Focus on Business Newsletter

The Seven Things Every Savvy Business Should Know About Commercial Real Estate Leases

Winter 2009

Whether your business is the lessor (landlord) or the lessee (tenant) of commercial property, negotiating the terms of a lease can be a complicated but rewarding process if done properly. Because the party that drafts the lease is often at an advantage, the party not providing the lease should pay particular attention to the provisions included. On the other hand, if you are the party drafting the lease, it is to your advantage to control the terms to the extent possible. As a practical matter, the lessor will frequently require that the lessee use its form; however, many large national lessees require use of their own form and may or may not be flexible with respect to modifications. In any event, because every clause in the lease has meaning and consequences, consider, among other things, your business’ present and future needs, and the need for an expansion or exit strategy if operations are successful or unsuccessful.

Pay particular attention to the following issues:

1.         The intended use of the premises.

When negotiating a lease, it is important for the lessor to be as specific as possible and state exactly what type of business may be operated on the premises in order to control the variety of its lessees. Consider addressing the use requirement by specifying a particular trade name under which the lessee will operate. Doing so will allow the lessor to control not only the use of the premises but the trade name under which the lessee operates in that space. On the other hand, the lessee needs to create flexibility to change its use and trade name if its operations are unsuccessful to allow for an alternative use. The lessor may require the lessee to continuously use the premises for a specified use at all times.  However, the lessee will most likely not want to have an obligation to continuously operate. If the business is unsuccessful, ceasing operations and paying the base rent is a helpful exit strategy for the lessee.  If the lessee requires the right to cease operations and continue paying rent, the lessor will want a right to recapture the premises at its election.

The lessee may need the exclusive right to operate a particular type of business in the development to protect itself from competition.  The lessor may not want to grant exclusives, but if it does, the lessor should be careful to specifically define what exclusive right it is granting to the lessee and for how long the exclusivity will last in order to avoid inhibiting its future efforts to lease or sell property. The lessor should consider prohibiting the lessee from opening a competing business within a certain radius of the premises in order to prevent dilution of gross sales which would result in a reduction in the percentage rental received by the lessor.

2.         Does your business need an anchor tenant?

Equally important to the lessee may be the requirement that a particular anchor tenant operate at all times in the development. An anchor tenant is usually the first, and leading tenant in a shopping center whose prestige and name recognition attracts other tenants and, hopefully, shoppers.  This particular provision is critical to lessees who are not destination lessees and require anchor tenants to draw customers into the development. The anchor tenant clause may allow the lessee the option to delay opening for business, terminate the lease or pay reduced rent in the event the anchor tenant never opens or ceases operations. Lessors must be careful to allow time for the anchor tenant to open initially and to replace the anchor tenant if it closes before the lessee may exercises its rights.

3.         Who will pay for taxes, insurance and maintenance on the premises?

Maintenance of the premises and the entire development should be negotiated and specifically addressed. In addition to determining what items on the premises will be maintained by the lessor and lessee, the lease should contain a provision regarding lessor maintaining common areas and collecting common area maintenance (CAM) charges from lessee. CAM charges can result in a substantial additional rental payment due from the lessee and deserves particular attention. In addition to CAM, the lessor will want to recover from the lessee its proportionate share of the insurance and real estate taxes on the development. The lessor and lessee need to decide if the lease is intended to be a net, net, net lease (also known as a triple net lease), where the lessee will pay for its share of taxes, insurance, maintenance and other development expenses, in addition to the rent.

4.         Establishing the term of the lease.

The lease must have an established term to obtain financing and to guarantee use of the premises for a sufficient time. The lessor and/or the lessee may want to have the right to terminate the lease early. The lessee should consider creating early termination rights in the event its operations are unsuccessful and should consider delaying commencement of rent payments until the occurrence of certain events such as the lessee’s opening for business, or the opening of the anchor tenant’s business. The lessor and lessee may both wish to include an additional option to extend the lease for additional years after expiration of the term.

5.         Will you need financing?

Lease financing is another complicated lease provision, but crucial to both the lessor and lessee. The lessee will want the right to grant a security interest in its lease and/or its improvements in a manner likely controlled by its lender. The lessor will want the right to approve of the lessee’s security agreement and to make sure it is in a commercially reasonable form. The lessor often finances the development by granting a security interest in the development, its lease agreements and the rents.  It is important for the lessor to be able to negotiate this with its lender without the need for the lessee’s consent or approval.

6.         To sublease, or not to sublease?

Once the lessor has determined who will be the lessee and what that lessee’s intended use will be, prohibiting the assignment of the lease and subleasing by the lessee without lessor’s prior consent will be an issue. From the lessee’s perspective this provision should include language stating that the lessor’s consent shall not be unreasonably withheld.  This allows the lessee some flexibility to assign the lease or sublease the premises, if its operations change. A more favorable lessee provision will allow the lessee to assign the lease or to sublease without the need for the lessor’s consent or approval.

7.         The importance of default clauses and boiler plate provisions.

Particular attention should be given to default clauses.  It is important to be aware of the events within the lease that constitute a default.  Likewise, what remedies are afforded to the non-defaulting party?  Typically, events of default include failure to perform any obligation under the lease and any failure to pay sums due under the lease.  Both parties will want to receive notice of any default and an opportunity to cure the default before a remedy may be enforced. The prevailing party should be reimbursed attorneys fees and costs.

The lessor and lessee have statutory liability arising from ownership, occupancy and use of the premises.  However, Louisiana law specifically allows the lessor and lessee to shift some responsibility. Where the lessor is not actively managing the premises, but, instead, the lessee has control, it is more important for the lessor to shift responsibility to the lessee, but lessee beware.

The lease will likely contain numerous boiler plate provisions, all of which have meaning and consequences.  The division of condemnation proceeds is important, particularly depending on the amount of improvements made by the parties. The ability to move into additional space to allow for future expansion may be provided for by a right of first refusal to lease space or an option to lease additional space.  The form of security required by the lessor may be in the form of a security deposit, lien and/or a guarantee of the lessee’s obligations from individuals. The terms of the guaranty should be carefully negotiated by the guarantor and the consequences need to be understood. The lessor will want to reserve the right to sell the development without the necessity of obtaining any approval from lessee and to be released from liability after the date of the sale. The lessor should include the right to impose rules and regulations governing the development. Lessee should be careful to limit these rules and regulations so as not to materially change the terms of the lease or increase rent, and to require that the rules and regulations be enforced against all lessees uniformly.  Limiting the lessor’s liability under the lease to its equity in the development and to exclude its other assets is key. The parties should address who will be responsible for compliance with all laws and regulations. Finally, of particular importance is the ADA and hazardous substances compliance.

There are many important lease provisions to be negotiated and this article addresses only a few of the more basic lease issues.  A lease is a binding agreement between the parties, and careful attention should be given by the lessor, lessee and any guarantor to every term of the agreement and their potential consequences.  Nevertheless, with leasing negotiations, as with respect to any other type of contract:  forewarned is forearmed.