by David J Lewis
The fifth and final article in this series explores the tricky area of negotiating leases and how to avoid the more common traps. After all, without rent there would be no construction, no buying and selling, no financing, no joint venturing and, as some less fortunate developers have discovered, no value.
Some typical lease provisions
Leases in the US are generally for shorter periods than their UK counterparts. Standard leases run from five to 10 years, rarely for longer periods. Lease negotiations therefore come up more frequently and, for a number of reasons, the scope for negotiation is wider than is usually the case in the UK. In part this is because the typical tenant of an American office or commercial building expects the landlord to furnish far more extensive services than are generally expected of British landlords.
It is typical for an office tenant in the US to expect the landlord to provide heating, air-conditioning, maintenance services, janitorial services, landscape maintenance and parking structure maintenance. To a lesser extent, the same is true for industrial and retail tenants, who generally will expect the landlord to be responsible for maintaining the exterior structure of the premises and for providing common area services such as landscaping. It is also frequently the case in the US that each floor is let to several tenants. Contrary to expectation, this tends to complicate, rather than simplify, the negotiating process.
There are also numerous legal distinctions between UK and US practice. Leases in the US, like their British counterparts, are expressed in varying degrees of “gross” or “net”, with the “triple net” lease being perhaps the most familiar to the UK investor. But, unlike the UK, in the US the triple net lease tends to be common only in retail properties and in buildings which are occupied by a single tenant.
The term “triple” generally refers to property taxes (ie rates), operating and maintenance costs and insurance. Because some practitioners use the term “single” and “double” net, it is sound practice to be specific about what these terms mean since they do not have broadly accepted interpretations. In this article the term “net” will consistently mean “triple net”.
In contrast to net leases, there are various types of gross lease. A typical example of a gross lease is where a “base year”, which may or may not be a calendar year, is established for the purpose of determining the landlord’s costs. From year two of the lease the tenant is required to pay all increases (or “escalations”), over and above the base year’s costs. An alternative, and one which landlords often prefer, is to establish an “expense stop”. In other words, an expense factor, say $7 per sq ft per year is established and the tenant is responsible for cost escalations above that figure.
Owing to the difficulties involved in allocating, determining and charging costs to tenants, particularly under gross leases, landlords should insist on certain protections. The most valuable one requires tenants to pay any amounts of escalation which are in dispute as a precondition to the right to dispute them. The protection operates whether the procedure to resolve the dispute is an internal arrangement between landlord and tenant (for example, the right of audit) or one that has to be adjudicated by a third party.
Other considerations can arise under local law. In California, for example, property taxes are levied by reference to the value of the property in question. Once established, this value fixes the property taxes until a subsequent valuation. New valuations may be made only if the property undergoes a change of ownership. Accordingly, it is vital to specify in any lease, whether gross or not, that increases in property taxes resulting from such an event are to be passed through to the tenant. If not, the capital value of the property will be reduced as the stream of income, which was net to the vendor, becomes less than net to the buyer.
Options to extend: do’s and don’ts
Pitfalls and traps abound in the area of extension options. In every state of the Union the assessment of non-residential rent between landlord and tenant is purely a private matter. The obvious question is how the new rent should be determined.
Tenants commonly request, and obtain, options to extend the term of their lease, usually at a market-related rent. Understandably they will push for fixed rents. For obvious reasons, options at a fixed rent should always be avoided. And, while it is relatively easy to define what “market rate” means, it is critical that the landlord should avoid some apparently straightforward yet not-so-obvious traps. One such trap concerns dates. For example, suppose that the lease provides only a date after which the option may not be exercised and states that the rent during the option period is to be the market rent prevailing at that time, meaning the date of exercise of the option. Taken literally, this gives the tenant the right to exercise the option the day after signing the lease, at a rent during the option period equal to that payable on the rent commencement date, assuming it is market rent.
Believe it or not, this error surfaces in many leases, though it clearly does not express the intention of the parties. A “not before” date must always accompany a “not later than” date for this reason.
The next question is how to determine a market-related rent for the option period. The usual approach is to institute an appraisal process some time before the date on which the option period begins. Care must be taken not to conduct this process too far ahead of the expiry of the original term, because appraisers will be hard pressed to establish a fair market rent for a date substantially later than that on which they are making their determination.
One useful method is to require the appraisers to determine market rent fairly close to the date the original term expires. If the determination is in fact made after the commencement of the option period, the tenant can pay any increase in rent retroactively, perhaps with interest.
In addition, to maximise the landlord’s cash flow, it is advisable to negotiate for an increase in rent to take effect at the commencement of the option period, at a figure that corresponds to the tenant’s best offer during negotiations. Of course, rent at the beginning of an option period should never be less than that payable at the end of the original term.
Landlords should also deny a tenant’s request for the right to revoke an option to extend the lease at a market-related rent after they have exercised it. This is because it allows tenants to influence the level of the rent for the extension period by participating in the selection of appraisers. It also effectively converts an option into a right of first refusal.
Another way of determining rent at the beginning of an option period is the “quotation method”. It is cheap, fast and gives the landlord the advantage of control. Here, the landlord quotes the tenant a rental rate. If the tenant accepts, the rent is automatically fixed at that rate. If the tenant declines, the option is converted into a right of first refusal exercisable only on potential tenants’ offers of rent which are lower than the quotation. If follows that, if the landlord pitches the quotation too high, the existing tenant will have the right to match lower offers. The period during which this right of first refusal may be exercised should always be kept as short as possible.
Pay first, argue later
The concept of rent can be deceptively simple. However, to ensure that rent is received promptly and without dispute, certain provisions must always be spelled out. The magic words are “without demand, counterclaim or offset”.
A problem often encountered with smaller tenants is where the tenant presents a cheque for less than the amount due, with a notation on the cheque that it is “in full and final payment”, or similar wording. The landlord may get stuck with a substantial legal bill if he asks his attorney whether, by cashing the cheque, he loses the right to collect the balance. Under California law, for example, such a notation does have that result. The landlord thus has the unhappy choice of either returning the cheque to the tenant, or cashing it and forfeiting the balance. It is far better to provide in the lease that acceptance of any amount by the landlord that is less than the amount actually due is not to be deemed a waiver of the balance.
Evictions, too, can be time-consuming exercises. In many jurisdictions in the US, the only way in which a tenant may be evicted is through a court action. All leases should therefore provide that all charges, parking charges for example, are deemed to be additional rent. In this way the failure to pay an escalation charge gives the landlord the leverage of threatening to terminate the lease rather than only being able to sue for money owed.
Improvements, rent-free periods and other inducements
It is common for landlords to provide improvements to tenants’ space as an inducement to sign a lease. Indeed, this practice has become so common it is even used as an inducement to persuade existing tenants to remain in their premises.
Where the landlord offers to provide a substantial allowance for the cost of building-out space to the tenant’s requirements, another fundamental issue arises. How is his portion of the cost to be protected if the tenant thereafter declares bankruptcy or is otherwise unable to fulfil his commitments? Letters of credit are a good solution in some cases; in others it is preferable for the landlord to require the tenant to pay for the improvements, but to give rent-free (or additional rent-free) periods so that the tenant can recover his part of the cost in due course.
Whatever the case, landlords should never fall into the trap of stacking all the rent holiday at the beginning of the term of a lease. A rent concession should be staggered over the life of the term as protection against tenants who enjoy a free ride at the beginning of the lease and then move out at the end of the rent-free period. Such tenants will no doubt repeat the process with a new and unsuspecting landlord.
Investors should also be familiar with the general principles of the Mechanics’ Lien Law, which most states have enacted. In brief, suppliers of labour and materials have the right to a lien on the property at which they have performed services or provided materials as the case may be, if payment for them has not been made. This is true even where the services were rendered for a party other than the owner. For example, a tenant may be responsible for building out his premises but, if he fails to pay the contractor, the landlord may find the building subject to a lien in favour of the bilked workers.
Statutes in many jurisdictions provide for special legal notices — notices of non-responsibility — which can prevent this from happening. Bonds are also available to assure the completion of, and payment for, work. It goes without saying that the landlord should always have the right to choose or to approve the contractor.
Finally, there should be a requirement that the landlord will be promptly informed of any alleged defects in the finished product so that the likelihood of dispute is kept to a minimum. Under no circumstances should tenants have the right to self-help if something is alleged to be wrong with the improvements.
A soundly drafted lease is vital. After all, it is fundamental to the protection of the investor’s interest. Nor are long leases necessarily the best. Indeed, it is a good rule of thumb that the longer the lease, the tougher the negotiation. It is therefore all the more important to make a lease concise rather than wordy; to know where the pitfalls are; and to ensure they are properly addressed at the outset.