Minimizing And Allocating Expenses In Commercial Leases (With Forms)

Minimizing And Allocating Expenses In Commercial Leases (With Forms) Cathy M. Rudisill Never leave doubt about the party responsible for expense items under a lease. Cathy M. Rudisill is a partner in Nelson Mullins Riley & Scarborough LLP s Raleigh office. She has experience in commercial real estate matters, including acquisitions, sales, leases, easements and restrictive covenants, title matters, and legal opinions; financial transactions, including real estate and asset-based loans; workouts and foreclosures; corporate law; and contract law. She has been named Business North Carolina magazine s Legal Elite in Real Estate (2013), and awarded the Triangle Chapter of Commercial Real Estate Women s Professional Service Award (2012) and its Member Networking Award (1999, 2000, 2001, 2002, and 2007). She has been named one of the Triangle Business Journal s Top Women in Business (1999), is AV Rated by Martindale Hubbell, is one of Business Leader s Impact 100, and has been named a Super Lawyer by Law & Politics magazine. FOR THE LAST SEVERAL YEARS with the economic downturn, the negotiation leverage with commercial leases has been largely with tenants. Financially capable tenants who sought to take advantage of this leverage were often rewarded with months of rent abatement; in some cases, as much as one month for each year of the lease term, and healthy upfit allowances all of which left some landlords scrambling to find the capital to finance upfit, sustain their property, and pay their mortgage until rent abatements ended. In many locations throughout the country, tenant leverage continues as occupancy levels remain high. In locations where the economic downturn has not been as significant, vacancy levels are lessening as growing businesses lease additional space, or new businesses lease initial space. Leases contain a myriad of issues; time and cost impact the number of issues that can be addressed in a lease negotiation. There are many useful treatises on commercial leases some of which are listed in Appendix 1. This article will discuss certain selected issues that can be significant cost items for the parties. The Practical Real Estate Lawyer 11

12 The Practical Real Estate Lawyer September 2013 Delivery Of Premises If the premises are not ready for delivery to the tenant on the date scheduled in the lease, this delay may be costly for one or both parties under a lease. Whether the delay is the fault of one or both parties or, due to force majeure, will impact whether either party can recover its costs from the other. If the tenant has failed to seek a delay penalty from the landlord, the delay is not due to an act or omission of the tenant, and the tenant is incurring holdover rent at its current location, the tenant will incur costs for which it cannot seek reimbursement from the landlord. With such a delay, the tenant could also incur costs due to having to reschedule its moving company, or modifying the termination date of its utilities at its current location and at the premises. An example of a delay penalty provision for the tenant is included in Appendix 2. For the landlord, if an act or omission of the tenant causes a delay in delivery of the premises, the landlord will lose rent and other charges under the lease until such time as the premises are delivered to the tenant. For these reasons, the landlord should include a provision in the lease that rent will start on the date the premises would have been ready but for the tenant delay. The parties should clearly define what constitutes a landlord delay versus a tenant delay, and also what constitutes force majeure. There is a legal definition of force majeure but the parties may wish to define what they consider to be force majeure. Operating Expenses The lease should detail what expenses to operate, maintain and repair the premises leased are borne by the landlord versus the tenant. With a triple-net lease, the tenant would bear the costs of real estate taxes, insurance costs, and common area maintenance expenses. In a gross lease, the tenant would bear the costs for expenses above a base year or stop (fixed amount) which is established by the parties, or the rent would be scheduled to include the expenses. The tenant will want to confirm that the expenses it must pay under the lease are actual, reasonable, and competitively priced. To confirm this, the tenant will need the ability to audit the records of the landlord and review the expenses included in the charges to the tenant and the amount for each of those charges. The tenant will also want to ensure that the lease contains language requiring that the expenses are actual, reasonable, and competitively priced. With competitive pricing, if the landlord uses an affiliated entity to perform maintenance and repair at the building, the tenant will want to ensure that the landlord affiliate charges rates that are competitive with other comparable providers in the market. The tenant will also want to review the items that the landlord includes within the definition of operating expenses to ensure that this definition does not include items that should be charged to landlord such as expenses incurred for any structural repair in the building, or depreciation of the Building. An example of an audit provision is included in Appendix 2. Maintenance And Repair The responsibility for the repair, replacement and maintenance of the components of the premises should be clearly delegated, and maintenance, repair and replacement should each be specifically addressed. If responsibility is not delegated, neither party may view themselves as responsible for the component affected, or the tenant could be viewed as responsible since the tenant is in possession of the premises. With full service leases, the tenant should have little to no responsibility for any repair or maintenance within the premises except to ensure its clean and neat appearance. With triple-net leases, the landlord will seek generally to require the tenant to have responsibility for all components of the premises except for the roof, foundation, common areas,

Expenses in Commercial Leases 13 and structural components of the building. Tenants can seek to expand the landlord responsibility to include additional items that may be viewed as building and not premises components to include electrical, plumbing, and heating, ventilation and air-conditioning systems. With high-cost items, the parties may seek to allocate the costs between the parties. For example, when an HVAC system is replaced during the term of the lease, the parties may agree that the costs for such replacement will be allocated between the parties based upon the years remaining in the term of the lease and the useful life of the system, or agree that the tenant will pay a certain amount of the costs for each repair or replacement and the landlord would pay the balance. Compliance With Laws Making alterations to its premises to ensure legal compliance can be a very costly item for a tenant. There is also the practical issue of having alterations performed once the tenant has accepted occupancy, the disruption that causes, and determining who will bear the costs for such alterations. When negotiating a lease, the parties should ensure that there is a clear delineation of responsibility for issues of legal noncompliance such as alterations required under the Americans With Disabilities Act (the ADA ). In addition, the tenant should seek assurances from the landlord that the building is in compliance with applicable laws, regulations and ordinances. A landlord may want to make this representation to the best of its knowledge and the parties should agree upon a definition of what is required of the landlord to define and limit its representation to its knowledge. If alterations are required to the premises due to the specific use of a tenant, the costs for these alterations should be borne by the tenant but otherwise, alterations required under the ADA and any structural alterations should be the responsibility and the expense of the landlord. A tenant can perform some due diligence to verify legal compliance including reviewing the permitted zoning for the building and the records of the local planning office, and having the premises inspected by an architect or contractor. A review of zoning records and the applicable zoning ordinances with allow the tenant to verify that it can conduct the usage it wishes to conduct within the premises. Planning and development records can confirm the issuance of certificates of occupancy for the building and the premises, site plan approvals, and whether there are any outstanding punchlist items. An inspection of the premises can help determine whether there is any failure of the landlord to comply with applicable laws, codes, and ordinances in its construction of the premises. Removal Of Alterations The cost of tenant upfit will vary depending upon several factors including the usage by the tenant of the space and the quality of the upfit. The tenant is generally provided with an upfit allowance in an amount as determined by the landlord and if the costs for the tenant upfit are greater than the allowance, the tenant will need to bear that expense. An example of a tenant allowance provision is included in Appendix 2. Whether or not alterations made by or for the tenant are to be removed by the tenant at the end of the term is a determination made by the parties. The tenant will not want to be required to remove any alterations due to the cost involved and since the tenant would be leaving, the tenant would not wish to spend any more money on the space. The landlord will be leasing to a new tenant who may or may not need the alterations that were made for or by the tenant. To address this issue, a tenant may request that the landlord advise the tenant in writing at the time an alteration is made whether or not it must be removed at the end of the lease term. The costs to remove a tenant alteration could be substantial especially if the alteration is a fixture such

14 The Practical Real Estate Lawyer September 2013 as medical equipment and the parties will need to have a clear designation of who bears this expense. Options To Extend Lease Term Or Expand Premises Before signing a lease, a tenant should review and consider its plan for growth for the next five to ten years. If the tenant anticipates growth within its company, it will want to seek the right to lease additional space in the building and the right to extend its lease term. With commercial office tenants, the lease term is generally at least five years. An option to extend its lease term is beneficial to a tenant as the option provides flexibility to the tenant to decide to remain in its premises or to move to a new location. A landlord will generally provide the right to extend the lease term conditioned upon (i) the tenant not being in default and (ii) the tenant providing a certain amount of notice to the landlord of the exercise of an option to extend. If a tenant is in default and has not completed a cure, or is habitually in default, the landlord will likely not wish to retain that tenant so the landlord will need to ensure that it is able to deny the tenant the right to exercise its option under those conditions. The landlord will need sufficient notice of the tenant not exercising its option to extend the term of the lease so that the landlord can locate a new tenant and upfit the space for that tenant. The tenant will not want to provide too much notice to the landlord so that the tenant will be in a position to have a good understanding of its current business needs when it exercises an option. There must be a definite amount of rent or a clear means to determine the rent so that that provision is not viewed as too vague to be enforceable, or as an agreement to agree and not enforceable. An example of an option to extend the lease is included in Appendix 2. While an option to renew places constraints upon the ability of the landlord to lease its space to a new tenant, the option does provide the landlord with the knowledge that its building will be considered when the end of the lease term is approaching. In the option, the landlord can also negotiate a rent payment for the extended term that is beneficial to the landlord, and if the tenant is a good paying tenant, the landlord will want to retain them. Assignment And Subleasing When negotiating the assignment and subleasing provisions in a lease, the tenant should review its business plan for the next five to 10 years. If the tenant anticipates that it will build its company and then sell the company and need to assign its lease to the new entity, the tenant will want to have the flexibility in the lease to do so. The tenant will want to ensure that the language regarding an assignment or sublease is broad enough to allow it to assign the lease in connection with a sale, merger, or other process. If the tenant is unable to assign its lease to its successor, the tenant would be in default if it elects to move forward and allow the new entity to occupy the space. Upon the tenant default, the landlord could pursue its remedies and remove the tenant from its premises and sue for its damages which could include rent and other charges under the lease until such time as the landlord locates a new tenant and the new tenant occupies the space. Uncertainty about the future of its business would also cause the tenant to want flexibility with respect to assignment and subleasing. If the tenant needs to downsize its business and locate another company to take a portion of its space, the tenant will want to be able to sublease to the new company. If a lease does not permit a tenant to sublease, the tenant would have to continue paying rent on the entirety of the premises despite its no longer needing that amount of space, or default, and be faced with the landlord exercising its remedies and seeking to recoup its damages from the tenant. When a tenant assigns or subleases its premises, the tenant remains liable under the lease to the landlord and is not released from liability unless the

Expenses in Commercial Leases 15 landlord expressly releases the tenant. Despite the tenant remaining liable under the lease, the landlord will want to have information regarding the financial capacity of the assignee or subtenant so that the landlord can make a determination as to the stability of the new party and its ability to pay rent. If a lease allows an assignment or sublease with the reasonable consent of the landlord, the landlord could refuse to allow the assignment or sublease based upon its review of certain items with respect to the new party which under applicable laws may include the new party s usage of the space, the legality of its usage, and its financial capacity. An example of an assignment provision is included in Appendix 2. Landlord Lien In addition to a security deposit, a lien held by the landlord on the personal property of the tenant can provide the landlord some repayment if a tenant defaults and thus lessen the loss incurred by the landlord. A provision would be included in the lease that the tenant grants the landlord a security interest to secure the obligations of the tenant under the lease. This security interest would need to be perfected by filing a financing statement in the records required for the location of the building. If the tenant defaults, the landlord could proceed to sell the property in accordance with applicable law and apply the receipts of the sale against the amount due by the tenant under the lease. Many tenants do not want to agree to grant the landlord a lien upon their personal property because they wish to use the personal property as collateral for other obligations of their business, or because the personal property will act as collateral for the loan obtained by the tenant to finance the purchase of same. Some landlords do not wish to go through the process to obtain a security interest in the personal property of the tenant due to the general recovery in a sale of used personal property which can be limited. A landlord should consider what personal property the tenant has in the premises and whether it would be beneficial and cost effective for the landlord to obtain a security interest. An example of a landlord lien provision is included in Appendix 2. Hazardous Materials The presence of materials considered hazardous under applicable laws could result in substantial costs to the tenant and/or the landlord. Before signing a lease, the tenant should confirm that hazardous materials are not present at the building. If hazardous materials are present at the building, the tenant should determine whether the materials present create a risk for the tenant, and its employees and customers. With the increase in Brownfields development, the issue of the presence of hazardous materials will become more prevalent. If, for example, a property is considered a Brownfields site due to the presence of unlawful and toxic substances in the groundwater but the water used in the building is provided by the municipality and no usage is made of the groundwater, the tenant may decide that the existing hazardous materials do not create a risk for its business operations. The tenant should also consider the other tenants in the building and whether they are the type of business that would be using hazardous materials in the building that could create the risk of airborne contaminants and other risks to the tenant, its employees and guests. The landlord will want to ensure that the operation of the business of the tenant will not create the risk of hazardous materials at the building that could cause harm to the other tenants in the building, or damage to the building and other property of the landlord, and a resultant loss in the value of the assets of the landlord. To clarify this issue and provide comfort to each party, it is helpful for the landlord to obtain a rep-

16 The Practical Real Estate Lawyer September 2013 resentation from the tenant as to the materials and substances to be used by the tenant at the building. The landlord will also want an indemnity from the tenant for issues for which it is responsible. The tenant will want information on what, if any, hazardous materials are present at the building, and a representation from the landlord regarding same. The tenant can request a copy of any environmental audits performed by the landlord or its predecessors at the building. The tenant will want to be indemnified by the landlord with respect to any issues created by the landlord at the building with respect to hazardous materials. Landlord Default A default by the landlord under its lease could be very costly to a tenant so the lease should address this issue. Clarity with respect to this issue is important for both the landlord and the tenant. The landlord default provision should include the grace period provided to the landlord and the remedies of the tenant for such default. The default could be of an item that is critical to the operation of the business of the tenant such as roof leak, a broken water pipe, or a damaged HVAC unit, and if the landlord will not repair the item, the tenant may be forced to do so in order to keep its business operating. The landlord will want to examine what it is comfortable providing to a tenant for its remedies as an agreement to allow a tenant to terminate its lease could prove problematic if the tenant does not exercise fair judgment in doing so. An example of a landlord default provision is included in Appendix 2. CONCLUSION Commercial leases contain many provisions that allocate the expenses under the lease between the landlord and the tenant. Each party should review these provisions and determine which expenses it will agree to bear. It is important that each provision be examined and clarified so that the expense is not wrongly allocated to a party, or that the parties are not in full agreement regarding the expense. APPENDIX 1 Lease Treatises Milton R. Friedman & Patrick A. Randolph, Jr., Friedman on Leases (Patrick A. Randolph, Jr., ed., 5th ed. 2005). Patrick A. Randolph, Jr., The Commercial Property Lease (1993). Mark A. Senn, Commercial Real Estate Leases: Preparation, Negotiation and Forms (Aspen Publishers 2003). John B. Wood & Alan M. DiScuillo, Negotiating and Drafting Office Leases (11th ed. 2005). APPENDIX 2 FORMS (Note that the forms provided below are an example that may be used as a draft to prepare a form that is applicable to the facts and circumstances of each lease and the applicable law.)

Expenses in Commercial Leases 17 Commencement Date with Delay Penalty In the event the Commencement Date has not occurred by due to a Landlord Delay (as defined herein), Landlord shall credit Tenant on the Commencement Date with an amount equal to one day of rent for each day the Commencement Date is delayed due solely by reason of the Landlord Delay. The aforesaid monetary amounts shall act as a sole and exclusive remedy to Tenant for any delay in the Commencement Date. A Landlord Delay shall be defined as a delay due in whole or in part to: (i) failure by Landlord to furnish information requested by Tenant within five business days of the request therefor, or if such request may not be satisfied by Landlord within five business days due to the time reasonably needed to satisfy such request if Landlord is acting in good faith and proceeding diligently, Landlord fails to commence its efforts to satisfy such request within five business days or fails to diligently pursue satisfaction of a request thereafter; (ii) the acts or omissions by a person or entity employed by Landlord in the completion of any work in connection with the upfit of the Premises by said person or entity; or (iii) other acts or omissions, whether negligent, willful, or intentional of Landlord, its agents, employees, officers, directors, or independent contractors, and as a result of the foregoing, Landlord does not deliver the Premises to Tenant on the Commencement Date, substantially complete and available for occupancy by Tenant in accordance herewith. Audit Provision Tenant or its designated representative, at its sole expense, will have the right once per calendar year during the term of the Lease to audit the books and records of the Landlord relating to the operating expenses of the building for the immediately preceding calendar year. This audit must take place on a mutually agreeable date during reasonable business hours at the offices of Landlord at the address stated above and only after Tenant has given Landlord at least fifteen (15) days prior written notice of the date and time Tenant desires to commence such audit. If the Tenant elects to audit the books and records of the Landlord, such audit shall be conducted by a reputable accounting firm and not on a contingency basis. If any such audit reveals an error by Landlord resulting in an overcharge to Tenant, then Landlord will refund to Tenant the amount erroneously charged to Tenant within fifteen (15) days after the written request of Tenant. Likewise, if any such audit reveals an error resulting in Tenant being undercharged, then Tenant will pay Landlord the amount of such deficiency within fifteen (15) days after the written request of Tenant. Tenant Allowance Landlord shall provide up to $ per rentable square foot for a total of $ for the Upfit Allowance for the Premises to be applied toward the costs, fees, and expenses (collectively, the Construction Costs ) for the upfit of the Premises as detailed in the Plans (the Tenant Improvements ). The Tenant Improvement Allowance shall be used to fund the following items from the Construction Costs (listed in order of payment):. Landlord and Tenant acknowledge and agree that the Construction Costs may be in excess of the Upfit Allowance, and all costs for the Tenant Improvements in excess of the Upfit Allowance shall be borne by Tenant. If Construction Costs exceed the Upfit Allowance, Tenant has agreed to place into a non-interest bearing escrow account

18 The Practical Real Estate Lawyer September 2013 maintained by Landlord with an FDIC-insured financial institution of its selection (the Escrow Account ) an amount equal to the Construction Costs as specified in the Budget (as defined herein) minus the Upfit Allowance (the Tenant Improvement Overage ). The Tenant Improvement Overage will be deposited by Tenant into the Escrow Account (as defined herein) on the date of execution of this Lease and shall be used by Landlord in payment of the costs for the Tenant Improvements as such costs are incurred and prior to the usage of the Upfit Allowance. Landlord shall provide evidence to Tenant of the Tenant Improvements funded with the Tenant Improvement Overage upon the written request of Tenant. Option To Extend Term Provided there is no default or event of default by Tenant hereunder at the time such rights are exercised or when the Extended Term (as hereinafter defined) will commence, Tenant will have the option to extend the term of this Lease for one (1) five-year (5-year) term by providing Landlord written notice of its desire to do so at least one hundred and eighty (180) days prior to the end of the then current term hereof. The date of the commencement of the Extended Term will be the day after the expiration of the then current term of the Lease (unless sooner terminated as provided herein). All terms and conditions of this Lease will be in effect during the Extended Term, except that the Rent shall be, and upon the exercise of Tenant s option hereunder, all rights of Tenant to renew or extend the term hereof will have lapsed. Failure of Tenant to comply strictly with the provisions of this subparagraph will render the rights of Tenant in this subparagraph null and void. Assignment And Sublease Except for a Permitted Transfer (as defined herein), Tenant shall not voluntarily or by operation of law assign, transfer, hypothecate, mortgage, sublet, or otherwise transfer or encumber all or any part of Tenant s interest in this Lease or in the Premises (a Transfer ), without Landlord s prior written consent, which shall not be unreasonably withheld, conditioned or delayed. Any request by Tenant for Landlord s consent to a Transfer shall be in writing and shall include, among other items reasonably requested by Landlord, all of the following information: (i) financial statements of the proposed transferee audited by an independent certified public accountant; (ii) a description of the business the assignee or subtenant intends to operate at the Premises; (iii) the proposed effective date of the assignment or sublease; and (iv) a copy of the proposed assignment or sublease agreement which includes all of the terms and conditions of the proposed assignment or sublease. Notwithstanding the foregoing provisions of this Section, the consent of Landlord shall not be required for (but Tenant shall give Landlord prior written notice of) any of the following Transfers (each of which shall be a Permitted Transfer ): (i) a public offering or transfer of shares of Tenant on a stock exchange or equivalent trading system; (ii) a Transfer to any person or entity that controls, is controlled by or is under common control (each a Related Party ) with Tenant; (iii) a Transfer to any entity resulting from a statutory merger, consolidation or other reorganization with Tenant, provided that the surviving entity immediately after such event has a tangible net worth greater than or equal to that of Tenant s as of the date of this Lease; or (iv) a Transfer to any person or entity that acquires all or substantially all of the assets of Tenant, provided that such transferee immediately after such Transfer has a tangible net worth greater than or equal to that of Tenant s as of the date of this Lease. For purposes of this paragraph, a

Expenses in Commercial Leases 19 public or private offering of Tenant stock is a Permitted Transfer and the term control means possession, directly or indirectly, of the power to direct or cause the direction of the management, affairs and policies of anyone, whether through the ownership of voting securities, by contract or otherwise. In the event of a Transfer to a Related Party of Tenant and such Related Party ceases to be a Related Party of Tenant, then the event giving rise to such cessation shall be deemed a Transfer requiring Landlord s consent as set forth in this Section. Landlord Lien In addition to any statutory lien for rent in Landlord s favor, Landlord shall have and Tenant hereby grants to Landlord a continuing security interest for all rentals and other sums of money becoming due hereunder from Tenant, upon all goods, wares, equipment, fixtures, furniture, inventory, accounts, contract rights, chattel paper and other personal property of Tenant, and the proceeds and products thereof situated on the Premises, and all such property shall not be removed therefrom without the consent of Landlord until all arrearages in rent as well as any and all other sums of money then due to Landlord hereunder all first have been paid and discharged. In the event of a default under this Lease, Landlord shall have, in addition to any other remedies provided herein or by law, all rights and remedies under the Uniform Commercial Code, including, without limitation, the right to sell the property described in this Section at public or private sale upon the notice to Tenant as required under applicable law, and in compliance with any and all other provisions of applicable law. Tenant hereby agrees to execute such financing statements and other instruments necessary or desirable in Landlord s discretion to perfect the security interest hereby created. Any statutory lien for rent is not hereby waived, the express contractual lien herein granted being in addition and supplementary thereto. Landlord Default If Landlord shall fail to comply with any duty or obligation hereunder within thirty (30) days after written notice by Tenant to Landlord specifying wherein Landlord has failed to perform any such duty or obligation it shall be an event of default hereunder, and for any such event of default Tenant shall have the right to exercise one or more of the following remedies:. To purchase the online version of this article, go to www.ali-cle.org and click on Publications.