"Are You Losing Money?" 10 Common Pitfalls for Commercial Tenants to Avoid
Robert C. Nicholas, Esq., Partner, Haas & Najarian
Although reading a commercial lease can be difficult and time-consuming, the consequences of not reading can be infinitely more unpleasant. Tenants frequently will only look at the provisions that have direct economic impact. There are, however, provisions buried in the lease which may have unintended impact on the tenant. While a tenant’s ability to delete or modify these objectionable provisions will depend on a number of factors, including, among others, the size and reputation of the tenant, market conditions, the vacancy level of the building, the size of the space and the length of the lease term, every tenant should make an effort to ameliorate the effect of these pro-landlord terms. Some of these provisions are explored below.
1. Common Area Maintenance (“CAM”) Expenses (also known as “Operating Expenses”):
Landlords may try to use this provision as a “profit center.”
- An Operating Expense or CAM provision requires the tenant to pay its pro rata share of the operating expenses incurred by the landlord in the operation and maintenance of the building. Unfortunately, landlords have expanded the list of expenses to include every imaginable expenditure. By doing so, some landlords have turned this provision into a profit center. Instead, the provision should only pass through to the tenant legitimate expenses relating to the operation and maintenance of the common areas.
- The tenant should carefully review the history of the building’s CAM charges for at least the three prior years. This will enable the tenant to compare the amount of operating expenses and their annual increases to other comparable buildings to determine whether they are reasonable, and to estimate what the charges might be in future years.
- The CAM provision should be rewritten so that only “legitimate” CAM charges are included and items such as capital improvements and compliance with laws are excluded. Most landlords will accept what has become known in the industry as a standard list of operating expense exclusions.
- Particular attention must be given to the definition of the base year in any CAM clause which requires the tenant to pay its prorata share of expenses incurred over a base year. The tenant should make certain that the tenant has no obligation to pay for expenses during the base year and that the base year variable expenses are subject to a “gross up” to reflect the full amount of operating expenses that would have been incurred by the building had it been 100% occupied.
- Watch out for any provision making the landlord’s determination of CAM charges final. The tenant should reserve the right to audit the landlord’s expenses and to review the landlord’s calculations.
- Review the operating expenses clause against the compliance with laws, repair and maintenance and real property tax clauses to prevent the landlord from passing through to the tenant expenses which it may have solely assumed under these and other clauses.
- Alternatively, if the situation permits such negotiation, attempt to insert a maximum upper limit (“cap”) on CAM charges, or a “kick out” clause allowing the tenant to terminate the lease if CAM charges exceed a certain amount.
2. Repair and Maintenance Provision:
Landlords may try to use this provision to require the tenant to repair and maintain areas located outside the leased premises.
- There are great distinctions among the clauses that define the tenant’s obligations under the lease with respect to repair and maintenance.
- The tenant must pay particular attention to any repair and maintenance provision that requires the tenant to repair and maintain items or areas that are traditionally the landlord’s responsibility.
- A typical lease will define repair and maintenance obligations with reference to the interior of the premises. However, depending on the definition of the premises, this may result in the tenant’s having to repair and maintain such things as plumbing, sprinklers, HVAC ducts, and the building’s structural elements.
- It is imperative that the tenant limit its repair and maintenance to the interior surfaces of the leased premises, excluding any structural elements or building systems located therein.
- Define exactly the extent of the tenant’s repair and maintenance obligations, taking care to exclude items such as regular wear and tear or items that are covered by the landlord’s property insurance.
- If the landlord is to be held responsible for the repair and maintenance of certain items, the lease must be specific about these items so that there is no doubt as to which party has responsibility.
- Finally, the tenant should try to make certain that the costs of the repair and maintenance for which the landlord is responsible cannot be passed on to the tenant, through, for example, the operating expense provision.
3. Real Property Taxes:
An unsuspecting tenant may find itself paying real estate taxes and special assessments for a period beyond the expiration of the lease.
- The real property taxes provision defines the respective obligations of the landlord and tenant for real property taxes. Landlords have expanded the definition of real property taxes to include any type of tax assessed against the property, the landlord or for doing business and are increasingly defining taxes to include future taxes of any sort, including rent taxes or income taxes.
- Define precisely which taxes and/or assessments are to be included in the definition of real property taxes and be sure to exclude federal or state income, franchise or estate taxes.
- Make certain that the tenant’s tax and/or assessment responsibilities do not survive the tenancy. That is, if, for example, a three year installment for assessments becomes due at the commencement of the last year of the tenancy, the tenant should be responsible only for its pro rata share of the total amount (i.e. one year).
- The tenant should be aware that its tax liability may increase dramatically if the landlord sells the property, particularly if the landlord has held the property for a long time and property values have greatly increased. The tenant may wish to put some limitation on increases in real property taxes resulting from a change in ownership by, for example, having increases occur incrementally over time or completely eliminated.
4. Compliance with Laws:
A tenant not appreciating the potential effects of this provision may find itself footing the bill for earthquake retrofitting, asbestos abatement, sprinkler installation, or compliance with the Americans with Disabilities Act.
- This provision typically requires the tenant to perform potentially expensive replacements, alterations, or improvements of the leased premises to comply with existing or future laws and government orders relating to the leased premises.
- In some instances the landlord agrees to bear the burden of complying with these laws or the lease places the onus to comply with such laws directly on the tenant.
- In either case, it is the tenant who, depending on the particulars of the situation, may have to foot the very substantial bill for items such as asbestos abatement, retrofitting or compliance with the Americans with Disabilities Act.
- If the landlord is to bear the responsibility, the tenant must curtail the landlord’s ability to “pass on” the cost of compliance through other provisions, such as the operating expense provision.
- If the tenant is to be responsible for compliance with laws, the landlord should represent and warrant to the tenant in the lease that the building is in compliance with all presently-existing laws and limit its responsibility for compliance with future laws to those items necessitated solely due to the tenant’s particular use of the premises.
- The tenant should try to place a cap on its annual exposure under this provision.
5. Assignment and Subletting:
Asking the landlord for permission to assign or sublet the premises may give the landlord the ability to terminate the lease.
- In the typical commercial lease, the landlord requires the tenant to get the landlord’s consent prior to any assignment or sublet.
- Negotiate several exclusions from the consent requirements, including assignment or sublet for reorganization purposes and space-sharing arrangements up to a defined square footage (the latter has particular application to office leases or retail leases where the business is seasonal).
- Where the lease requires consent and the landlord consents to an assignment or sublet, the landlord may get to keep all rents paid by the assignee or subtenant in excess of the tenant’s fixed rent obligation to the landlord. The tenant should ask for at least a portion of this “excess” rent.
- Furthermore, it is imperative that the tenant have subtracted from the “excess” the book value of leasehold improvements made for the assignee or sublessee and any broker’s commissions paid by the tenant in locating the assignee or sublessee. Not doing so may severely overstate the excess rent and can result in a windfall to the landlord.
- In the absence of a release, the tenant will continue to bear the economic risks of paying the rent and all other charges under the lease for the balance of the lease term, including any existing options to to extend or renew (“Options”) following an assignment. The tenant should attempt to get a release of liability for the Option periods.
- Carefully review the lease to determine whether it contains a recapture clause. Under a recapture clause, a request by the tenant that the landlord consent to an assignment or sublet triggers an option enabling the landlord to terminate the tenant’s lease. The tenant should have the recapture clause deleted or should insert an option allowing the tenant to withdraw its request if the landlord elects to terminate the lease.
- Insert a clause that requires the landlord to give the tenant notice of any default following an assignment so that the tenant will have the right, but not the obligation, to cure the default and regain possession of the premises.
6. Subordination, Nondisturbance and Attornment (SNDA) Provision:
If the landlord asks you for what amounts to a favor for the benefit of its lender, the tenant should be sure to get something in return.
- This provision defines the important relationship between the landlord’s current and future lenders and ground lessors, and the tenant in the event the landlord defaults on its loan obligations or obligations to the ground lessor. A subordination clause typically readjusts the priorities that normally would result from general legal rules, by providing, for example, that any existing or subsequent lender of the landlord can elect to deem its deed of trust superior or junior to the lease, regardless of the date on which the lender’s deed of trust was recorded. An attornment provision generally obligates the tenant to recognize the foreclosing lender or ground lessor as the new landlord under the existing lease.
- In exchange for its subordination and attornment agreements, the tenant must assure continuation of its lease by requiring the landlord’s lender or the ground lessor to agree not to disturb the tenant’s lease if the lender forecloses or the ground lessor asserts its right to the property. This becomes especially important to a tenant in a market with little inventory and escalating rental rates. Without a nondisturbance clause tied to the subordination and attornment provisions, the tenant’s lease could be wiped out by virtue of the subordination provision.
7. Tenant Remedies (Termination and Abatement Rights):
A lease containing waivers of tenant remedies may leave a tenant with no place to turn if the landlord defaults in its obligations.
- This clause defines what, if any, remedies are available to the tenant in the event of a default on the part of the landlord.
- Many commercial leases cause the tenant, by accepting the terms of the lease, to waive a host of remedies provided by the law. Other leases fail to mention tenant remedies entirely.
- When negotiating a lease, ideally the tenant would like to preserve its “repair and deduct” rights so that if there is a problem, the tenant can remedy the problem and deduct the cost from its rent; in most cases the landlord will require a waiver of this right.
- A tenant should, therefore, negotiate a lease which contains abatement and termination rights.
- Abatement rights allow the tenant to abate, in proportion to the area of the premises affected, the amount of rent it pays if the landlord fails to remedy items for which it is responsible that interfere with the tenant’s use of or access to the leased premises.
- Termination rights may give the tenant the option, under the above circumstances, to vacate the entire premises without further obligation.
8. Termination, Relocation or Expansion Rights:
A tenant who has not had its lease carefully read may be surprised to learn that the landlord has reserved the right to unilaterally terminate the lease or relocate the tenant.
- A termination provision in favor of the landlord allows the landlord to unilaterally terminate the lease, usually on the occurrence of some condition.
- A re-location provision allows the landlord to relocate the tenant to other premises within the building.
- An expansion provision, on the other hand, may give another tenant the right to expand into the tenant’s premises and may allow the landlord to terminate the tenant’s lease or relocate the tenant.
- Ideally, a tenant should not agree to such clauses.
- If conditions require acceptance, the tenant should make certain that it can only be relocated to a comparable location and position and that the landlord has to pay for all expenses related to the relocation, including the cost of moving the business and installing tenant improvements.
9. Damage and Destruction:
A trap for the unwary.
- This provision provides what will happen if the leased premises or the building housing the leased premises is damaged or destroyed. It typically provides that the landlord may elect, in its sole discretion, to continue the lease or to terminate it. In the case of continuation, it usually provides for an abatement of rent in the same proportion that tenant’s use of the leased premises is impaired.
- The tenant must make sure that the abatement of rent language is fair. Some leases base it on the amount of square footage of the leased premises that is damaged or destroyed. This is unfair since sometimes the entire leased premises may not be useable even where the damage is to a small area.
- The ability to terminate should reside in both landlord and tenant. Otherwise, the tenant may find itself bound to a lease under which it is unable to use the leased premises for a significant time. This can throw a real wrench into any tenant’s business plans.
- Beware of provisions that make the tenant liable for rent if the damage or destruction results from the negligence of the tenant. Why should the tenant remain liable if the landlord has business interruption insurance, or other similar insurance?
- Watch out for provisions that allow the landlord to terminate the lease if the damage or destruction occurs within some period of time (typically the last two years of the lease), and that allow the landlord to invoke the provision where the damage or destruction is to other buildings comprising the project but not effecting the leased premises.
- Make sure the tenant retains the right to complete your improvements following the landlord’s repair or reconstruction before your rent obligation resumes.
10. Tenant Improvements:
Now you see them, now you don’t. If improvements are to be made to the leased premises prior to the tenant’s occupancy, the tenant must understand the economic impact of such improvements and know what it will get.
- Make certain that the obligation to pay rent and other charges do not begin until the tenant improvements are complete.
- Determine whether the landlord will be designing and constructing the tenant improvements at its sole cost (a “turnkey” arrangement) or whether the landlord will be giving the tenant an allowance, with either the tenant or landlord designing and constructing the improvements (an “allowance” arrangement).
- Before entering into the lease, in an allowance arrangement, the tenant should have final space plans and estimates for the work so that the tenant is not exposed for the cost of improvements in excess of the landlord’s allowance or, at the very least, will know how much it will have to pay.
- In both turnkey and allowance arrangements, the tenant must be certain to work with a competent broker and space planner to make certain that the space will be built out to satisfy the tenant’s needs.
- Where the landlord does the design work, reserve the right to look at, review and approve all designs and materials utilized, and the right to make changes up through the design stage of the tenant improvement design documents.
- Additionally, in an allowance arrangement, make sure that the allowance will not be used up for base building work, such as bathrooms located in common areas, asbestos abatement, or sprinkler systems.
- Agreement should be made as to the disposition of the landlord allowance if the actual tenant improvements cost less than the allowance. The landlord would like to keep the unused portion of the allowance, but the tenant should attempt to get the landlord to apply the allowance to the costs of other work that is the responsibility of the tenant under the lease or work letter, pay it to the tenant, off-set it against future rent, or allow the tenant to use some portion of it.
- Negotiate remedies for landlord-caused delay and carefully define and limit the consequences of tenant-caused delay.
About the Author
Robert C. Nicholas, Esq. is a partner at Haas & Najarian of San Francisco who specializes in commercial leasing.