away from this option. "Understanding Your Lease" is a series of articles designed to highlight important commercial leasing issues. The articles are intended to arm business owners with the ABCs of "commercial leasing", and are not intended as a substitute for professional negotiation. Most commercial leases are triple net leases. Along with the base rent, tenants are required to pay a pro rata share of the common area maintenance expenses (CAM expenses). The scope of these expenses varies from lease to lease, but is most often inclusive of every imaginable cost. See Understanding Your Lease - Common Area Expenses. In this article we briefly summarize the type of expenses included. It's important to review your lease and make sure you know what the CAM expenses are.

Common area expenses typically include: repair and maintenance of the property's common areas; landscaping; exterior painting; parking lot paving, resurfacing, painting and lighting; roofing; repair and maintenance of central plumbing, electrical, sewage and HVAC systems; other repair and maintenance expenses relating to the property's common areas including renovation and redesign expenses; utility expenses related to the common areas; advertising and promotional expenses incurred by landlords; security systems and on-site personnel; permits, taxes, insurance and legal costs; and management and administrative expenses including the salaries of management personnel. On top of these expenses, tenants are required to pay all expenses directly related to the leased space including utilities, repair and maintenance of electrical, plumbing and HVAC systems, compliance with government regulation such as the American with Disabilities Act and are required to maintain a minimum level of general liability insurance.

Common areas typically include parking lots, landscaping, hallways, elevators and stairwells, lobbies, public restrooms, on-site management offices and other public areas. Ask to see CAM histories to help you get a better picture of what your future expenses will look like, and ask about anticipated renovations. These costs can be significant and you'll want to know what's on the horizon. Finally, management and administrative costs can be profit centers for landlords, particularly where both management and administrative costs are sought. Be careful that your landlord isn't double dipping. Work closely with your attorney to reduce uncertainty.

Common CAM expense exclusions include:

• Initial cost of the land or the construction of the original buildings, parking and other improvements;
• Mortgage principal, interest and related expenses; 
• Refinancing costs;
• Ground rent and related costs;
• Depreciation and amortization of property and equipment;
• Cost of complying with government regulations including compliance with environmental laws; 
• Costs, fines or penalties incurred by landlord for violation of government regulations and costs for correcting code violations or defects; 
• Interest or penalties from landlord's late payments;
• Advertising, renovation, improvements and other costs associated with seeking and obtaining new tenants and retaining existing tenants;
• Brokerage commissions;
• Tenant alterations and alterations made to leasable space;
• Capital expenditures; 
• Costs reimbursed by other tenants;
• Costs reimbursed by insurance and/or warranties;
• Costs reimbursed by government agencies; 
• Special services for specific tenants;
• Legal services relating to leases with other tenants or with the transfer, sale or disposition of land or buildings located on the property;
• Off site management personnel and overhead;
• Operation of services or amenities for which landlord charges a fee to third parties;
• Costs associated with remedying construction defects;
• Utility costs directly payable by tenants or other occupants;
• Salaries and benefits of landlord's executive officers;
• Excessive costs for sculpture, paintings and other fine art;

This is not an exhaustive list of exclusions. See Understanding Your Lease - Common Area Expenses for a summary of important common area expense considerations.

It's now estimated that the San Diego commercial lease market will hit bottom in 2010. Whatever the future has in store for commercial real estate, the present news is not good for commercial property owners. Office vacancies in San Diego are at almost 20% and retail vacancies, while not as high, are still significant at around 8%. It's likely that most commercial property owners in San Diego cannot remember the market every being this bad. With vacancies so high, commercial landlords are forced to negotiate better lease terms in order to retain existing tenants and to attract new ones. In this highly competitive market, it's the smaller commercial property owners that are being hit the hardest.

The competition for new tenants is tough. Larger companies can afford to offer cash incentives for improvements, free rent for six months and significant first year discounts to lure the most attractive tenants, leaving smaller properties desperate to fill their empty space. For many smaller property owners, the only way to compete with these incentives is rent reduction. It's an economic reality that commercial property owners of all sizes cannot get around - continued downward pressure on rent coming from all sides.

Offering incentives to prospective tenants is a good business decision for those that can afford it. For those that cannot, holding on to existing tenants is of paramount importance at least for the foreseeable future. As the market continues to tighten, landlords are beginning to recognize that existing tenants are their most valuable asset. There is little to be gained by eviction of a tenant who can pay partial rent if it proves difficult if not impossible to fill the space once the eviction process is complete. Moreover, existing tenants are known quantities. A tenant with a history of timely payment and who is not constantly at odds with the landlord is a good tenant. This is also the type of tenant that will remember a landlord's goodwill during tough times. While it may be impossible for smaller commercial property owners to offer cash incentives to prospective tenants, they may be able to afford accepting lower rents for a fixed period of time to keep existing tenants. This also provides the landlord with some control over the term of any renegotiation.

Of course, not every tenant is a good tenant. However, commercial property owners of all sizes should carefully weigh the benefits of keeping existing tenants against the cost of eviction and the all too real risk of empty space. Struggling businesses are increasingly aware of the tightening market and, with or without the assistance of a commercial lease lawyer, are approaching their landlords hoping to trade on their track records to stay alive.