Most new businesses are required to enter into a commercial lease of one form or another. The owners of the business are typically presented with thirty to forty page leases set out in fine print on legal size paper. These standard leases are comprehensive and contain provisions that inexperienced business owners usually don’t fully understand. With proper scrutiny and research it is possible for the inexperienced owner to sufficiently navigate their commercial lease. However, this type of scrutiny (in essence due diligence) takes significant time and effort. Ideally, new business owners will instead consult with an experienced commercial lease lawyer before moving forward. Whether or not legal counsel is sought, it is important for all new lessees to be aware of certain pitfalls. This articles summarizes on the most common areas of concern:
Common Area Maintenance (“CAM”) Expenses: In shopping centers and office buildings where numerous tenants share common space Landlords typically require their tenants to share the costs of maintaining these common areas. Shopping center leases are usually triple net (NNN) leases. Office leases are typically base leases. Either way, landlords are looking to pass on the costs of maintenance to tenants in one form or another. Common area expenses may include expenses associated with landscaping, sidewalks and parking lots, sprinklers, public address systems and music, bathrooms, signs, garbage collection, security and utilities for the common areas such as parking lots, hallways, food courts and any other areas where customers and clients gather or walk through. Most landlords also include an administrative and/or management fee. In addition to base rent, tenants will usually have a monthly CAM bill which represents a twelfth of the tenants pro rata share of the estimated CAM expenses for the year. At the end of the year, if the landlord underestimated the CAM expenses, the tenants are required to pay the difference to the landlord upon receipt of an invoice (the opposite is true if the landlord overestimated –tenants are refunded accordingly). It is vital that new tenants know precisely what these CAM expenses are, how they are calculated and the process for reconciliation of said expenses at the end of the year. Tenants should try and negotiate with the landlord towards ensuring that only legitimate expenses (expenses directly related to common area maintenance) are included. It is helpful to ask the landlord to provide CAM reconciliations for the last three years. This allows prospective tenants to better understand what these expenses are and how they grow over time. It’s also important to seek the right to audit annual reconciliations to ensure proper accounting. Finally, in some cases, tenants may be able to seek a cap on annual CAM expenses. The ability to negotiate for better terms of course depends on the parties’ relative bargaining positions.
Repair and Maintenance Obligations: It is not uncommon, particularly in retail leases, for landlords to require tenants to assume the obligations of all repairs and maintenance to the premises including repair and maintenance of plumbing systems, mechanical systems and equipment such as boilers and HVAC (Heating and Air Condition) systems. In a triple net lease, the entire obligation is shifted to tenants including sometimes full replacement of unrepairable equipment. The average business owner may first learn of this only after a major system breaks down and the landlord points them to the repair and maintenance provisions of the lease. An HVAC failure can have a devastating impact on a tenant’s business. The HVAC system must be repaired (or replaced) and the costs can be prohibitive. It’s important that tenants fully understand their repair and maintenance obligations before entering into a commercial lease. While it may not always be possible to negotiate better terms, it is important to at least try. If you fail, you at least have a better understanding of precisely what your obligations will be. For instance, it is not unreasonable to ask the landlord to warranty the premises mechanical systems and equipment for one or two years. It’s also not uncommon for landlords to agree to replace major equipment at its expense and to capitalize the expense over time so that the tenant pays only the annual capitalized portion of the total expense.
Real Property Taxes: One of the biggest unexpected expenses commercial tenants can face is a change to real property taxes. In most leases, tenants are required to pay their pro rata share of property taxes. Usually, tenants have a pretty good idea of what these property taxes are and are billed for their share of the annual tax on a monthly basis. However, what most tenants do not realize is that any property tax increase due to a reassessment (usually due to a sale of the property) is also passed on to them. The tax on a property that has not been reassessed for decades can increase by tens of thousands of dollars overnight. At reconciliation, this new expense is passed on to the tenants and continues year after year thereafter. A tenants monthly layout can increase by hundreds if not thousands of dollars monthly under this scenario. Ideally, again depending on the parties’ relative bargaining strengths, tenants will try and negotiate a reduction of this obligation. At the very least, a prospective tenant should ask about when the property was last assessed and for how much so that in the event of a sale, there is a reasonable understanding of what the potential tax increase might be.
Assignments and Subletting: The are a variety of reasons tenants may want to assign their lease to a third party – the business may be struggling, the owners wish to sell the business or the owners are simply ready to move on to some other venture. Either way, landlords retain strict control over the process. For those tenants anticipating the desire to assign the lease (particularly those hoping to grow and then sell a business), understanding and negotiation better assignment and subletting terms is critical. While not complete, the following is a list of some important provisions worth pursuing and/or removing:
- Recapture Clauses: These clauses allow landlords to terminate the lease and retake possession of the premises merely because a tenant asks for an assignment. All tenants should try and remove or at least limit the landlords power to do so.
- Consent Requirements: The lease should contain language that the landlord “shall not unreasonably withhold consent” to an assignment.
- Continued Liability: Tenants/assignors typically remain liable under the lease should the assignee default. This liability may extend throughout the term of the assignee’s lease leaving the assignor responsible for years even though they have sold their business and washed their hands of the venture. Seeking language that limits the extent of this liability is advisable.
- Options: In most commercial leases, options to extend the lease do not extend to assignees. This can make it difficult to sell a business, particularly if there is only a short term left on the lease. For those hoping to sell their business for a profit, extending options to assignees is extremely valuable. Every effort should be made to negotiate to that end.
Subordination, Nondisturbance and Attornment (SNDA) Provisions: SNDA provisions can get quite complicated. The short story is that these provisions require tenants to subordinate their lease to any of the landlord’s lenders or to a buyer of the property. To ensure the continuation of the lease upon events like foreclosure, tenants should ensure that such provisions include language mandating that the lease relationship will not be disturbed (nondisturbance). Without such language, a tenant’s lease could be terminated by virtue of the subordination provisions.
A comprehensive list of pitfalls is beyond the scope of this article. Other areas to look out for include: whether a tenant has the right to repair and deduct (cure landlord defaults and deduct any associated costs from rent); whether landlord has the right to unilaterally relocate the tenant within the property; whether the landlord or the tenant is obligated to pay for readying the premises (who will pay for tenant improvements); whether rent will start immediately or only after tenant opens for business (after improvements are completed); what happens if the landlord delays in turning over possession of the premises; is a personal guaranty required; does the landlord retain the right to lease adjacent space to competing businesses; are there limitations to the tenant’s use of the premises; and numerous other issues that are of varying concern to tenants. See also “Tips On Negotiating California Commercial Leases“.
Call San Diego Business lawyer Donald R. Oder for a free consultation at (888) 900-9002.