01
Oct
2004

Commercial Leases: A Few Points to Ponder

Real Estate & Construction Advisor & Alert

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PUBLISHED ON: October 1, 2004

Besides finding an acceptable tenant for its space, a landlord must consider many matters in negotiating the lease, some of which are discussed below.

Measurement of the Space

The annual fixed rent is commonly described as an agreedupon rate per square foot, and the determination of the area of the leased space will have financial implications. Landlords will include a portion of the building’s common area in order to establish the “rentable square feet.” Tenants will focus on the “usable square feet” within the four walls of the leased space. Because the rent will be calculated on the rentable square feet, tenants need to know the loss factor to determine the real cost per usable square foot. Of course, other considerations, such as the layout and utility of the space, are also very important to the parties. For new leases and even for renewals of existing leases, a landlord may be able to increase its rental income through an updated, accurate re-measurement of the leased space.

Escalations

Commercial leases typically require tenants to pay for all or a proportionate share of real estate taxes and operating expenses, or at least the escalations in those items over the base amounts. The landlord and tenant must carefully review the components of those escalations. Abroad definition of real estate taxes that includes water charges, sewer rents, assessments, business improvement district and similar charges will yield a greater rental income to the landlord. Similarly, an expansive list of operating expenses, which may, for example, include the cost of certain capital improvements, will increase the landlord’s rental income. Given the recent dramatic increase in insurance costs, a landlord may require a tenant to pay all or a portion of the landlord’s insurance costs.

Electricity and HVAC

All tenants pay for electricity one way or another. The rent-inclusion basis is easy to administer, and it is the method most desirable to a landlord if it results in a profit over the landlord’s cost of electricity. The landlord should reserve the right to increase the rent if a subsequent survey indicates excessive use of electricity by the tenant. If the electricity is submetered, it is common for the landlord to impose a surcharge above the utility company’s rates, although the surcharge is often less than what the landlord can achieve through the rentinclusion method. The method most beneficial to a tenant is the direct metering of the tenant’s electricity service. However, even a direct meter may provide a cost-savings to the landlord if, for example, the electricity for the heating, air conditioning and ventilation equipment servicing the leased premises is provided through the tenant’s meter.

Alterations

The scope of the landlord’s workletter, the timing and amount of the rent concession, and the landlord’s contribution toward the cost of the tenant’s qualifying work must be carefully considered. In order to reduce its upfront investment in the leased premises, a landlord may be willing to accept a lower rent if the tenant assumes the credit risk of building out the space. Alternatively, a landlord may provide some work-related concessions in order to maintain a higher rent roll so as to satisfy the requirements of an existing or prospective lender, investor or purchaser. Tax and insurance issues are involved in these decisions. To preserve the integrity and value of the building, the tenant’s alterations must be subject to the landlord’s consent. The tenant’s alterations raise other concerns, such as the abatement of asbestos, lead paint and other hazardous materials, and compliance with applicable laws, including the building code, fire code, the Americans with Disabilities Act, and New York City Local Law 58 or the like. For the
landlord to avoid a costly demolition expense, the landlord may require the tenant to remove its alterations at the end of the lease term.

Maintenance and Repairs

Usually a landlord is responsible for the structural and public portions of the building (except in a net lease situation), and the tenant is responsible for maintaining the leased premises and the fixtures therein. The lease can specifically make the tenant responsible for the maintenance of dedicated HVAC equipment and electrical or water meters. The lease should provide for the parties’ respective obligations regarding any existing or new sprinkler system and any modifications thereof. The tenant must comply with laws, although the tenant may seek to limit that obligation to those matters arising out of the tenant’s particular use of the leased premises.

Assignment and Sublease

The lease must spell out under what circumstances, if any, the landlord will consent to an assignment of the lease or a sublease of the premises. The factors include the identity and creditworthiness of the proposed assignee or subtenant and its proposed use of the space. The landlord should retain the right to recapture the leased space in order to take advantage of market conditions or to accommodate other tenants. If the landlord does not recapture the space, all or a significant portion of any profits derived by the tenant from the assignment or sublease should be paid to the landlord.

Financeability

An overriding concern affecting many of the provisions in a lease is whether the provisions will be acceptable to the landlord’s mortgage lenders. The income stream from the property must remain uninterrupted under all circumstances. The tenant must not be permitted to setoff any claims against the rent payments. The lease must be subordinate to existing and subsequent mortgages. The landlord’s lender must be given the opportunity to cure any lease defaults by the landlord before the tenant seeks any remedies. To avoid the loss of a valuable tenant upon a foreclosure of the landlord’s mortgage, the tenant must agree to attorn to the lender or a successor landlord. The lease must provide that the lender will not be responsible for the acts or defaults of the foreclosed landlord. The tenant must provide to the landlord or its lender an estoppel certificate certifying the status of the lease. The prescribed insurance must be maintained by the tenant. The lease should allow reasonable modifications required by the lender so long as the tenant’s obligations or rights are not materially affected.

Conclusion

A landlord must carefully scrutinize the many provisions of its lease in order to enhance its net income and to limit its liability.