Principles of Real Estate Chapter 17-Leases And Property Management This chapter will explain the elements needed for a valid lease, the different rights ascribed to tenants and property owners, and the principles of property management. Overview 17.1 P a g e
Objectives At the end of this chapter, the student will be able to: List the essential elements of a valid lease Apply the statute of fraud to long-term leases Define "restrictive covenant" Define "protective covenant" Describe the applications of restrictive and protective covenants Discuss tenants' rights to possess as well as responsibilities regarding maintenance typical of residential and commercial leasing Define assignment and subleasing Discuss destruction and its effect on a lease List examples of lease termination Describe what constitutes a breach of a lease Define actual eviction Define constructive eviction List and describe the seven types of leases and discuss the differences between them Define a property manager List the varied duties of a property manager Discuss sources of obtaining management business in a steady and selective manner Name the important elements that should be contained in the management agreement Standard Lease Provisions In determining the validity of a lease, the courts apply the rules governing contracts. If the intention to convey temporary possession of a certain parcel of real estate from one person to another is expressed, the courts generally hold that a lease has been created. Most states require no special wording to establish the landlord-tenant relationship. The lease may be written, oral, or implied, depending on the circumstances. 17.2 P a g e
Lessor and Lessee Once a valid lease has been executed, the lessor, as the owner of the real estate, is usually bound by the implied covenant of quiet possession. Under this covenant, the lessor guarantees that the lessee may take possession of the leased premises through a leasehold estate and that he or she will not be evicted from these premises by any person who successfully claims to have a title superior to that of the lessor. The lessor retains a reversionary interest. Demise means to convey by lease. Validity The requirements for a valid lease are essentially the same as those for any other contract. Generally, the essentials of a valid lease are: Competent parties: The parties must have the legal capacity to contract. Offer and acceptance: The parties must reach a mutual agreement on all terms of the contract. Consideration: All contracts must be supported by a valid consideration. In leasing real estate, rent is the normal consideration granted for the right to occupy the leased premises. Legal objective: The objectives of the lease must be legal. Signed and Dated The statute of frauds usually requires that leases that will not be fully performed within one year of the date of making must be in writing. When the statute of frauds applies and the provisions of the lease do not comply with its terms, the lease is considered to be unenforceable. In addition, a description of the leased premises should 17.3 P a g e
be clearly stated. A street address is usually sufficient. To be valid, a lease for more than a year's duration must be signed by the landlord, since the courts consider a lease to be a conveyance of an interest in real estate. The tenant's signature is usually not essential if the tenant has actually taken possession. Of course, it is preferable for both parties to sign the lease Standard Lease Provisions-Use of Premises A lessor may restrict a lessee's use of the premises through a restrictive covenant in the lease. This is most important in leases for stores or commercial space. For example, a lease may provide that the leased premises are to be used only for the purpose of a real estate office and for no other. In the absence of such limitations, a lessee may use the premises for any lawful purpose. A protective covenant, on the other hand, protects the tenant in that the lessor agrees not to rent space to a would-be competitor in the same complex. 17.4 P a g e
Term of Lease The term of a lease is the period for which the lease will run, and it should be set out precisely. The date of the beginning of the term and the date of its ending should be stated together with a statement of the total period of the lease. For example, a lease can state, "for a term of thirty years beginning June 1, 1986 and ending May 31, 2016." Courts do not favor leases with an indefinite term and will hold that such perpetual leases are not valid unless the language of the lease and the surrounding circumstances clearly indicate that such is the intention of the parties. Security Deposits Most leases require the tenant to provide some form of security. Many states have laws that set maximum amounts for security deposits and specify how they must be handled. Some require that lessees receive annual interest on their security deposits. Virginia, for example, has its own rules on security deposits. The Virginia Landlord and Tenant Act will be discussed in great detail later in this course. Possession of Leased Premises Leases carry the implied covenant that the landlord will give the tenant possession of the premises. In most states, the landlord must give the tenant actual occupancy, or possession, of the leased premises. Thus, if the premises are occupied by a holdover tenant, or adverse claimant, at the beginning of the new lease period, it is the landlord's duty to bring whatever action is necessary to recover possession and to bear the 17.5 P a g e
expense of this action. An action to remove someone who is illegally in the property is called an ejectment. Improvements In the absence of an agreement to the contrary, the tenant may make improvements with the landlord's permission. Any such alterations generally become the property of the landlord; that is, they become fixtures. However, a tenant may be given the right to install trade fixtures by the terms of the lease. It is customary to provide that such trade fixtures may be removed by the tenant before the lease expires, provided the tenant restores the premises to the condition they were in when he or she took possession. Maintenance of Premises Under the principles of caveat emptor, a landlord is not obligated to make any repairs to the leased premises. However, many states now require a residential lessor to maintain dwelling units in a habitable condition and to make any necessary repairs to common elements, such as hallways, stairs, or elevators. The tenant does not have to make any repairs, but he or she must return the premises in the same condition they were received, with allowances for ordinary use. Assignment and Subleasing The lessee may assign the lease or may sublease if the lease terms do not prohibit it. A tenant who transfers all of his or her leasehold interests 17.6 P a g e
assigns the lease. A tenant who transfers less than all of his or her leasehold interests by leasing them to a new tenant subleases. In most cases, the sublease or assignment of a lease does not relieve the original lessee of the obligation to make rental payments unless the landlord agrees to waive such liability. Most leases prohibit the lessee from assigning or subletting without the lessor's consent; this allows the lessor to retain control over the occupancy of the leased premises. The sublessor's (original lessee's) interest in the real estate is known as a sandwich lease. Destruction of Premises In land leases involving agricultural land, the courts have held that damage to or destruction of the improvements, even if it is not the tenant's fault, does not relieve the tenant from the obligation to pay rent to the end of the term. In general, residential leases are terminated by the destruction of the premises. Right of First Refusal Right of first refusal is the right of someone (typically a tenant) to have the first opportunity to either rent or buy property. The right only extends to property that has been offered or if the owner is entertaining offers from others. Typically, the right of first refusal is more advantageous to the tenant than the owner but is included in a lease to encourage improvements to the property during a tenancy. 17.7 P a g e
Termination of Lease A written lease for a definite period of time expires at the end of that time period; no separate notice is required to terminate the lease when it expires. Oral and written leases that do not specify a definite expiration date (such as a month-to-month or year-toyear tenancy or a tenancy at will) may be terminated by giving proper notice in advance as required by state law. Generally, the laws specify a minimum time period or number of days' notice that must be given by the party who wishes to terminate the lease. When the conditions of a lease are breached or broken, a landlord may terminate the lease and evict the tenant. This kind of action must be handled through a court proceeding according to state law. It is possible that the parties to a lease will mutually agree to cancel the lease. The tenant may offer to surrender the lease, and acceptance by the landlord will result in termination. A tenant who abandons leased property, however, remains liable for the terms of the lease -- including rent. The terms of the specific lease will usually dictate whether the landlord is obligated to try to re-rent the space. When the owner of leased property dies or the property is sold, the lease does not terminate. The heirs of a deceased landlord are bound by the terms of existing valid leases. In addition, if a landlord conveys leased real estate, the new landlord takes the property subject to the rights of the tenants. If a tenant under an estate for years or from year-to-year dies, the lease will remain in effect; the deceased lessee's heirs will be bound by the terms of his or her lease agreement. 17.8 P a g e
Breach of Lease When a tenant breaches any lease provision, the landlord may sue the tenant to obtain a judgment to cover rent past due, damages to the premises, or other defaults. Likewise, when a landlord breaches any lease provision, the tenant is entitled to similar remedies. Actual Eviction When a tenant breaches a lease or improperly retains possession of leased premises, the landlord may regain possession through a suit for possession. This process is known as actual eviction. Law requires the landlord to serve notice on the tenant before commencing the suit. Usually, at least a ten-day notice is required in case of a default in most lease terms, but in many states, only a five-day notice must be given before filing a suit for possession based on a default in payment of rent. When a court issues a judgment for possession to a landlord, the tenant must peaceably remove him- or herself and all belongings, or the landlord can have the judgment enforced by a sheriff or other court officer, who will forcibly remove the tenant and his or her possessions. 17.9 P a g e
Constructive Eviction If a landlord breaches any clause of a lease agreement, the tenant has the right to sue, claiming a judgment for damages against the landlord. If an action or omission on the landlord's part results in the leased premises becoming uninhabitable for the purpose intended in the lease, the tenant may have the right to abandon the premises. This action, called constructive eviction, terminates the lease agreement if the tenant can prove that the premises have become uninhabitable because of the conscious neglect of the landlord. In order to claim constructive eviction, the tenant must actually remove him- or herself from the premises while the uninhabitable condition exists. Types of Leases The manner in which rent is determined indicates the type of lease that is in force. The types of lease include: Gross Lease Graduated Lease Index Lease Reappraisal Lease Net Lease Percentage Lease Ground Lease (Land Lease) Sale-Leaseback Gross Lease In a gross lease, the tenant's obligation is to pay a fixed rental, or a flat fee, and the landlord pays all taxes, insurance, mortgage payments, repairs, and the like connected with the property. The gross lease is also called a straight lease. This type of lease is most often used for residential apartment 17.10 P a g e
rentals. A clause that allows the landlord to pass along to the tenants any increase in taxes or insurance is called an escalator clause, or participation clause. Graduated Lease A graduated or step-up lease provides for rental increases of predetermined amounts at specific times. Longer term leases may be graduated leases. Index Lease In an index lease, the rent may be adjusted up or down periodically based on changes in a designated index, such as the Consumer Price Index (CPI). Reappraisal Lease Another method the landlord may use to guard against losses due to inflation is to negotiate a lease which varies the rent payments in direct proportion to changes in the market value of the leased property. Because the property must be reappraised at specific intervals, the lease is called a reappraisal lease. In order to assure fairness, the appraisals are usually made by a qualified, reputable appraiser. Net Lease The net lease provides that in addition to the rent, the tenant pays most or all of the property charges. The monthly rental paid to the landlord is in addition to these charges and so is net income for the landlord after operating costs have been paid. Leases for entire commercial or industrial buildings and the land on which they are located, ground leases, and long-term leases are usually net leases. 17.11 P a g e
Percentage Lease A percentage lease provides that the rental is based on a percentage of the gross or net income received by the tenant doing business on the leased property. This type of lease is usually used in the rental of retail business locations. The percentage lease usually provides for a minimum fixed rental fee plus a percentage of that portion of the tenant's business income that exceeds a stated minimum. Ground Lease (Land Lease) A ground lease is a long-term lease of undeveloped land, usually 50 years or more. The lessee would not hesitate to make major improvements as he or she is assured of use of the land for a long period of time. At the end of the lease, all improvements would become the property of the lessor. Sale-Leaseback A sale-leaseback involves a property owner selling his or her property to an investor, and leasing it back. 17.12 P a g e
The sale-leaseback is generally applied to commercial properties, because rental charges are fully deductible expenses during a tax year. The capital gained from the sale to the investor can be used by the business owner for expanding the enterprise or renovations Property Management In the simplest terms, a property manager is someone who preserves the value of an investment property while generating income as an agent for the owners. More specifically, a property manager is expected to merchandise the property and control operating expenses so as to maximize income. In addition, a manager should maintain and modernize the property to preserve and enhance the owner's capital investment. The manager carries out these objectives by: Securing suitable tenants Collecting the rents Caring for the premises Budgeting and controlling expenses Hiring and supervising employees Keeping proper accounts and making periodic reports to the owner 17.13 P a g e
Property Management-Fixed and Operating Expenses In order to properly maintain budgets and accounting practices, the property manager must be aware of his fixed expenses and operating expenses. Fixed expenses are recurring expenses that have to be paid regardless of whether the property is occupied. For example, real property taxes, hazard insurance and debt service are fixed expenses. These expenses contrast with operating expenses necessary to maintain the production of income from the operation of the property. Operating expenses are recurring expenses that are essential to the continuous operation and maintenance of a property. Operating expenses are generally divided into the following categories: Fixed expenses Variable costs such as utilities, payroll administration and property management fees Reserves for replacement Operating expenses do not include items such as mortgage payments, capital expenditures and deprecation. 17.14 P a g e
Property Management-Securing Management Business In today's market, property managers may look to corporate owners, apartments and condominiums, investment syndicates, trusts, and absentee owners as possible sources of management business. In securing business from any of these sources, word-of-mouth is often the best advertising. A manager who consistently demonstrates that he or she can increase property income over previous levels should have no difficulty finding new business. Before contracting to manage any property, the professional property manager should be certain that the building owner has realistic income expectations and is willing to spend money on necessary maintenance. Attempting to meet impossible owner demands by dubious methods can endanger the manager's reputation and prove detrimental to obtaining future business. Property Management-Time Management Agreement The first step in taking over the management of any property is to enter into a management agreement with the owner. This agreement creates an agency relationship between the owner and the property manager, just as a listing agreement creates an agency relationship between selling owner and listing broker. A property manager is usually considered to be a general agent of the principal whereas a real estate broker is usually considered to be a special agent. As agent in a listing, the property manager is charged with the same agency responsibilities as the listing broker. 17.15 P a g e
This agreement is a personal services agreement, and therefore would be terminated with a change in one of the parties. Property Management-Time Management Agreement Essentials The management agreement should be in writing and should cover: Description of the property. A street address is usually sufficient. Time period the agreement will cover. Definition of management's responsibilities: All of the manager's duties should be stated in the contract; exceptions should be noted. Statement of owner's purpose: This statement should indicate what the owner desires the manager to accomplish with the property. One owner may wish to maximize net income and therefore instruct the manager to cut expenses and minimize reinvestment. Another owner may want to increase the capital value of the investment; in which case the manager should initiate a program for improving the property's physical condition. Extent of manager's authority: This provision should state what authority the manager is to have in such matters as hiring, firing, and supervising employees; fixing rental rates for space; making expenditures; and authorizing repairs within the limits established previously with the owner. (Repairs that exceed a certain expense limit may require the owner's written approval.) Reporting: Agreement should be reached on the frequency and detail of the manager's periodic reports on operations and financial position. These reports serve as a means for the owner to monitor the manager's work and as a basis for both the owner and the manager to assess trends that can be used in shaping future management policy. Management fee: The fee can be based on a percentage of gross or net income, a commission on new rentals, a fixed fee, or a combination of these. Allocation of costs: The agreement should state which of the property manager's expenses, such as office rent, office help, telephone, advertising, association fees, and Social Security, will be paid by the manager, and which will be charged to the property's 17.16 P a g e
expenses and paid by the owner. After entering into an agreement with a property owner, a manager must handle the property as if it were his or her own. In all activities, the manager must be aware that his or her first responsibility is to realize the highest return on the property that is consistent with the owner's instructions. In Review A lease may be written, oral, or implied, depending on the circumstances. Generally, the essentials of a valid lease are competent parties, offer and acceptance, consideration, and legal objective. The term of a lease is the period for which the lease will run, and it should be set out precisely. Many states have laws that set maximum amounts for security deposits and specify how they must be handled. An action to remove someone who is illegally in a property is called an ejectment. A tenant who transfers all of his or her leasehold interests assigns the lease. A tenant who transfers less than all of his or her leasehold interests by leasing them to a new tenant subleases. When the conditions of a lease are breached or broken, a landlord may terminate the lease and evict the tenant. Types of leases include: gross lease, graduated lease, index lease, reappraisal lease, net lease, percentage lease, and ground lease. 17.17 P a g e