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Practice Area Commentary
Understanding Commercial Leasing
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05-04-2009 | 01:06 PM
ABA YLD 101 Series
Understanding Commercial Leasing
The task of drafting and negotiating a commercial lease can be daunting to the uninitiated practitioner. The attorney must not only have a grasp of the basic real estate concepts underlying a lease agreement, but also must have a working knowledge of the business concerns driving the transaction. In order to effectively advocate for a commercial landlord or tenant, counsel must understand the business concerns from the perspective of both lawyer and businessperson. Foremost in the mind of commercial clients are their business interests; and as attorneys, it is critical that we understand how these business interests impact the legal advice we are to render.
Commercial leases do more than memorialize transactions which transfer interests in land. They create value for landlords and tenants. How a lease is drafted and negotiated will determine just how much value that lease agreement provides for each of the landlord and the tenant. For instance, both landlords and tenants desire stability. A tenant wants to know that it can rely on paying a certain base rent and can reasonably estimate and control what it pays in additional fees over the term of the lease. Similarly, landlords desire a steady income stream from their tenants, timely payments of rent, and coverage of all additional costs that may be incurred with respect to the property at issue in the transaction.
What follows is a brief discussion of a few of the critical provisions which should be given careful consideration in every commercial lease transaction.
The parties to a lease must be clearly defined. This is of particular importance in the commercial leasing arena, as the attorney must be attuned to the business structure of the entities involved. This seemingly simple provision of a lease requires the commercial real estate attorney to evaluate the business and tax law implications of doing business as a particular type of entity.
The description of the leased premises must be clear. If the premises are in a multi-tenanted building, this distinction must be noted, along with a description of the larger building within which the premises lies. Also included should be a description of the square footage of the premises. It is in the interests of both parties to avoid disputes over the size of the premises during the term of the lease, and as such calculations should be conducted beforehand, resulting in the parties stipulating to the size of the leased space within the express terms of the lease.
As mentioned above, both parties seek the stability afforded by a lease, in terms of controlling costs from the tenant's perspective, and assuring a steady income stream from the landlord's perspective. Leases frequently contain renewal options. Rent for renewal terms can be calculated any number of ways - by reference to the Consumer Price Index ("CPI"), fair market rental value, a fixed percentage increase, etc. While a reference to the CPI or use of a fixed percentage increase provides certainty, the use of a fair market rental value can yield a dispute between landlord and tenant resulting in the need for retention of appraisers, and potentially arbitration or litigation proceedings in order to resolve the dispute. When evaluating the standard for determining a rent renewal the parties must be careful to select a standard that provides both a fair and reasonable rent increase while at the same time affording the parties with a degree of certainty in arriving at that amount without the need for additional time and cost commitments.
Who pays for what? Landlords and tenants may come to the table with vastly different ideas of who is responsible for paying for what during the lease term. Landlords and their attorneys will seek to pass every cost associated with the operation of the property through to the Tenant, while the tenant will seek to eliminate or limit these pass through items. Whatever the result of these negotiations, the effective attorney will be clear and concise while drafting, leaving no room for dispute over payments in the future. Again, certainty creates value and avoids the additional time and cost commitments brought on by dispute resolution requirements.
Use clauses set forth the conduct a tenant may engage in at the premises. Tenants seek broad use clauses, giving them maximum flexibility for engaging in their operations, and for experimenting with new and different business concepts. Landlords want to restrict the array of possible uses in order to control the nature of the business establishment and the synergy of the leasehold complex. Attorneys also must be aware of the impact a use may have on the environmental condition of the property as well as any transaction triggered environmental laws which may be invoked by virtue of a tenant's operations. A regulatory nightmare can result for a landlord if its counsel does not properly restrict potential uses to those that will avoid triggering environmental laws.
Condition of Premises
Landlords will desire to transfer the property in its current state, "As-Is", making no representations regarding the condition of the property or its fitness for a particular purpose. A tenant, on the other hand, will not want to take on liability for the actions of others, and will seek to be released from liability for conditions which existed prior to their tenancy. A tenant will also seek assurances that the utilities, HVAC system, roof, and structural supports of the building are sound and in good working order at the time it takes possession. A well crafted compromise can provide that such systems are in good working order at the time of lease commencement, giving the tenant a window of time to report non-compliant conditions, failing which the building conditions are conclusively deemed in good working order.
Assignment and Subletting
Landlords typically resist the free right of a tenant to assign and sublease, for they fear entering relationships with "unknown" entities. Further, they disdain the notion of allowing a tenant the opportunity to take advantage of a "hot" real estate market by re-letting the leased space at a rental rate higher then the lease rate. As such, to the extent that a landlord grants a right to assign or sublease, such landlord's counsel must craft the lease document to provide that the landlord has the right to recapture any profit that a tenant makes on the assignment or sublease. In addition, counsel should also secure in favor of the landlord, a right to recapture leased space prior to the tenant concluding the assignment or sublease. Finally, if a lease does permit a right of assignment or sublease then upon an assignment the lease must obligate the assignee to sign an assumption agreement in order to provide the landlord with privity of contract with the assignee and upon a sublease must obligate the tenant to collaterally assign the sublease to the landlord so that if the tenant defaults under the lease the landlord also has privity with and recourse against the sublease.
A tenant will desire the right to make alterations to the premises to accommodate changing business concepts or needs. As with the use clause, the tenant will seek the greatest flexibility in order to maximize the value of the lease to the tenant. The landlord, on the other hand, will want to limit the extent of permissible alterations, avoiding alterations that affect the building structure and systems. A landlord will also desire certainty over who is responsible for removing the alterations, and whether or not the landlord is entitled to keep the alterations at lease end. A well drafted clause will provide the landlord with a right to elect whether the tenant must remove the alterations, or leave them in place upon the conclusion of the lease.
There are numerous additional clauses of significance that must be considered, including: insurance, indemnification, damage and destruction, condemnation, maintenance, events of and remedies upon default, surrender and holdover, to name but a few. Each of these provisions is potentially capable of an independent paper. However, the principles underlying these clauses are the same as those above. The attorney must craft them with an eye toward the business concerns driving the transaction, and a clear understanding of their impact on the value of the leasehold for the particular client that they represent.
When drafting any document, particularly a lease agreement, it is impossible to overstate the significance of attention to detail. Lease clauses do not stand on their own; rather, they form a part of an intricate, interdependent web, affecting the meaning of many other portions of the lease document. When approaching a commercial lease for the first time it is critical to think through each issue, evaluating it from the perspective of attorney and businessperson.
Mr. Stout, is an associate at the Westfield, New Jersey firm of Farer Fersko, a Professional Association, where he is a member of the Real Estate and Redevelopment Practice Group. He concentrates his practice on the representation of businesses, real estate owners, developers, landlords and tenants.
The 101 Practice Series: Breaking Down the Basics
helps lawyers in their first three years of practice learn the basics of both substantive and practical aspects of law practice. For more information about the series
visit the American Bar Association Young Lawyers Division website
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