Major Commercial Lease Terms That Don't Show Up In Your LOI
After years of planning, months of searching, and weeks of negotiation you have it – a signed LOI for your new commercial space. You got the rent rate you wanted, the right number of years, and the Landlord even agreed to throw some cash into the deal to help you with the construction.
But one of the primary rules of negotiating is that it’s not just the price; it’s the package, and in this case, there are a lot of details that influence the value of your deal that aren’t in the numbers and basic terms of an LOI. The same numbers for rent, square footage, guarantees, and landlord contributions could lead to two very different situations based on some of the lease language clarifying how those numbers get applied in practicality. The following are a few terms that can turn a good price into either a great package or a cumbersome drain on an otherwise successful business:
Assignability and Guarantees: When is a ten year lease not a ten year lease? When the ownership of the tenant can be transferred. Unlike residential leases, commercial leases generally have entities, not individuals, as tenants. Because of this, the ability for a Landlord to collect from the tenant depends on that entity being able to pay its bills. If an entity is stuck in a lease it can’t pay, or gets an offer to buy out the lease with the Landlord, a corporate equity restriction assignability clause can make all the difference.
Most leases have a provision that the landlord has to approve the assignment of the lease to a different entity. But what if, instead of the lease being assigned to a different entity, the entity was simply assigned to different owners? If the lease doesn’t provide that a change in equity or control of a company is deemed an assignment, the tenant is able to simply sell the entity to another ownership group, with a new concept or new business, and the landlord has little ground to contest the transfer. Likewise, without these restrictions in the assignment clause, a tenant unable to pay rent can simply create a new entity, transfer the ownership of the leased entity to the new, worthless entity, and let the Landlord know that they can now only collect from an entity with no assets.
This isn’t an option, however, if the tenant’s principles agree to personal guarantees, as those guarantees typically remain regardless of the ownership of the entity. But while most landlords and tenants negotiate the straightforward concept of a personal guarantee in the LOI, many ignore the assignability provision, which can be just as, or more, important. Personal guarantees may be a necessity for a landlord, but typically they can be subject to a reduction over time, and typically a release at the end of the first term. Landlords may balk, but at which time the landlord should not need a guaranty to assure the landlord got what it bargained for - the initial term should have provided landlord its fair compensation for the deal, and the initial term was satisfied.
HVAC Replacement: Until you’ve been on the roof of a restaurant, arguing with a landlord and an HVAC repairman about vague repair quotes and even more vague lease language about responsibility for HVAC repairs and replacements, you probably haven’t considered how important the oft overlooked details of HVAC repair and replacement can be.
The HVAC (heating, ventilation, and air conditioning) system in a building is often the most expensive piece of equipment related to a commercial lease. In a market like Chicago, which faces polar vortexes and sweltering summers, not having proper temperature control can cause customers to quickly reconsider their patronage.
There are multiple concerns related to an HVAC supply – does it cover just the tenant under the lease, or other tenants as well? Who is responsible for maintenance? Repair? Replacement?
In many cases landlords will require tenants to replace a broken HVAC system, regardless of when the system breaks, knowing that if the system breaks in Year 9 of a 10-year lease, the tenant will still have to replace the system at the risk of losing business. Thus the tenant will have to pay the full cost of a system it may only use for a year. Tenants should try to negotiate landlord replacement of HVAC systems if the tenants provide regular maintenance, and in the event the landlord wants the tenant to pay, the tenant should try to negotiate the Landlord fronting the cost of the project, with the tenant reimbursing the Landlord an amortized monthly amount linked to the useful life of the HVAC system.
Form and Timing of Landlord Contributions: The Landlord agreed to chip in $200,000! While the number is great, how that money is provided can vary greatly. Some landlords may have a work letter that provides for specific items of work to be done by the landlord prior to a tenant beginning their work. While some landlords will provide you with up front cash to start construction, most large projects require the tenant to use a construction escrow, which requires the tenant to cover the initial costs, with the landlord providing reimbursements on a rolling basis with proof of work completed. A final method would be to withhold all landlord contributions until the work is done, a certificate of occupancy issued, and the business open to the public.
While each of these situations could have the same $200,000 “value” to the client, in terms of actual dollars spent by the Landlord, they each affect the finances of a new commercial tenant differently. If a business plans a new location budget including the tenant improvement dollars, but those dollars don’t come until the business opens, the business may have trouble funding ongoing construction, causing the project to stall or fail. In summary, not all landlord contributions are the same, even if the dollars are, and it is important to know how and when you can get access to those funds.
Square Footage: It’s amazing how the same space can have so many square footage measurements. Between varying standards, the motivations of different parties conducting the measurement, and different definitions of what constitutes a square foot, variations of up to 20% in the same physical space are not impossible.
The first thing is to determine if your rent rate is based on a per square foot rate or a flat rate, with an estimated square footage. The latter is more likely in the case of an already-demised space. All parties see what the finished space looks like, so the square footage is more of a report than a representation. Rent rates are flat, so regardless of if you re-measure the space and it is 10% more or 10% less, you still pay the same. In unfinished projects, however, leases often contain provisions that allow for the re-measurement of spaces at the conclusion of construction.
If you are measuring to determine rent rate – and you should if you are doing new construction and have a per square foot rent rate - standards are key. Leasable, or rentable, square footage includes a percentage of the common areas allocated to all tenants as included in the square footage. Useable square feet is the actual feet the tenant has exclusive use to. Make sure you understand which of these standards is being used. The next step is to make sure you are comfortable with the provisions for the selection of firms conducting the measurement, your ability to challenge the calculation, and the measurement standard that will be used (BOMA is the most common). While a few square feet here and there may not seem like a big deal when you are negotiating the LOI, each additional foot adds expenses each month, of each year, of a multi-year deal.
Option Term Details: It is typical to see a commercial lease structured with an initial term and one or more option terms, that the tenant can opt into. While the basics may be in the LOI – a ten year term and two five year options – how those options are exercised, and under what terms, can vary greatly.
First, tenants should make sure the option is unilateral, at the sole discretion of the tenant. If it is a mutual option, and the Landlord is required to agree, you have no real option at all, as both parties have to agree to contract. Next, tenants should be careful about how the option is exercised. If the contract auto-renews unless the tenant provides notice that they don’t want to exercise the option, they could find themselves legally tied to an option term they didn’t want. Conversely, if the tenant is required to provide notice well in advance (in some cases up to a year, but more regularly six months) and fails to hit the deadline, they could find themselves kicked out of their decade-long home for failing to mail a letter.
Finally, the desirability of the option will also be dependent on the terms of renewal. Some leases have fixed rates, either dollar amounts or percentage increases, while others provide for a re-assessment of fair market value by an appraiser at the time of renewal. Tenants with unilateral exercise options should push for defined rental rates. If the rate is below market, the option can be exercised (and even if you don’t want to stay, the tenant can possibly sell the entity if your assignment clause provides for it). If the rate is above market, the tenant can negotiate a new lease rate with leverage from the threat of walking away at the end of the term.
While a personal guaranty, mechanical system upgrades, landlord capital contributions, and option terms are often addressed in an LOI, the underlying details of each of these – the assignability of ownership in the tenant entity, the amortization of replacement HVAC systems, the process for receiving landlord contributions, and details of the cost and mechanisms of exercising options – will likely not be.
Because of this, both tenants and landlords should be very careful when finalizing lease details, and most probably, retain the advice of experts like Joe Kreeger at Troglia•Kaplan to walk you through the dozens of other potential pitfalls that this article didn’t touch on.