Protecting Your Interests In Leasing Commercial Space
By Andrew B. Golkow, Esq.
Among the most critical decisions an organization can make are the selection of an appropriate location, and the acquisition of space. Frequently, an organization will elect to lease space, rather than purchase commercial property outright. The focus of this article is the leasing process, once the location has been selected and the decision has been made to lease rather than purchase the premises.
Prospective landlords and tenants should be aware that the maxim “it’s all negotiable” applies more in commercial than in residential agreements. Like many jurisdictions, Virginia has a residential landlord-tenant statute (the Virginia Residential Landlord and Tenant Act [VRLTA], Virginia Code §55-248.2 et seq.), but that statute applies to “residential dwelling units”, not to commercial space. Even though the VRLTA will not apply, general provisions of Virginia Title 55, Chapter 13 (Landlord and Tenant), common law, and general contract law will apply.
Once a company has selected a location and has decided that the premises will be leased, the next step is a letter of intent (“LOI”) between the prospective landlord and tenant. It is strongly recommenced in most commercial leasing transactions that a letter of intent be executed before proceeding to prepare and negotiate a lease. The size and complexity of lease documents has grown over the years, particularly where there are construction or buildout issues. Given the terms that are typically found in the first draft of a commercial lease, a tenant would be poorly advised to spend the energy, time, and resources required to review and negotiate a lease before all of the material terms important to the tenant are specified. If you find out that the parties simply cannot come to an agreement, it is far better to find out at the LOI stage, and walk away at a lower cost.
An LOI outlines the terms of the deal and serves as a non-binding agreement to enter into negotiations for a lease which will contain the specified terms, among others. A well-prepared LOI should make it absolutely clear that the LOI is not an enforceable contract, and that no legally binding agreement will exist unless and until a final, written lease is executed and delivered by the parties. While in some situations, such as mergers and acquisitions, there may be both binding and non-binding elements (such as a confidentiality provision, or an exclusive dealing clause), great care needs to be taken to make it clear what is binding and what is not. The legal landscape is littered with the wreckage of aborted transactions where a plaintiff later claimed that there was an enforceable contract (See Texaco, Inc. v. Pennzoil Co., 729 S.W.2d 768 (1987), where in an acquisition context a preliminary memorandum was held to have sufficient elements of a contract to permit an action for tortious interference with a contract).
Parties will sometimes hear that since a well-prepared LOI is not a binding contract, and either party is free to walk away at any time, or to totally disregard the LOI, the prospective landlord and tenant should not get “bogged down” on the LOI and move quickly to the lease. It is true that parties can likely walk away from the LOI. However, rushing past the LOI only means that issues that could have been addressed earlier, at less cost, will be negotiated later, when the costs and stakes are higher, and time deadlines may become more pressing. The LOI essentially serves as the framework for the initial preparation of lease documents. Moreover, even though a party can walk away before the actual lease is signed, once the LOI is signed, absent important or compelling circumstances, disregarding the terms and conditions specified in the LOI will have deal risk. The other party may choose to go along for one reason or another, but the party walking away from a provision of the LOI runs the risk that it may prejudice the deal itself.
Among the matters to be addressed in the LOI are the following:
1. Base Rent: In a commercial situation (both office and retail), there is typically “base rent” and “additional rent”, being the additional items that are charged to a tenant. With office leases, base rent is typically quoted on an annual basis as the price per “rentable square foot” (“RSF”). As a hypothetical, if there was an office that is 55 feet by 55 feet, one may think that the base rent would be based upon 3,025 square feet, but that would be wrong! “Rentable square feet” adds to the actual square footage what is known as “core factor”, which is an allocation of core areas of the building to the leasable spaces. For example, if a building has a “core factor” of 10 percent, the 55 by 55 square foot office would be 3,327.50 RSF. In that situation, the quoted base rent of $30 per RSF would mean annual base rent of $99,825, or $8,318.75 per month. At the LOI stage, if there is a rental abatement (meaning a certain number of months of rent is waived as an inducement), that should be stated in the LOI.
2. Pass-through Expenses: Common area maintenance (“CAM”), real estate taxes, and landlord’s insurance are typically passed through to tenants, allocated on a per rentable square foot basis. Office leases will typically have a “base year”, i.e., passing along increases in pass-through costs above the base year. Retail and industrial leases will typically have pass-through expenses from the first dollar, without regard to the base year. Certainly, this is negotiable. In the case of older industrial space, a prospective tenant might be able to negotiate no pass-throughs, just base rent. But if you’re talking about Class A office space in Tysons Corner, you should expect to pay pass-throughs. However, depending upon the situation, you may be able to negotiate limitations on annual increases, and some kind of estimate of the first year’s pass-through expenses. Also, if the lease will commence in, for example, December 2019, the prospective tenant would insist that the first base year be 2020.
3. Percentage Rent: Typically, in retail leases, the landlord will set the base rent so that it can participate in increases in sales. “Percentage rent” is additional rent that is a percentage of sales above a certain target, or “breakpoint”. In retail leases, particularly for desirable space, one will typically see the term “natural breakpoint”. That is the level of sales at which the percentage rent would equal the base rent. For example, if, in a retail lease, the percentage rent factor is 6% of sales above the “natural breakpoint”, and the base rent is $60,000 per year, then the natural breakpoint would be $1,000,000 ($60,000 divided by 0.06 = $1,000,000).
4. Critical Dates: A LOI will identify the date that the lease commences (usually when the premises is tendered to the tenant) and the date that the tenant is obligated to start paying rent, called the “rent commencement date”. This depends on the situation – is the premises “turnkey” (ready to go when the tenant obtains possession), or is some kind of buildout required? If a buildout is required, who is doing the buildout – will the landlord do it, or will the tenant obtain its own contractor (as well as building permits) and do the buildout based upon landlord plans? One of the biggest traps for tenants is specifying a rent commencement date that does not take into account the contingencies that must occur before the tenant can even start construction of its buildout. Before your contractor can hammer one nail, there has to be a building permit, and before you can apply for the building permit, there must typically be plans approved by the landlord. Some tenants have had a very unpleasant surprise by agreeing to a stated rent commencement date, and then finding out that approvals and permits took longer than expected.
5. Buildout Allowances and Construction: Frequently, depending on the state of the rental market, if the tenant is doing its own buildout, the tenant may receive an allowance from the landlord toward permanent improvements. While construction details are usually reserved for the lease, the amount of the allowance and payment should be stated in the LOI. The landlord would like to pay the allowance when the construction is completed and the certificate of occupancy is in hand – the tenant will want to receive the allowance on a percentage of completion basis, so that the tenant can pay its general contractor.
Where there is a substantial buildout, the LOI should have an exhibit stating what is already in the premises. For example, does the tenant have to bring utilities to the space from another point, or is the landlord bringing utilities into the space? For certain types of applications it may not be clear whether the existing utilities will accommodate the tenant’s proposed usage (i.e., an office building may not be set up for super-computers), and who is responsible for upgrading the utilities.
6. Term: How long is the lease term? If there are upfront costs, the parties will want enough term to be able to recapture or amortize their upfront costs. A critical issue will be the renewal. It is important to understand that in Virginia, as in most states, a commercial landlord has zero obligation to renew a lease when the term has expired. A restaurant tenant does not want to have spent a million dollars to build out its space and then built up a loyal following at its location, and then have to negotiate a lease renewal when the initial term is expired! A government contractor or professional services firm does not want to spend a lot of money to build its space, and then be faced with a disruptive and costly move, and have to negotiate with the landlord if it elects to stay in the premises. You can bet that negotiation will be painful! If there is a right to renew or extend, the LOI should state that will be in the lease. Additionally, the LOI should state what the new rent will be, or how it will be determined, if the lease is renewed.
Beware of a “right to negotiate” the renewal rent! In Virginia, a right to negotiate is not worth the paper it’s printed on. In order to be enforceable, a right to renew must state that the base rent for the renewal period is either a specific stated amount, or fair market rent with an objective method for determining “fair market”. In many applications, variations of the “three broker” method are used.
7. Restrictions on Tenant’s Use: In retail leases, this is hugely important to the landlord. A shopping center owner does not want to have all clothing stores or all Italian or Chinese restaurants – they want a proper tenant mix to ensure good results for tenants and the landlord. The tenant, on the other hand, wants the permitted use to be as broad as possible, so that it can take advantage of changes in the marketplace without having to deal with the landlord. In an office lease, prospective tenants should be careful about a permitted use that is too specific (i.e., a law firm or an accounting firm) – it should just say “general office use”. Otherwise, if in the future, the tenant wants to assign or transfer the lease, and the use is too narrow (such as “an accounting firm”), it would make the assignment process that much more difficult.
8. Leasing Restrictions/Exclusives: This is the “flip side” of permitted use. A retail tenant will want to make sure that its competitor doesn’t open up right next door! A landlord will want to have as much flexibility as possible. The reason why this should be stated in the LOI is that if the tenant fails to do this, and then raises it during the course of lease negotiations, the landlord would be able to argue that an exclusive was not part of the deal, and that by raising it now, the tenant is seeking some additional consideration that was not in the deal before. Of course, this is posturing, and the tenant may well be able to negotiate an exclusive at the lease negotiation stage – but then be ready for “what’s good for the goose is good for the gander”.
9. Condition of the Premises: This is a “trap for the unwary.” If the premises is leased “as is”, what happens if there are existing violations in the premises, such as existing building code or Americans with Disabilities Act (“ADA”) issues? A tenant does not want to be in a position of having to correct someone else’s problems in the premises, or increase the cost of their buildout in order to correct what is already there.
10. Security Deposit: At the LOI stage, a landlord may want to say that it reserves the right to set this upon review of the tenant’s financials. The tenant will no doubt want to set the amount, such as one month’s base rent, and not have to haggle over the deposit while negotiating the lease. One of the items typically negotiated at the LOI stage is a “burn off” of the security deposit – that means if there has been no default during a period of time, the deposit is then waived or reduced. When there is a more substantial lease, such as a larger tenant taking an office building, there is a big risk in the event of a landlord bankruptcy. If the landlord goes into bankruptcy, the amount held by the landlord which is not in a separate account (i.e., commingled) is a general asset of the “debtor in possession”, and the tenant is treated as a general unsecured creditor. The risk of losing a large sum in a landlord bankruptcy may be unacceptable to the tenant, and the answer is frequently a letter of credit issued by a bank in lieu of a security deposit. The letter of credit is not necessarily easy – it may reduce the credit available for borrowing, and there will be fees charged by the lender.
11. Guaranty: In many situations, particularly where the tenant is a small business, or a single-asset entity (such as a chain of restaurants where each location is a separate corporation or limited liability company), the landlord may want a guaranty from the owner, or parent entity. This is entirely negotiable, and should be stated in the LOI. Even if there is a guaranty, the LOI should state whether there are limitations on the guaranty, such as a dollar limitation of liability, or that the guaranty will expire at some point in the future. Of course, the fact that limitations are not stated in the LOI does not preclude the subject from being brought up in negotiations. However, a prospective tenant should realize that their bargaining position is never as great as when the landlord (or the landlord’s broker) is trying to get an LOI signed – and it is easier to walk away from a deal – so that is the time to make sure the limitations are agreed to so that the subject does not have to be revisited while negotiating the lease.
12. Other Important Matters: Each prospective tenant may well have certain things that are near and dear to them. It could be parking, or a certain amount of reserved parking. It could be that the landlord will need to cooperate with the tenant’s financing, or special provisions permitted an easier assignment or transfer of the lease. The general principle is that if a particular item is important to the tenant, such that the tenant would not want to take the location without it, then it should at least be stated in the LOI. The LOI is not the lease, so these issues do not have to be written out in great detail in the LOI. However having them in the LOI will make sure they are on the table when the lease is negotiated.
13. The LOI Is Not Binding: From the landlord’s perspective, it is critical to make it absolutely clear that neither party is bound to anything unless and until a final lease agreement is signed by the parties. The parties may fail to come to terms on the lease for any number of reasons. Either the landlord or the tenant may get a better offer. The bottom line is that if either party decides to walk away, for any reason, nobody wants to then be possibly facing litigation over whether or not there was some kind of contract or reservation of space.
These are not the only considerations in a well-prepared LOI, but an indication of the type and complexity of the issues involved. From the perspective of both the landlord and the tenant, when they proceed to the next stage – drafting and negotiating a lease – the cost, level of effort, and complexity goes up. Because of the size and complexity of commercial leases, it does happen that sometimes the parties cannot come to terms. But, if there is not a deal to be had, it is best to know at the LOI stage rather than at a later stage.
Once the LOI is finalized and signed, the parties will then proceed to negotiation of the lease. It is important to emphasize that while a well prepared LOI is helpful, the LOI is not the lease. Over the past decades, the size and complexity of commercial leases has grown exponentially. Property owners want to protect their investment, and will need to have leases that will make the property attractive to potential lenders or buyers. If a landlord’s lease fails to adequately protect the property owner, it may make the property less marketable. Conversely, tenants will need to protect their interests as well, and not agree to provisions that will unduly restrict or burden the tenant. For prospective tenants, it is a mistake to assume that the provisions of the lease that do not address the rent and term are mere “boilerplate” or “standard”, and one should just sign the lease if the rent is right.
While most landlords operate in good faith, and will make sure that the first draft of the lease is consistent with the LOI, sometimes a prospective tenant will find that, even though the LOI was carefully drafted, the first draft of the lease deviates to some degree from the LOI. Enough cannot be said about allowing sufficient lead time for the leasing process, so that a prospective tenant has sufficient leverage to ensure that the deal they bargained for is the deal they get.
While not an exclusive list of the possible issues that parties will face in a commercial lease, these are just a few:
1. Allocation of Pass-Through Expenses: As noted above, retail and office leases typically have allocations of real estate taxes, landlord’s insurance, and operating costs. The question is how are these costs allocated among tenants, or what is the fraction that is the basis for the allocation. A prospective tenant should pay close attention to the denominator in this fraction. The denominator should be the total leasable space in the property. For example, if an office has 20,000 RSF, and the total leasable space in a building is 250,000 RSF, then the tenant should be allocated .08 of the costs (20,000 divided by 250,000). There are, however, some leases (or at least the first draft) where the denominator is stated as the “leased and occupied” space in the property. This is a “trap for the unwary.” In that situation, the landlord is trying to make tenants bear the cost of vacancies.
In some shopping center leases, the landlord will have special arrangements with major tenants (such as department stores) so that their space is not included in the denominator. In that situation, the prospective tenant should do its “due diligence” to find out what the costs will be, and ensure that those costs that are paid by the major tenants are not included in the total costs passed through to tenants.
2. Compliance With Laws: Some things are not all that they appear to be! Be wary of a blanket requirement that a tenant comply with all laws, ordinances, and codes. First, there is a difference between laws expressly pertaining to the use and occupancy of the premises, and laws pertaining to the conduct of tenant’s business generally. A tenant should insist that this only apply to the former – a tenant would not want to have its lease at risk because of, for example, an asserted wage and hour violation by a disgruntled employee. Second, what about code or Americans with Disabilities (ADA) violations existing in the premises? Without clarification, an obligation to comply with “all laws” could impose an obligation to fix violations in the premises that were not intended or expected.
3. Assignment and Subletting: As a general legal principle, contracts which are not for personal services can be assigned. From a landlord’s perspective, the landlord needs to ensure that they have a hand in the process, that a substitute tenant (if the lease is assigned) or a subtenant is financially capable, and there will be no changes to the permitted use. In a retail lease, the landlord wants to ensure that a new tenant is consistent with the tenant mix in the center, and has the operational capability so that the landlord will not be dealing with a default situation in the future. From the tenant’s perspective, there needs to be flexibility so long as it does not impinge upon a major interest of the landlord. In particular, a tenant will need to be able to sell the business, and realize the gain from that sale.
In Virginia, if the lease says that the tenant can assign or sublet only with the landlord’s consent, and nothing more, it means that the landlord can grant or condition its consent in the landlord’s sole discretion. In Virginia, in a commercial setting, the landlord has no obligation to be “reasonable” unless that is provided for in the lease. A tenant wishing to sell its business, faced with the need for a landlord’s consent in the landlord’s sole discretion, may have an unanticipated obstacle. In negotiating the lease, if a prospective tenant has expansion, or merger/acquisition plans, it is critical that these be dealt with properly.
4. Landlord’s Lien: Above all, a landlord needs to ensure that the rent will be paid, and that if there is a default, the landlord will have remedies to enforce the tenant’s obligations under the lease. In Virginia, as in many states, there is a statutory landlord’s lien, that automatically grants the landlord a lien on any property belonging to the tenant found on the leased premises, or which may have been removed from the leased premises no more than 30 days prior to the landlord’s exercise of the lien. This statutory lien exists as a matter of law, whether or not it is mentioned in the lease.
In some cases, the landlord may conclude that the statutory lien is insufficient. It only secures rent for a specified period of time. The statutory lien only applies to tangible personal property (referred to as “any goods of the lessee” in Virginia Code §55-231) in the premises, so it would not apply to a tenant’s intangible property or to tangible personal property used at another location. As a result, a landlord may wish to take a contractual lien (called a “UCC lien”, because it is subject to the Uniform Commercial Code) in addition to its statutory lien. This is where the tenant has a problem. If a landlord has a UCC lien, it will complicate a tenant’s efforts to obtain bank financing when the bank will no doubt want a UCC lien on the collateral. In a worst case scenario, if a prospective tenant has an existing bank loan where the loan documents contain a covenant prohibiting further liens on the bank’s collateral, if this is not properly dealt with, the tenant will be in default on its bank loan the instant that it signs the lease.
Commercial leasing has become more complicated. Proper planning, with sufficient lead time, is essential. Whether the party is a property owner or a prospective tenant, counsel should be sought at each step of the way to avoid expensive mistakes.
Andrew B. Golkow is a shareholder at Rees Broome, PC, practicing business law. Mr. Golkow represents professional services firms, government contractors, restaurants and retailers, and other businesses in leases of all types and sizes. He brings an experienced and pragmatic business perspective to the lease negotiation process. Please contact Mr. Golkow at agolkow@reesbroome.com should you have additional questions.