Articles Posted in Commercial Leasing

Landlords routinely request estoppel certificates from their tenants. Tenant estoppel certificates are signed statements requested by third parties (typically lenders or prospective purchasers of commercial real estate) in order to verify certain terms between the current tenant and landlord of the commercial real estate property, things that cannot be ascertained by simply reading the commercial lease agreement.. The estoppel certificate confirms that a valid lease exists, that the lease remains in full force and effect, that neither the landlord nor tenant are in default and that the rent is paid up. This allows for instance a prospective buyer of a shopping center to better evaluate the shopping center’s performance. Once a tenant verifies these details in the estoppel certificate, they cannot be later disputed. Potential purchasers of the commercial property rely on the certificates to evaluate the risks associated with purchasing the property and to determine an appropriate offering price.

What Information is Included in a Tenant Estoppel Certificate?

Typically, an estoppel certificate will ask a tenant to verify the following:

• The date of the commencement of the lease;
• That the lease has been unmodified and is in full force and effect or that it has been modified;
• The most current date in which rent is paid through; and
• That there are no defaults by the tenant or the landlord.

Other information that may be requested in an estoppel certificate includes the financial health of a tenant, the amount of any security deposit paid, the tenant’s ownership structure, or whether there is any ongoing litigation related to the tenant. Most of the time, but not always, landlords will attach a form of the estoppel certificate as an exhibit to the actual lease agreement to help avoid disputes that may arise in the future regarding what information should be provided by the tenant. It is in a tenant’s best interest to negotiate which information should be included in the estoppel certificate prior to entering into the lease. For example, information that can be determined by reading the lease or statements that modify the lease agreement in any way should be avoided.

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A Tenant Improvement Allowance (TIA) is a landlord incentive designed to assist new tenants with the build-out of their space. Build-outs are improvements to leased space to make the space usable for a particular tenant’s needs. Whether or not a landlord will offer a TIA and how much the landlord will offer depends on a variety of factors including the relative bargaining power of prospective tenants, the current market for commercial space, the current condition of the premises, the extent to which the current condition suits a prospective tenant’s needs, the tenant’s desirability, the base rent and other key terms being negotiated. Often, new business owners are surprised when a TIA is offered and may over estimate its significance. While TIAs are important landlord incentives, landlords are careful to minimize the true costs. In most cases, tenant improvements are capital improvements that provide a long term benefit to the property. Even where the improvements are specific to a tenant’s needs, landlords most often build the cost of TIAs into the base rent. However one looks at it, TIAs are an important factor in commercial lease negotiation. If a tenant improvement allowance is being offered, the associated lease language is critical for both landlords and tenants. When negotiating TIAs and associated lease terms, it is important that the parties have a clear understanding of the improvements needed and their likely cost.

Two Common Approaches – The Stated Dollar Amount Approach and the Turn-Key Approach:

With a stated dollar amount, the landlord offers a fixed sum to the tenant for the build-out. The tenant must absorb any additional costs that exceed the fixed sum. In some cases, landlords will require any excess monies be returned after completion of the job. Where landlords do not require the return of excess funds, they are more likely to allow soft costs such as architectural and engineering fees. Again, ensuring that these issues are clearly addressed in the lease avoids any potential future conflict. The stated dollar amount method is fairly straight forward. The landlord knows the precise amount it will be responsible for and tenants (who typically oversee the build-out) retain control of the process. It is also possible for landlords to offer a fixed sum while retaining control of the build-out process.

With the turn-key approach, the landlord allowance covers certain specified work which the landlord typically oversees (i.e. build out of a new kitchen or bathroom, erection of interior walls and partitions, installation of new doors and windows, new flooring and ceilings, etc.). Any additional work would be considered extra work to be absorbed by the tenant. Some new business owners may prefer the turn-key approach so that they may remain focused on other important aspects of forming their new business. Overseeing construction while simultaneously focusing on licensing, trademarks, dbas, incorporation, employees, inventory, insurance and other business responsibilities can be daunting. However, it’s important that new business owners understand the downside to landlord control of build-outs. When landlords control the process, they are motivated to limit expenses. They may not have the same quality goals and may take short cuts the tenant wouldn’t be willing to take. Tenants will want to ensure that they get the most work possible with the allowance provided, that the landlord warranty the work, that the work be completed by a specified date and that the tenant have a reasonable opportunity to inspect the work to be sure the work was done properly including retaining the ability to submit a punch-list of things that need to be completed after taking possession. In addition, it’s helpful to ask landlords to undergo a competitive bidding process where sealed bids are opened in the tenant’s presence.

In some cases, landlords will allow tenants to control the build-out process choosing their own architects and contractors (subject to landlord approval). However, the tenant’s expenses would be limited by the allowance. If the tenant goes over budget, the tenant would be responsible for the excess costs.

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Most commercial leases in California are triple net leases. With a triple net lease, tenants contribute to the payment of the landlord’s operating expenses, such as building insurance, taxes, repairs, maintenance, and utilities in addition to base rent. Typically, these expenses are referred to as Common Area Maintenance Expenses (CAMs). As one might imagine, what should and shouldn’t be included as an operating expense is an important part of lease negotiation. Depending on the parties’ relative bargaining positions, tenants are often able to negotiate for a list of CAM exclusions.

Under Generally Accepted Accounting Practices, capital expenditures are defined as the costs of obtaining items that last beyond the current accounting period and increase the value or the life of an asset. Capital expenditures include things like additions, improvements, renovations, repairs and upgrades to existing facilities, and can be thought of as investments that are intended to yield long-term benefits. Commercial leases deal with capital expenditures in a variety of ways. Many, but not all, commercial leases contain a general capital expenditure exclusion that excuses tenants from having to contribute to the costs of such expenditures with two major exceptions: expenditures necessary to comply with new laws and improvements that reduce operating expenses. In some cases, these lease exclusions will also exempt those capital expenditures when the costs of replacing equipment (an HVAC system for instance) would be greater than the replacement cost of the equipment.

Negotiation in this area is important to both landlords and tenants because capital expenditures can be significant. The issue is often a point of heated dispute. Tenants contend that their contribution towards the capital expenditures unfairly confers a permanent benefit on the landlord. Landlords argue that tenants benefit from adequately maintained facilities, repairs to existing equipment and additions that make the property more attractive. For the most part, capital expenditures benefit the property overall. As such, it is generally accepted in the commercial leasing community that such costs should be built into base rents.

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It is more common than one might imagine for a commercial tenant to pack up and leave the premises rather than negotiate with its landlord for lease termination. This is most often because the business owner/tenant is far behind in rent and doesn’t believe that there are any other options available. It is also most likely that, for whatever reason (whether a past history of conflict, landlord bureaucracy or tenant complacency), a lack of communication between landlord and tenant has contributed greatly to the problem. Whatever the reason, landlords and tenants should be careful about how they approach lease termination and abandonment.

The best way to avoid dealing with abandonment is to maintain open lines of communication. Business owners who better understand available alternatives are more likely to consider agreeing to a payment plan with respect to past due rent and/or voluntarily turning over possession of the premises to the landlord on some fixed date. Landlords are in turn better able to gauge the tenant’s position and ultimately to avoid costly litigation. Depending on the circumstances, landlords will often find that it makes more economic sense to agree to a lesser amount owed and to release the tenant from future obligations. It is surprising how often simple communication (even with lawyers involved) leads to a peaceful and voluntary turnover of possession. Better yet, in some cases, the parties are able to work out an arrangement that results in a continued tenancy.

While it seems sometimes lost on landlords, there is a significant benefit to retaining long time tenants with a proven track record. This is usually due to bureaucracy in this writer’s view. There are systems in place, and managers tend to let the systems control. For example, it is not uncommon for corporate landlord’s to serve three-day notices demanding rent and then to ignore tenant inquiries regarding the problem whether or not they actually intend to pursue eviction. The result is to encourage abandonment. This is not necessarily problematic for landlords. If the circumstances clearly warrant eviction as soon as possible, the cost of abandonment isn’t so great. However, even in the worst of scenarios, communication tends to reduce friction.

When Is a Property Considered Abandoned?

So when is a commercial property considered abandoned? This is an important question for landlords. First, the tenant must be at least 14 days behind in rent. Second, the landlord must have a reasonable belief that the tenant has abandoned the property. It may seem obvious in most cases: the tenant is closed for business; hasn’t been seen on the premises for more than a month and has stopped paying rent and communicating in any way. While intuitively this seems like clear abandonment, the law is a bit more complicated. There must be a demonstrated intent to abandon the premises taking all circumstances into account . The standard is one of a reasonable belief – such that a reasonable landlord would believe that there was an intent to abandon. In the above example, the property may not be considered abandoned if for instance after investigation, the landlord discovers that all of the tenant’s property remains and/or that utility bills are still being paid. Some facts that tend to show abandonment include accumulating mail and newspapers, disconnected utilities, no one answering the door, out of business signs and premises empty of personal property. In more obvious cases, a tenant might actually tell the landlord he is abandoning the premises.

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There are a myriad of provisions in commercial leases that benefit either the lessor, lessee, or, in certain circumstances, both.  As the provisions contained in a commercial lease can drastically impact the rights and obligations of the parties, it is of particular importance that each party effectively negotiate its position in order to obtain the most favorable terms possible.  Sublet and assignment clauses are important provisions that should be considered carefully by both landlords and tenants when negotiating the terms of a commercial lease.

Subleases Versus Assignments

Sublease and assignment clauses accomplish similar results.  They allow tenants to transfer their lease obligations to another individual or entity.  However, each clause operates in a different way.  With a sublease, a tenant transfers part of the leased property to another tenant while remaining on the premises, or transfers the entire property to another tenant for a period of time during the term of the lease.  An assignment occurs when a tenant transfers all of its rights and obligations under the term of the lease to another individual or entity for the entire remaining term of the lease.  Essentially, the new tenant takes the place of the old tenant and releases the old tenant of its obligations to the landlord.  The extent of the obligations released depends on the terms of the assignment clause.

Commercial lease clauses can significantly impact the rights and obligations of landlords and tenants.  Subordination, non-disturbance and attornment (“SNDA”) provisions are standard in commercial leasing and they have a substantial affect on the nature of the relationship between the landlord’s current and future tenants.  As such, consideration of such clauses is essential in the negotiation of any commercial lease.

Generally speaking, SNDA’s are covenants between the tenant and landlord that outline the rights of the parties, and certain non-parties, to the lease where third party lenders are involved.  The three key elements – subordination, non-disturbance, and attornment are closely related.  Subordination to a third party lender is problematic for tenants without the inclusion of non-disturbance language.  

The Subordination Clause

A subordination clause is a lease provision whereby the tenant subordinates its possessory interest in the leased premises to a third-party lender, usually a bank (the rights of the tenant are thus subject to the rights of the lender).  The purpose of this provision is to allow a landlord seeking financing for the purchase of a commercial property additional flexibility in dealing with lenders. Most lenders are unwilling to finance (or refinance) commercial loans where the tenants’ leases do not contain subordination clauses.  Before they will extend financing, lenders require that all tenants subordinate their possessory interest in the premises to the lender’s mortgage interest.  This is so that the lender has the ability to terminate the tenant’s lease (absent a non-disturbance clause) and initiate foreclosure proceedings should the landlord default on the mortgage.

Usually tenants lack the bargaining power necessary to refuse the inclusion of a subordination clause in a commercial lease.  That’s why it is important that tenants always request the addition of a  non-disturbance provision.  

The Non-Disturbance Clause

The non-disturbance clause affords tenants that are not in default the right to continue occupying the leased premises.  The effect of the non-disturbance clause is to protect the tenant in the event a subordination clause is triggered.  A typical non-disturbance clause states that the lease shall not be subordinate to any mortgage arising after the date of the lease unless and until the landlord provides tenant with an agreement from the mortgagee (lender) stating that so long as the tenant is not in default, the landlord’s and the tenant’s rights and obligations under the lease shall remain in force and tenant’s right to possession shall be upheld. Without the protection afforded by a non-disturbance clause, a commercial tenant, through no fault of its own, could easily find itself evicted from a property due to the delinquent loan obligations of the landlord. Maintaining the possessory interest in leased premises is especially important in the commercial leasing context because tenants are usually businesses that would suffer substantial losses if forced to move locations.

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In today’s commercial real estate market, the possibility that your landlord will declare bankruptcy is very real making it important that tenants are aware of their rights. When a landlord declares bankruptcy under Chapter 11 of the Bankruptcy Code, the bankruptcy trustee (the person or entity placed in charge of the landlord’s assets) is given the power to determine whether to accept or reject tenant leases.

If the bankruptcy trustee decides to accept a lease then the tenant must continue to satisfy its obligations thereunder as if the bankruptcy never happened. Both the landlord and tenant remain obligated to perform. Before the trustee can accept the lease, however, it must obtain permission from the bankruptcy court, cure any defaults that arose under the lease, compensate the tenant for any losses arising from the landlord’s breach, and provide sufficient assurances that the landlord will be able to perform its obligations under the lease in the future.

In the event the trustee rejects an unexpired lease, the tenant may terminate the lease so long as the rejection amounts to a breach under the terms of the lease or under applicable bankruptcy law. Alternatively, the tenant may opt to retain its rights under the lease, including rights to continued possession of the premises, rental amounts, due dates, use rights, exclusivity, quiet enjoyment and assignment. Essentially, tenants retain rights that are in or appurtenant to the real property for the balance of the lease term and any enforceable renewal or extension periods. However, the trustee is relieved from lease obligations requiring future performance by the landlord such as the provision of utilities, repair and maintenance and janitorial services. Tenants who opt to retain their rights after the trustee has rejected the lease are entitled to offset damages caused by the rejection and resultant failure of landlord to perform its obligations under the lease against rent due under the lease. This becomes tenants’ exclusive remedy for landlords’ failure to perform.

Generally, the rejection of a lease by a bankruptcy trustee doesn’t void the underlying lease but, rather, provides the tenant with a general unsecured claim against the estate. Consequently, such a claim should accrue to tenants who elect to treat an unexpired lease as terminated and vacate the premises after the trustee’s rejection in bankruptcy. A tenant desirous of obtaining a security deposit is also an unsecured creditor and said obligation by the landlord may be discharged.

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There are a number of provisions that can be written into a commercial lease that benefit either the lessor, lessee, or, in certain circumstances, both.  Although commercial lease terms are important to every business, they are of particular importance to restaurant owners where low profit margins require added attention to limiting operating costs.  Lease payments can directly impact the success or failure of a restaurant.   

Prior to entering into lease negotiations, it’s helpful to start with a feasibility study.  A feasibility study evaluates the potential of a restaurant concept taking into consideration the location and demographics.  Feasibility studies analyze the industry, relevant markets and marketing needs, capacity, traffic in the area, competition, costs structures and management requirements.  Obtaining a feasibility study prior to entering into a lease increases the likelihood that the restaurant concept will be successful.  

Although it’s best to consult an experienced commercial lease lawyer prior to entering into any restaurant lease, there are some key issues and terms restaurant entrepreneurs should play particular attention to:

Consider the Space

Seating and aesthetics play an important role in the operation of a restaurant .  Seating capacity is dictated by the size and shape of the leased space.  In the restaurant business, any where from ten to twenty square feet per person is generally considered sufficient for seating purposes. However, the restaurant’s theme, operation and aesthetics affect capacity.  It’s important to ensure that the guests have enough space to dine comfortably and the staff have enough room to adequately serve the guests.   It’s also important that adequate space is reserved for the kitchen, particularly when the location wasn’t originally a restaurant.  Does the proposed location provide adequate square footage for the concept?      

Short Term Lease

Because the restaurant business is so unpredictable, it is difficult to say with any certainty whether a particular new venture will be successful.  A short term lease provides a prospective new restaurant owner with less long-term risk.  With a two or three year lease, the tenant is provided greater flexibility if the business starts to fail.  Landlords on the other hand generally prefer longer term leases and will most often seek a higher rent in exchange for a shorter term. A short term lease can also backfire.  Landlords may take advantage if the restaurant later proves a huge success demanding much higher rent and less favorable terms for a new lease.  To limit this risk, prospective tenants should seek an option or options to extend the term of the lease.  
 
Tenant Improvements

Building out (remodeling) a new location is perhaps the largest expense for any new restaurant.  A successful restaurant design is fresh and innovative and requires significant modification to the premises including the tearing down and erection of new walls, partitions, doors, windows, skylights and ceilings.  Creating an ideal atmosphere is critical to any restaurant concept.  It is often possible to negotiate for build-out costs in the form of a tenant improvement allowance.  Landlords are often willing to pay some or all of the costs associated with a build-out particularly where a long term lease is being negotiated.  Of course, as with any negotiation, there is a give and take with respect to other important terms.  Short term leases are often desirable for new businesses, making it necessarily more difficult to secure larger tenant improvement allowances.  

Exclusivity

New restaurants want as little competition as necessary.  Determining where the nearest competing businesses are is an important factor in selecting the right location.  The worst thing that can happen after opening for business is to have a competing restaurant move next door or in the same center.  There’s not much that can be done about properties that aren’t under the control of your landlord.  However, Landlords will often agree to exclusivity within the property they control, as long as the exclusivity language is not too broad.  Language that restricts the landlord from renting to any other Italian restaurants during the term of the lease is reasonable.  It’s always a good idea to negotiate for exclusivity. 

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A triple net lease is a type of commercial lease agreement requiring tenants to pay the property’s operating expenses such as utilities, taxes, insurance, and maintenance fees in addition to base rent. Essentially, each tenant is responsible for their own repair and maintenance and each tenant further pays a pro rata share of all of the landlord’s expenses associated with the operation of the commercial property including a management fee to the landlord. Triple net leases are commonly used for multi-tenant industrial and retail properties where operating expenses can be very high.

Commercial property landlords prefer triple net leases because they pass on the risk of unexpected costs to tenants. While landlords most often oversee the maintenance of the common areas including maintaining insurance, paying property taxes, making improvements and marketing the center to the public, they don’t have to worry about the costs related to these efforts. If there are unexpected increases in utility rates or insurance rates, the cost is generally absorbed by the tenants. If the commercial property’s value is reassessed resulting in an increased property tax, the cost is generally absorbed by the tenants. With each tenant responsible for the expenses associated with their specific space and each tenant paying their pro rata share of the rest of the property’s expenses, landlords eliminate or at least limit their risk of unexpected costs. Moreover, hiring management to oversee the property’s maintenance of the common areas and passing this expense onto the tenants allows landlords to collect the base rent free of expenses. This provides landlords with a consistent income stream from rental income. Otherwise, landlords seek a higher base rent when they are paying for all of the property’s expenses.

Although tenants generally dislike triple net leases because of the uncertainty associated with the payment of operating expenses, triple net leases often feature a lower base rent than tenants may otherwise get with more traditional leases. This aspect of triple net leasing can prove particularly beneficial to tenants in newer properties which require less maintenance and often make more efficient use of utilities.

To see how a triple net lease works in the real world, consider the following example:

The owner of a small computer business enters into a triple net lease to rent a 2,000 square foot retail space at $20 per square foot annually for a term of five years with an annual 3% increase in base rent. The 2,000 square feet represents 20% of the retail center’s square footage. The base rent for the property for year one would be $40,000 per year. Because this is a triple net lease, the tenant is responsible for paying 20% of the landlord’s operating expenses for the retail space (its pro rata share). Operating expenses include real estate taxes, insurance, repairs and maintenance, utilities and an annual management fee equal to 10% of the annual operating expenses.

Assume that, in year one, the landlord incurs the following expenses:

• $20,000 for real estate taxes.
• $5,000 for insurance
• $10,000 for repairs and maintenance.
• $15,000 for utilities.
• $5,000 for management fees.

During the first year of the lease, the tenant pays the landlord a total of $51,000.00 ($40,000 in base rent and $11,000.00 for its pro rate share of the total operating expenses). Assume in year two that all of the operating expenses stay the same but the building’s roof caves in and the landlord spends an additional $100,000.00 on repairs. The tenants total burden increases from $51,000.00 in year one to $72,200.00 in year two ($41,200.00 in base rent including the 3% annual increase and $31,000 in operating expenses including the cost for the roof repairs).

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A waiver of subrogation clause is one of the most important provisions in California commercial leasing.  It’s beneficial to both the landlord and tenant, particularly when it comes to insurance issues.  Yet this type of clause tends to be misunderstood and/or generally overlooked because landlords and tenants see the terms as too technical when compared to other commercial lease terms.  However, it’s important to know what these clauses do and why they are important.
 
In general terms, when one party (typically an insurer) makes a payment on behalf of a second party (usually the insured), that first party becomes subrogated to the second party’s rights.  Subrogation is just a technical legal term for “substitution,” or “stepping into the shoes” of another person.  A waiver of subrogation clause prevents one party from “stepping into the shoes” of another party and filing a claim.
 
It’s a bit easier to understand how this works by looking at a couple of real-world examples. Let’s say a tenant leases commercial space from a landlord in a large, multi-unit space.  Usually, both parties are required to have insurance.  The tenant is required to obtain insurance for her personal property in the space she rents, and the landlord is required to obtain insurance for the entire building.  Typically, the tenant will contribute a pro rata share toward the landlord’s premium under the terms of the lease agreement (as with a triple net lease – see “Understanding Your Lease – Common Area Expenses“).  The following examples assume that the parties do not have a waiver of subrogation clause in their lease agreement:
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