COMMERCIAL LEASING: A Legal Perspective for Brokers

08 Jun COMMERCIAL LEASING: A Legal Perspective for Brokers

By Brown & Altman, LLP

Economic necessity produces change and the commercial real estate rental market is no exception. Now, more than ever, the economic climate is forcing landlords and tenants to look for ways to reduce costs, causing them to scrutinize the bottom line when entering into a new lease agreement or restructuring an existing one. Reviewing some vital elements of a lease transaction and the elements to which commercial brokers should pay special attention can add value for their clients. This is the first of a series of articles that explore many of these important issues that arise during a commercial lease negotiation.

Due Diligence: Know Who You Are Getting Into Bed With

Landlord’s Due Diligence: The current market forces the landlord to closely scrutinize a prospective tenant. The prospective tenant’s financial condition and industry standing are of supreme importance. The landlord must ensure that the prospective tenant is on sound financial footing and can meet its leasehold obligations throughout the term of the lease. The landlord should require the prospective tenant to produce:

• Audited financial statements for the past two years;
• Tax returns for the past two years;
• Current balance sheet;
• Good standing certificate;
• Rental history and references; and
• A representation from the tenant that it has not defaulted in payment, or otherwise, under the terms of a lease in the past ten years.

This information can be vital in uncovering facts that will prevent the landlord from leasing space to a problem tenant. A tenant with solid financials and a strong business is as good as gold – especially today. The broker can provide value to the landlord in this area by:

(1) Performing an initial screening of prospective tenants;
(2) Facilitating the delivery of documents requested by the landlord;
(3) Performing its own independent analysis of the prospective tenant’s financial stability;
(4) Keeping the lines of communication open between the parties; and
(5) Advising the landlord with respect to current market conditions and how the prospective tenant compares to other prospective tenants that may be interested in the space.

Of course, this higher level of scrutiny competes with the landlord’s need to fill vacant space. One of the landlord’s biggest challenges in today’s market is to minimize vacancy. This may require the landlord to make concessions that it might not otherwise make in better financial times, such as free or reduced rent, tenant improvement allowances, space re-measurement, or space upgrade. The broker can add value by helping the landlord understand the type of concessions that are becoming more relevant in the market and by negotiating with the prospective tenant to limit the scope of concessions requested. (Of course a broker acting on behalf of the prospective tenant will focus his or her efforts on maximizing the concessions to be obtained from a landlord operating with high vacancy).

Tenant’s Due Diligence: On the other side of the equation is the tenant’s need to make sure the landlord is on sound financial footing. Accordingly, the tenant should ask the landlord for:

• Current financial statements;

• Mortgage status and payment history;

• Performance history of the building, including:

• Historical occupancy rate;

• Tenant turnover rate;

• Landlord / tenant dispute history;

• Building system performance and maintenance history, including HVAC, heating, lighting, and technology platform;

• Certificates of Occupancy and/or Completion; and

• Representation of no violations and/or open permits.

The prospective tenant also is well advised to perform a lien search on the building and the landlord to find out whether any mortgages, judgments or other liens exist. This is a “red flag” opportunity for the tenant — the relatively small amount of time and money spent for a lien search could save the tenant substantial trouble in the long run. The tenant must do more than just kick the tires – it must perform a thorough analysis to ensure that the landlord is not in any financial danger. A common-sense rule is that a landlord’s financial problems will almost certainly translate into lease problems, and that will adversely affect the tenant’s use of the leased premises. A broker can add value here by helping the prospective tenant perform its due diligence and by providing timely and useful information that the tenant can use in its decision making.

Choose Your Space Wisely

Know What Space You Need: First, the prospective tenant must carefully select the space to be leased. Of course, the tenant must consider location, but of extreme importance is the need to accurately determine the size of the space it needs to lease. Not only must it accurately determine what space it currently needs, the tenant must project how much more (or less) space it will need over the term of the lease. The days when a tenant would routinely lease “shadow space” (empty space that is leased in addition to the tenant’s current need for potential and unspecified future expansion) and leave it empty for future use are largely over. Instead of leasing shadow space for the entire term of the lease, the tenant may want to determine the potential for expansion into additional space in the building as the need arises. However, if a tenant does decide to lease shadow space, it should make sure that the lease allows for subleasing so that, if necessary, it can fill the shadow space with a subtenant to help cover costs. A broker can add value here by knowing the building and Landlord with respect to whether there is potential for the Tenant to expand into additional space as needed, knowing the potential in the market for subleasing opportunities, and helping the tenant negotiate for the most appropriate space.

Know What You Are Paying For: Once the tenant has selected the appropriate space, it must make sure the space is accurately measured and reflected in the lease. Now the fun begins, the lease will speak of square footage in one or more of the following terms: rentable square feet, usable square feet and actual or carpetable square feet. Rentable and usable square foot measurements will be different than the actual or carpetable square footage of the leased space. A prospective tenant needs a savvy broker to help it navigate this area, because this can be an opportunity for substantial savings or for a costly mistake.

Rentable square footage is the largest of the square footage calculations and is the one used to calculate rent. Rentable square footage includes the gross space actually being leased, plus the prospective tenant’s share of building common areas, such as lobbies, hallways and cafeterias. A “loss factor” is then subtracted (usually 8% to 20%) and you are left with the actual space the tenant inhabits. The smaller the loss factor, the less money the prospective tenant will spend on space that it does not actually use.

Usable square footage is a smaller measurement than rentable square footage, because it does not include common areas. However, it is still not the true measurement of the space occupied because usable square footage is measured from the middle of demising walls that separate the leased space from the rest of the building to the middle of the building’s exterior glassline. It also includes interior unusable space, such as interior walls and columns.

Carpetable Space reflects the actual space you can use, or carpet, in the leased premises. After accounting for interior walls and columns, you may find that the actual square footage is 5% to 10% less than usable square footage. Knowing and understanding these calculations can help the broker advise and guide the tenant in lease negotiations. The tenant needs to minimize the unusable square footage it must pay for under the lease and the broker can be an invaluable asset by effectively guiding the tenant in this regard.

Know Your Use Pattern: In conjunction with understanding how much space a tenant will need, the tenant (with the broker’s help) should evaluate the use pattern of its particular business. What this means, is how will your business use the space in the most efficient way possible. This provides another opportunity to minimize your expenses – if a tenant can use the space efficiently by locating offices, conference rooms, copy rooms, cubicles and hallways without waste, then it can save money. Different buildings have different configurations. Some businesses will be able to work within a given configuration, some will not. For example, is the tenant a law firm that requires many individual offices and secretary stations so that it can minimize the impact of interior columns and walls or is it a financial services firm that requires a large, open space for trading desks? Office space design is critical in this area and a design that minimizes the impact of interior obstructions can potentially provide more carpetable space to the tenant and save money over the term of the lease. A good broker can match a prospective tenant with a building that meets its needs, which will, in turn, save the tenant money.

Lease Terms

Rent: Base rent is the most basic and, obviously, one of the most important elements of the lease. The landlord and prospective tenant must determine the

Base Rent (monthly payment of a fixed amount by the Tenant) and when it will be paid. Base Rent will vary depending on whether the building is classified as an “A” (most desirable), “B”, or “C” (least desirable) building. Factors, such as location, age and amenities, play a role in the classification of the building.

Base rent, however, is just a starting point for the amounts a tenant will be required to pay under a lease. Base rent is just what is sounds like – the base upon which “additional rent” will be added. Additional rent (the tenant’s contribution toward the cost of operating the property and not usually a fixed amount) should be discussed in detail with the landlord. The landlord will normally propose a triple-net lease, under which the prospective tenant would be responsible for its proportional share (along with the other tenants in the building) of tax increases, building utility costs and building insurance costs. The tenant must beware of hidden costs, such as supplemental building services (lighting and air), and it must also determine what its responsibility may be for repairs or upgrades to base building systems, such as mechanical, electrical and fire safety. It benefits the landlord and prospective tenant to have a clear statement and understanding of what items are included within additional rent. The broker should become familiar with what additional rent is required under the lease. Accordingly, a prospective tenant cannot focus solely on base rent, but, instead, it must consider all other factors that can drive costs up.

In this market, there is a fair amount of vacant space. The landlord may tempt the tenant with free rent and other concessions to gain leverage in trying to lock the tenant into a longer lease. The broker should know if the landlord is able and willing to give free rent. Obviously, free rent will allow the tenant to temporarily reduce overhead and divert funds to other business needs. In the current market, where cries of “cut costs” can be heard everywhere, free rent and landlord concessions are powerful tools to attract Tenants and avoid high vacancy rates.

Lease Term: The term of lease is also an important point of negotiation. Both the landlord and prospective tenant must determine whether they prefer a short- or long-term lease. A landlord generally would prefer to lease space to a solid tenant for a relatively long period of time. Outside factors may actually force a landlord to negotiate longer lease terms, such as in a refinancing situation where a lender may require the landlord to have a certain percentage of its leases in-term for a required number of years. A prospective tenant will want to keep its options open as much as possible and that may mean entering a relatively short-term lease. A good benchmark is a five-year lease, which gives the landlord a tenant for a substantial amount of time, while not being so long as to unreasonably bind the tenant. Leases typically include an extension option (usually to be exercised by the tenant), under which a lease can be extended for a stated period of time on the same general terms as the original lease. This gives the tenant additional flexibility in deciding whether to continue its occupancy at the end of the lease term, or to look for a more appropriate space. The tenant must be careful to adhere to any notice provision contained in the lease with respect to an extension period. A favorable extension option could be lost if the tenant loses sight of the notice date and fails to exercise its option. In this area, the broker should: know the landlord’s approach to lease term and extension options; help the tenant determine what initial lease term and extension options it will look for; and advise the tenant on how and when to exercise the extension option and about what may happen if the tenant fails to properly exercise the option.

Use of the Premises: The parties should clearly understand the prospective tenant’s planned use of the premises. The tenant should attempt to negotiate for a term in the lease that provides for “any lawful use” of the premises. The landlord will most likely prefer to place certain parameters on the planned use so that it is not objectionable to other tenants in the building or neighbors. This should not be a difficult point of negotiation, since the broker, at the outset, should look to match a planned use with a suitable building space. The broker should understand whether a tenant needs a special location (corner or mid-block) or special access (multiple curb cuts, tractor-trailer access, rail spur, etc.).

The tenant’s planned use of the premises may involve altering or improving the premises and, most common in the retail setting, signage. All of these items should be described in the lease and who bears responsibility for each item.

The tenant may want or need to make alterations to the leased space, but it will need to take account of restrictive language in the lease. The restrictive language should be negotiated to allow alterations – some with consent, and some without consent. For example:

For alterations that must have landlord consent, the tenant should make sure the lease provides that such consent “shall not be unreasonably withheld.” In some instances, the landlord may provide a tenant improvement allowance, by which the landlord contributes toward tenant improvements, or allows the tenant to reduce rent payments in the amount of the improvement allowance. The broker should know what the landlord’s approach will be to alterations, and should determine the prospective tenant’s plans in terms of altering the premises.

In certain instances, the premises will require alteration or improvement before the tenant takes occupancy. This creates two main areas of concern: cost and timing. The cost issue will revolve around the scope of the desired changes, and who will pay for them. In many cases, the landlord will offer a “build to suit” situation, where it will pay for the improvements before the tenant takes occupancy. In other cases, the landlord will place the burden on the tenant for improvements. In this instance, the tenant should ask that the landlord share the cost, because the landlord will benefit from the improvements after the lease term has expired.

Timing is critical as well. The tenant must include protection in the lease in the event alterations are not completed by the occupancy date. For example, the tenant should seek to have the following provisions included in the lease:

• Landlord to provide, at its sole expense, alternate suitable space until the leased space is complete;
• Landlord to pay for tenant’s holdover in the space it intends to vacate (or allow tenant to deduct such cost from rent due under the lease);
• Landlord to provide tenant additional rent credit commensurate with the extra time taken to complete the alterations; and
• Landlord to pay for storage of equipment and inventory to be delivered after planned occupancy date, but before alterations are complete.

Signage is particularly important for retail tenants. Often, a retail building will have the necessary permits for a prospective tenant’s signage. If not, the tenant is responsible for obtaining all necessary permits and paying for sign installation. The lease should be clear as to whether the landlord has pre-approved signage and, if not, who is responsible for the requisite permits. The lease should also be clear as to who is responsible for paying for sign repairs, maintenance, and upgrades, as well as who will be responsible for any damage to the building as a result of the signage.