Negotiating Commercial Leases (Part 2)

Signing a commercial lease is often one of the first significant financial commitments that an entrepreneur will be required to make to his or her new business venture. Landlords will generally demand a personal guaranty of the lease by the business owner(s), requiring personal assets to be placed at risk. Accordingly, any prospective tenant should obtain the advice and guidance of knowledgeable advisors, as well as understand the terms of the lease presented by the landlord.

In Part I of this article, we examined those sections of the commercial lease that address the most negotiated lease terms, including rent rate, lease term, improvements and signage. This Part II continues with a discussion of some of the provisions often buried deeper in the lease, including maintenance obligations, insurance coverages, personal guaranties, subleasing rights, and an explanation of some of the “boilerplate” language you are likely to encounter. As in Part I, most of the issues are approached from a tenant’s perspective, but landlords may find the discussion helpful as well.

Maintenance Obligations

While likely given far less consideration than rent rate in the average lease negotiation, maintenance obligations have the potential to significantly affect the cost of leasing a particular space. As described in the discussion of rent in Part I, leases may be described as “triple net” or “full service”, and the reality is that there are a variety of hybrids of each. A triple net lease is fundamentally understood as a lease in which the tenant will be responsible for nearly all expenses related to the property, including most repairs. Specific maintenance obligations will vary from lease to lease. However, in perhaps the majority of triple net lease arrangements, the landlord is responsible for “structural” repairs and maintenance, and the tenant is responsible for interior and “non-structural” repairs. Longer term leases tend to lean toward imposing most maintenance obligations upon the tenant, including structural repairs and maintenance, since the tenant is more likely to derive the benefit of major maintenance.

A full service lease is one in which the quoted lease rate includes all or nearly all property-related expenses, including utilities, maintenance, routine cleaning and janitorial. Office leases in multi-tenant buildings are often structured such that the quoted rent rate is all-inclusive, leaving the tenant with few property-related expenses outside of paying rent. However, the quoted rate may include a second component for “CAM charges”, which will be specifically defined in the lease, but often include all anticipated expenses of operating the property, including taxes, insurance, maintenance, utilities and property management. Total CAM expenses are usually estimated and collected from tenants monthly on a pro rata basis, with a reconciliation of actual expenses taking place after completion of each year. Tenants may be responsible for all CAM expenses, or in other leases the tenant is only responsible for any future increases in expenses exceeding a defined “base year” amount. In either case, the tenant should review the definition of CAM charges carefully, ensuring that no capital improvement expenditures are included. If CAM charges are quoted at a particular rate in lease negotiations, one option may be to ask the landlord to fix charges at the quoted amount for the term of the lease, or a tenant should at least review the history of property expenses to gain an understanding of expected total lease costs.

Prospective tenants should be sure to review the maintenance provisions of the lease carefully, to ensure they are not surprised by unexpected leasehold expenses. Generally there should be an affirmative requirement that one party or the other maintain the property in good, clean condition, except insofar as the lease specifically places the burden on the other party. This ensures the tenant that the property will be maintained during the term of the lease. Particularly if the tenant is going to be responsible for some repairs, the tenant should inspect the space carefully prior to signing the lease – or at least have the right to inspect prior to taking possession – for the purpose of noting any defects that the landlord must correct prior to lease commencement.

In reviewing maintenance obligations, tenants leasing for relatively shorter terms should take particular note of any language that would shift the burden of major capital expenditures to the tenant. For example, many leases require the tenant to maintain the interior of the leased space, including all building systems and HVAC. While plumbing and electrical problems tend to be fairly easily fixed in newer buildings, an HVAC system may be expensive to replace when it fails. Clearly the negotiated lease terms must be taken as a whole, but it is safe to say that a tenant signing a two-year lease for space will not be pleased if the HVAC system fails during their term and the lease requires the tenant to replace the system. A common compromise is to require the tenant to maintain a regular service contract for the HVAC system and pay for routine maintenance expenses, perhaps defined by a cap on annual expenditures. Landlords will typically negotiate maintenance language, if and only if the tenant asks.

Insurance

As with maintenance obligations, insurance requirements will vary depending upon the type of lease. Triple net leases will typically impose the costs of building casualty insurance upon the tenant, while landlords carry the casualty insurance in full service leases. The tenant will be responsible for insuring its own property, including any improvements that the tenant makes to the leased space. Additionally, the tenant will generally be required to carry liability insurance for the protection of both itself and the landlord, insuring against any personal injury or property damage that may occur at the leased space during the term of the tenant’s lease. While responsible landlords generally carry their own liability insurance as well, they will want the tenant’s insurance coverage to be the primary means of defense for both landlord and tenant, for anything that may occur while the tenant is in possession of the property.

If the landlord is responsible for obtaining building casualty insurance, the tenant should insist in the lease on requiring the landlord to list the tenant as an additional insured, or at least obtain a waiver of subrogation from the landlord’s insurer in favor of the tenant. This is important to ensure that the tenant, or its liability insurance company, will not have to pay for any damages that the tenant or its employees or visitors may negligently cause to the building. An accidental fire caused by the tenant or its employees may be the simplest example of this problem. Although the building is covered against fire damage by the landlord’s policy, the landlord’s insurer may have the right to enforce the landlord’s claim against the tenant for negligence (through a legal right known as “subrogation”), if it has not otherwise waived that right or specifically insured the tenant as well as the landlord.

Personal Guaranties

The obvious point about personal guaranties is to avoid them if you can. In practice, however, the majority of landlords are going to insist upon some manner of personal guaranty unless your business itself can be proven to be a strong credit tenant. Most landlords are savvy enough to know that if a corporation or limited liability company without substantial assets defaults on the lease obligation, there will be little opportunity to collect unpaid rent without a personal guaranty from the owners. A personal guaranty provides the added benefit to the landlord of having the owners’ attention in a default situation. Nevertheless, even though the owners may be required to personally guaranty the lease in some manner, there are significant opportunities in this area to limit personal financial exposure. If you as tenant find yourself in a default situation due to unexpected circumstances, having signed a limited personal guaranty will substantially improve your negotiating leverage with the landlord.

A limited personal guaranty is simply a personal guaranty of something less than the full tenant obligations under the lease, for the full term of the lease. Examples include guaranties limited to a specific maximum dollar amount of exposure, or guaranties of the tenant’s obligations for only a specific period of time. The latter might limit the owners’ exposure to either a specific period of time after the commencement date (e.g., performance of all tenant obligations for a period of two years after lease commencement), or a specific period of time after default (e.g., payment of rent for up to twelve months). For example, the tenant signing a five-year lease might convince a landlord to accept a personal guaranty that expires two years after lease commencement, meaning that (a) the landlord is assured of having a paying tenant for at least two years, and (b) the tenant/owners’ personal guaranty exposure will expire after they have paid rent for two years. The actual terms acceptable to each of the parties will depend upon their comparative negotiating positions, the amount of investment required by the landlord, the parties’ experiences with other leases, and other factors. However, in this author’s experience, rarely will a tenant meet a landlord that will not be willing to negotiate some manner of personal guaranty limitation.

Assignment or Subletting

In business and in life, it is challenging to predict the future – particularly when you are looking at signing a lease of perhaps five years or longer. Landlords prefer the security of longer leases and strong tenants, and will be willing to offer more concessions for a longer-term lease. While tenants may enjoy the stability of securing rights to a leased space for a long term – preferably through a base term with multiple renewal options, lease assignment provisions will increase a tenant’s flexibility to exit the space if things do not go quite as planned.

The lease should specifically address whether the tenant has the right to sublease to another tenant or to assign (transfer) its rights in the lease to a new tenant. The original tenant will generally be responsible for securing the new tenant and will be responsible if the new tenant fails to pay, but having the right to assign or sublease at least allows the original tenant the opportunity to recover some of its expenses. Generally the landlord will have the right to approve any subtenants or new tenants, although the lease should limit the landlord’s approval rights by saying that approval will not be “unreasonably withheld”, or something along those lines. Longer commercial leases often go into great detail about when the landlord does or does not have the right to withhold approval.

“Legal Boilerplate”

A lease of any length is likely to have something between a handful and a slew of sections that tend to be repeated from one lease to another, and from one type of agreement to another. As a result, they are often referred to as the “boilerplate” language. (Originally, this word was used to refer to text stamped in steel plates used for frequent printing of the same text.) A brief explanation of these common provisions may be helpful to some, while others may prefer to skip straight to the conclusion. (Admit it, you do the same thing when reading long, boring contracts.)

“Merger clause”

Example: This lease contains the entire agreement of the parties related to its subject matter.

Meaning: This clause is actually quite important – it means that if it’s not in the lease, it’s not part of the deal. So the lesson is to be sure that anything important to the deal is in the lease, since most leases include some form of merger clause.

“Governing Law and Jurisdiction”

Example: This lease shall be governed by the laws of the State of North Carolina. The parties agree to exclusive jurisdiction and venue for any matter related to this lease in Hackensack County.

Meaning: The first part is obvious, but the latter part means that any lawsuit related to the lease – by either party – will have to be filed in the stated location, which may or may not be convenient for the tenant.

“Subordination”

Example: This Lease shall be subject and subordinate at all times to the lien of any mortgage or deed of trust or other encumbrance(s) which may now or which may at any time hereafter be made upon the Property, or upon Landlord’s interest therein.

Meaning: This means that the lease will not interfere with a lender’s first lien against the property, which will be important to the lender if it has to foreclose the loan to the owner secured by the leased property. Be sure that the lease includes language protecting the tenant’s right to “quite possession” of the leased property for the term of the lease, and that any subordination to a lender’s rights includes a commitment from the lender not to disturb the tenant’s possession under the lease as long as the tenant performs its obligations.

“Estoppel Certificates”

Example: Tenant agrees to deliver to Landlord upon request an estoppel certificate in the form attached as Exhibit A.

Meaning: An estoppel certificate is the means by which a landlord may require the tenant to certify to the landlord’s lender or a purchaser of the property certain information related to the lease. As long as the certification includes only factual information that can be readily certified, it should be fine.

Other Lease Considerations

It is impossible to summarize all the issues that might be important to consider for any particular lease. Do the lease and any applicable restrictive covenants permit your expected use of the property? Do you want the landlord to agree not to lease space in the same (or a nearby) shopping center to a competitor? If you are counting on an anchor store within the center to bring customers your way, do you have the right to abandon the lease if the anchor store leaves or never materializes? Has the landlord promised to do any work to the space prior to your lease commencing, and is it clearly detailed in the lease? Do you expect to do any work to the space, and is it permitted by the lease? What about signage – are you permitted to install the signs that you anticipate using? If the landlord has a right to relocate you to another space within the shopping center, does the lease require the landlord to cover all your anticipated expenses, including the change of your address in advertising materials, letterhead, etc.?

These and other questions may be raised for your consideration by an experienced representative familiar with your particular plans and circumstances. It is important to consider the special needs of your business as they relate to leased space, and to ensure that those needs are specifically addressed in the lease agreement. As noted in the preceding section, most leases will contain a “merger clause”, and it is likely that any promises made to you prior to lease signing will not be enforceable, if not incorporated in the signed lease agreement.

The Final Analysis

Hopefully this article will provide some guidance to you in identifying the types of issues that you will encounter in lease negotiations. Taking the time to review your lease carefully and to obtain professional guidance can be well worth the effort and expense, particularly if everything does not go exactly as planned with your business. Be sure you understand what your lease says, but also try to anticipate any potential problems and ensure that you will be satisfied with how your lease addresses them, should they occur.

Steve Minnich is a North Carolina attorney and a North Carolina real estate licensee. His law practice includes representation of both landlords and tenants in commercial leasing transactions, as well as assistance to clients in buying and financing commercial properties. He also represents sellers and buyers of businesses – providing business transition consulting or legal services – and is a member of the International Business Broker Association.

The information contained in this article is for general educational purposes only, does not constitute tax or legal advice to the reader, and cannot be used for the purpose of avoiding penalties under the Internal Revenue Code. You should consult with an attorney or tax advisor to review the details of your business situation.