CORONAVIRUS UPDATE FOR COMMERCIAL TENANTS

Articles Posted in Commercial Leasing

There are a variety of terms that may be written into a commercial lease 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 individual effectively negotiate his position so as to obtain the most favorable terms possible. Although it is always advisable to consult with an experienced commercial lease lawyer, the following are a few tips to keep in mind throughout the negotiation process. It is not by any means a comprehensive list of issues, but these tips address some of the major concerns. Preliminarily, keep in mind the parties’ relative bargaining positions. In most cases, landlords have the upper hand. Understanding relative bargaining power helps a business decide where and when to use its bargaining chips.

536818_key.jpgDecide What Terms Are Important to Your Business
The most obvious terms that need to be considered when negotiating a commercial lease are the length of the agreement and the amount of rent to be paid. It is generally advisable not to commit to a lease more than two to five years in duration, with an option (or options) to renew the agreement at the time of expiration. The length of the lease is significant because businesses need flexibility to move and expand as they grow. Entering into a longer lease may leave a business that has outgrown its current space with little recourse.

The amount of rent is probably the most important factor during the negotiation process. A fundamental understanding of what the business can afford in the short and long term is critical. It’s important to factor in the annual rental increases and any common area maintenance expenses (CAM expenses) when making this determination. A well drafted business plan with realistic projections is the best way to ensure success.

In addition to these key terms, determine any other specific issues that are of concern to the business. Try and consider all eventualities. Every business has different needs resulting in different priorities. For instance, a yoga school may require more parking spaces than other tenants in a particular strip mall. If this is the case, be sure to address the issue of parking in negotiations with the landlord.

Determine Which Party Is Responsible For Maintaining And Repairing The Premises
Unlike residential leases, where the responsibility of conducting repairs and maintenance generally falls on the landlord, commercial leases typically allocate this burden to one party or the other. Most commercial leases require the lessee be accountable for all upkeep of the premises, while others specify that the tenant is only responsible for certain items such as utilities, plumbing and air conditioning. In the triple net lease (the most common type of commercial lease especially in the retail context), all CAM expenses are passed on to the tenants. It’s important to have a clear understanding of which expenses will be allocated to the landlord and which expenses will be allocated to the tenant. There are often CAM exclusions specified in the lease. During lease negotiations consider whether additional CAM exclusions are worth negotiating for. See “Understanding Your Lease – Common Area Expenses“.

Be Clear On The Terms Of Default
No one enters into a lease intending on defaulting, however, the reality is that many companies fail and are unable to satisfy their obligations. Accordingly, it is imperative that the terms of the lease be clear as to what constitutes default and as to the remedies available to the non-breaching party. If the tenant falls behind on rent, how long before the landlord can initiate eviction proceedings? If the tenant fails to maintain required insurance, what are the landlord’s options? Will the tenant have time to cure the problem before eviction proceedings are instituted? Are there incurable breaches in the lease? Are there limitations on the tenant’s remedies for landlord breaches? It is common for commercial leases to restrict tenant’s remedies to actual damages (no punitive damages or lost profits) and to prohibit termination of the lease without legal action. Negotiating the terms of default and available remedies up front provides both landlord and tenant with clear dividing lines which in the long run helps avoid future head-ache and unnecessary costs.

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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).
 
1318581_modern_business_glass_facade.jpgDepending 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).   

Escalator.jpgProblems 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.  

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.  

1188945_into_the_hell_hole.jpgThose 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.
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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.

1037039_scenes_from_the_mall_5.jpgMost 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.

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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.

139045_shopping_centred_4.jpgFor 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.

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.

997479_french_cafe.jpgA 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.

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.

833931_klcc_2.jpgThe 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. 

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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.

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.

453592_2_ladies.jpgParagraph 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.

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