Commercial Leasing 101: Protect Your Business and Avoid Pitfalls
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A business leasing commercial property must be careful in agreeing to and signing a lease. Beyond the dollars and cents of the agreement and the location and layout of the premises, a business leasing real estate (a “lessee” or “tenant”) must consider how to protect itself before, during and after the term of the lease.
This overview addresses these issues directly, but is not an all-inclusive summary with respect to important issues facing a commercial tenant. Leasing and contract preparation requires expertise—from the lessee, from outside consultants and preferably from an experienced real estate attorney. While the author represents commercial landlords and tenants, and has substantial legal experience in real estate and leasing matters, this article should not be construed as formal specific legal advice to the reader, nor should the reader consider the author to be his/her attorney solely on the grounds of having read this article. Every tenant, every owner and every lease is unique and advice for particular circumstances really does require individual review and consideration.
Legal disclaimers aside, a lessee who wants to adequately plan for the future while protecting themselves from potential liability, unwarranted responsibilities and unnecessary legal fees should consider the issues detailed below with respect to the following five lease provisions, which commonly should be a central focus of any commercial tenant.
1. Use Limitations, Exclusive Use Provisions and Maintenance Obligations
While the intended use of the property has undoubtedly been considered well in advance of the signing of the lease agreement, it is essential that a tenant negotiate sufficiently broad limitations and inclusive language with respect to any use limitations on the premises. Due to assumptions, prior informal conversations and failure to consider potential ramifications, a tenant may overlook this important portion of any lease. Additionally, a tenant must be aware of neighboring locations within the same shopping center or similar environment which would directly compete with the tenant’s business. When possible, a provision should be included barring other similar businesses that would compete with the tenant. Finally, a tenant must demand clearly defined maintenance and repair obligations.
The following considerations are recommended:
- Broadly define the permitted use of the premises. The lease should broadly state what the property can be used for (ex: retail clothing and apparel store, fast-food restaurant, general non-retail office space). Ideally, the lease would allow for “any lawful use” but a landlord may demand a more narrow limitation. Regardless of oral understandings, prior use or anticipated current use, the lease should provide some detail on allowed use of the premises. A tenant must consider possible changes of modifications in their business and be sure to account for such.
- Negotiate the Obligations that You Undertake. A tenant should be sure that maintenance and repair obligations are clearly defined in the lease. The agreement should clearly detail who is responsible for regular maintenance, small repairs, major repairs and any needed improvements. Typically, a tenant will be responsible for daily maintenance and potentially some small repairs, but all larger or less frequent matters should be the responsibility of the landlord.
- Exclusive Use Provisions. If a tenant is moving into a large shopping center, retail facility or similar premises, care should be taken to evaluate potential competition which can be limited or eliminated with careful planning. An ‘exclusive use’ limitation will bind the landlord to not allow any uses on the property that directly compete with the use or business of the tenant. For example, a jewelry store that leases space in a retail shopping center can negotiate a provision that precludes the landlord from leasing out space to any other jewelry store. Exclusive use provisions are only relevant and effective where one landlord owns a large shopping center or similar facility.
2. Options to Extend the Term of the Lease
While a tenant must be careful to commit to an overly extensive term to the lease (i.e. too long), it also has an interest in securing its location and preventing an unwanted move of its business. An ideal lease term would be relatively short (2-5 years) with multiple options to extend the lease. Such an arrangement allows a tenant maximum flexibility to expand to new space if needed or to remain at the leased location for a longer period of time. The following matters should be squarely addressed in any lease extension provisions:
- No Changes in Any Lease Terms. Any extension of the lease should not change any non-monetary obligations. The lease should continue on precisely the same terms, except with respect to rent and similar payments.
- Applicable Rental Increase. A lease that includes options to extend the term of the lease should clearly state the amount of the rent to be charged during any extended period. Increases between rental terms should not typically exceed 5%, but cannot likely be expected to increase by an increment of any less than 2%. More complicated formulas are sometimes uses but run the risk of potential disputes or unclear definitions.
- Automatic Extension or Notice to Landlord. The lease should be clear in what it takes to extend the lease. Extensions may occur ‘automatically’ unless the tenant provides notice to landlord of its intention to not exercise the option. Alternatively, certain defined ‘notice’ may be required of tenant in order to extend the lease, which if not timely provided will result in the natural termination of the lease.
- Updates or Redecoration of the Premises. In connection with extended lease terms, a tenant should be sure to include a periodic obligation of the landlord to update the property and provide reasonable redecoration or renovation if needed. This type of obligation might be expected to exist every ten years.
3. Non-Rent Financial Obligations
Most lease agreements include financial obligations of the tenant in addition to simple rent payments. These may include shared utilities, property taxes, common area maintenance (CAM) expenses, insurance premiums and a variety of other case-specific fees and expenses. A tenant must be sure to adhere to the following guidelines with respect to all such financial obligations:
- Clarity, Clarity, Clarity: The language providing any financial obligations of the tenant must be exceedingly clear. Nothing should be left to assumption or later negotiation.
- Demand Documentation: All expenses that the tenant is required to pay should be contingent upon landlord providing adequate documentation. For taxes this would include a copy of the tax bill, for utilities this would include a copy of the utility bill, for common area maintenance this would include a detailed report of incurred expenses, etc.
- Clarify the Result of Non-Payment: A lease should be clear on the result of a missed payment. A tenant will prefer for any such missed payment to amount to a non-material breach of the lease. Furthermore, the lease should be clear as to the result of non-payment due to a dispute of the amount of validity of the expense. In this regard, a tenant will want to provide some right to challenge any errant or inaccurate expenses/fees.
4. Assignment and Subletting
While the initial term of the lease typically represents the anticipated needs of a commercial tenant, most business owners understand the need for flexibility. In order to avoid the unwanted position of being ‘stuck’ in a lease, a careful tenant will be sure to reserve and retain its ability to assign its interest in the lease or sublease the premises. Landlords often want to limit or prohibit subleasing and assignment, so this represents a key area of negotiation. A well-advised tenant will be sure to include the following provisions with respect to assignment and subleasing:
- A General Right to Assign and/or Sublease. Clear and concise language should be used to grant the tenant the right to assign or sublease the premises in its sole discretion.
- Limit Landlord Discretion. If a landlord requires its consent to assign/sub-lease, this language should be included which requires the landlord to use ‘reasonable’ discretion.
- Limit Tenant Liability. In the event of an assignment or sublease, a tenant must protect its exposure to potential liability. The assignment/sublease provisions of the lease should clearly define the limits of a tenant’s liability in the event that a new tenant is taking over the lease.
5. Sale of the Property During the Lease Term
Most tenants are aware of the possibility that the owner of the property will sell the property. A tenant must be sure to secure its right to lease and use the property in the event of a sale of the property. Similarly, a landlord will want to bind the tenant to its obligations in the event of a sale of the property. A landlord will additionally want to secure related rights and assurances in connection with any sale of the property. The following represents an overview of several key concepts:
- Termination of Landlord’s Liability: A landlord will want to terminate its lease obligations in the event that they sell the property. A tenant should be comfortable with this language and it represents a reasonable request by landlord.
- Subordination and Attornment: A landlord will often include language in a lease requiring a tenant to sign a ‘subordination and attornment’ agreement in the event of a sale of the property. Such an agreement binds a tenant to the new owner. This provision exists solely to benefit the owner/landlord (as well and the new buyer/owner). While its existence is not entirely objectionable to a tenant, it should be understood that agreeing to continue the lease with a new landlord carries with it some potentially substantial risk.
- Estoppel Certificate: A landlord will desire a tenant to execute an ‘estoppel certificate’ in anticipation of a sale of the property. An obligation to execute such a certificate is often included in the lease. An estoppels certificate certifies that a lease is in place, details some its terms and certifies that there has not been a breach by the landlord. The need for such a document is understandable, but a tenant should be careful to assure that only reasonable information will be requested and that a sufficient timeframe will be granted.
- Transfer of Deposit: A landlord will often want to transfer any tenant security deposits to the new owner. While this transfer does not pose any problems, a tenant should be sure that the lease clearly addresses this issue and relieves the tenant of any obligations to provide a renewed security deposit.
- Right of First Refusal: In some instances, a tenant may want to negotiation a right of first refusal, to purchase the property. A right of first refusal gives the tenant the right to purchase the property on the same terms as received by the landlord in a bona fide offer which they are considering accepting.
Jim Schleiffarth practices in the areas of business law and real estate law. Mr. Schleiffarth represents business as tenants in lease transactions as well as landlords and real estate investors. Schleiffarth Law Firm LLC is focused on providing superior client service, straightforward legal advice and reasonable fees.
This article is for informational purposes only and should not be construed as legal advice with respect to any particular lease, circumstance or owner. For additional information, please contact Jim Schleiffarth, Schleiffarth Law Firm LLC, (314) 315-4117, firstname.lastname@example.org.
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