California Commercial Lease Agreements – Traps For the Unwary Tenant and Landlord
|Prepared By: Melissa C. Marsh, Los Angeles Real Estate Attorney
Written: March 2009
We provide experienced legal guidance to both landlords and tenants in the drafting and negotiation of commercial lease agreements, renewals, notices, and addendums when making changes or amendments to an existing lease.
First let me start by stating that every commercial tenant would be wise to seek the advice of a real estate attorney BEFORE signing a commercial lease agreement. Commercial lease agreements are very different from residential lease agreements, and a thorough understanding of each paragraph is essential to avoiding future onerous expenses that often can lead to bankruptcy. Buried among the myriad of clauses setting forth legal rights and obligations are loopholes, traps for the unwary, and major ambiguities that often can and do lead to bankruptcy. Our office can assist you with understanding the lease terms presented by a prospective landlord and in negotiating better terms.
Most landlords and their real estate brokers opt to use a form commercial lease agreement prepared by the American Industrial Real Estate Association on behalf of commercial brokers and agents. Although this less costly form is often used, it does come with great risk for both landlords and tenants. Most experienced commercial landlords and tenants realize that the form lease does not address their major concerns in a clear and concise manner and consequently amend or completely revise these pre-printed documents. It is therefore important to understand that both landlords and tenants can and should negotiate, and revise as necessary, a "standard" commercial lease's terms. To do so effectively, however, it is important to understand what each of the "standard" lease clauses mean.
This article seeks to provide a brief overview of the "standard" commercial lease and the terms that should be amended, or negotiated.
Every commercial lease should at the very least clearly set forth the following terms:
- Proper description of The Premises.
- The Permitted Use of the premises.
- The Term (length) of the initial lease.
- The amount of Base Rent.
- Whether the tenant is responsible for the Landlord's maintenance costs, real property taxes, insurance and Operating Expenses, and if so the exclusions.
- How Rent Is To Be Increased during the term of the lease, or upon its renewal.
- The Security Deposit required, and any Personal Guarantees required.
- Detailed Listing of any Improvements, Alterations and/or Repairs: Whether, by whom, and the procedures that must be followed.
- Who will own and pay for any trade fixtures the tenant and/or landlord install and its removal at the end of the lease.
- Who will be responsible for Maintenance, Utilities, And Code Compliance (e.g. handicap accessible bathroom).
- Tenant's Right Of Access to premises, hours of operation and HVAC Hours of operation.
- Landlord’s Right of Entry (reasonable notice and at reasonable times?).
- Tenant's responsibility to carry Insurance and the amount of coverage.
- Business Sale Clause.
- Any Options To Renew, the new base rent (specifically) if the option is exercised and the length of each option.
- Right to Sublet and Assign.
- Going Dark Rights.
- Exit Clause – Tenant's Right To Terminate The Lease.
- Pet Clause.
- Breach of the Lease.
It is important that the correct legal name of both the landlord and tenant are set forth. Unfortunately, it is all too common for the real estate agent to use a fictitious business name (DBA), or an individual's name, when the tenant or landlord is a corporation or a limited liability company.
It is ultra important that the premises clause not only precisely define the space to be rented (location and usable square footage), but also any parking spaces, and common areas that can be used. If the tenant is leasing an entire building, the Premises Clause should simply provide the address of the building and any adjoining structures the tenant will have access to (e.g. parking garage). However, if the tenant is leasing less than an entire building the Premises Clause should specifically set forth the space to be rented, the usable square footage, as well as any access the tenant will have to parking spaces, storage facilities, conference rooms, and common areas.
Tenants should be aware that most landlords will try to use the actual square footage, as opposed to the usable square footage. Many tenants would be wise to engage a qualified consultant and confirm the measurements and verify its percentage, especially if utility and other charges are also based on the stated rentable area.
The Use Clause and Exclusive Use Clause.
You might think this is a no brainer…but the reality is many tenants execute a lease only to later find out that they cannot use the premises for their intended purpose. From the landlord's perspective, it is best to keep this clause general and vague. From the tenant's perspective, it is sometimes best to specifically set forth the tenant's intended use(s) for the premises, and restrictions (if any); while other times it is best to use the broadest definition to facilitate subleasing.
Regardless of which method is used, the tenant should insist that the Landlord provide written assurances in the lease that the Premises are zoned appropriately for the tenant's intended business purpose.
An Exclusive Use Clause, which typically must be requested by a tenant, is a clause in a lease under which the landlord promises that no other tenant will be permitted to either engage in a particular type of business or sell a particular line of goods. These types of clauses are most often negotiated in strip malls.
This clause describes the length of your lease and specifies the starting and ending dates. Exercise caution and pay attention as there are two traps here for the unwary. First, some leases start as of the date the lease is signed, while others will start when the landlord is prepared to turn over possession of the premises to the tenant. Avoid a lease term that starts on the date the lease is signed, but does not require the payment of rent until a later date. Why? Because even though the tenant may not be required to pay rent, the tenant will still be responsible for other liabilities such as insurance, the requirement that the tenant rebuild in the event of fire, earthquake, or other damage, etc...
The second trap is more an assumption made by many eager tenants that a longer lease term is better. While this may be true for an established savvy businessman, it is often not the case for a new business owner. A $2,000 per month lease for five years equates to a $120,000 commitment, which is usually accompanied by a personal guarantee executed by the owner of a business (tenant). For a new business owner who may strongly believe his or her business will succeed, we suggest a short one to two year lease term with multiple options to renew for three years each. The option period costs nothing, and in the event the business does not succeed or would do better in a different location, the shorter two year lease term will limit the potential liability (in the example above from $120,000 to $48,000).
While a tenant would like to fix the base rent for an extended period of time, most experienced landlords will insist on an escalation provision to account for inflation. In a down real estate market, however, the tenant should be able to negotiate for a fixed base rent for at two, if not three years. Rent escalations are often tied to one of the many indexes, the most common of which is the Consumer Price Index. Which index to use, whether to place a cap on any annual rental increase, and whether or not the rent will remain fixed for a certain number of years, are all negotiable items.
Although the amount of the base rent is an important consideration, it should not be the only consideration. Rent is usually comprised of multiple items: (1) Base Rent (stated monthly rent); (2) Operating Costs for Common Area Maintenance (a.k.a. Pass Through CAM expenses); and (3) Required Insurance. As stated above, the Base Rent is typically a fixed monthly fee, but many commercial leases also seek to require the commercial tenant to pay a proportional share of the landlord's operating costs incurred in connection with the management, operation, repair and maintenance of the property. This too is negotiable and a common trap for the unwary tenant who may not realize that these pass through operating expenses can substantially increase.
Although the "triple net lease" was originally designed to protect the landlord against increases in utilities, property taxes and operating expenses (e.g. maintenance costs), it has become a major source of profit for the landlord at the expense of the unassuming tenant who is forced to bear the extra costs, which often times can be quite expensive.
We strongly advise prospective tenants to negotiate for a gross lease (which does not permit the landlord to pass through any expenses), and at the very least insist upon a "Cap" or limit on the pass through expenses that can be charged to the tenant in any given month and year. It is also important for the tenant to insist that the landlord provide the tenant with an "exclusive" list of the operating expenses the landlord will pass through to the tenant. Tenants should insist that certain costs be excluded such as: charitable donations made by the landlord, lease expenses incurred by the landlord with other tenants, entertainment and travel expenses, salaries paid to the landlord's relatives, capital expenditures, Proposition 13 protection, etc...
A tenant should also insist that the tenant be given the right to audit the landlord’s books and records concerning operating expenses.
A typical commercial lease will require the commercial tenant to provide up to 6 month's rent as a security deposit. However, commercial landlords should be aware that California Civil Code §1950.7 prohibits a landlord from applying the security deposit toward a defaulting tenant's future rent obligations, absent a written agreement to the contrary. It is often in the landlord's best interest to ensure the tenant waives the protection of Civil Code §1950.7 somewhere in the lease.
Improvements, Alterations and Repairs.
A tenant will often require the landlord, as a condition to leasing the premises, to make certain improvements or alterations to the premises before the lease start date. If a tenant is expecting the landlord to make such improvements or alterations, it is important for the lease to clearly state exactly what the landlord will be undertaking, who will perform the work, who will pay for the work, a date for commencement and completion, and either an exit clause or a formulaic rent reduction if the agreed upon alterations or improvements are not completed in a timely manner.
For the tenant, it is also important that a contractor evaluate the premises before the lease is signed to determine if the roof, HVAC, plumbing, electrical, etc.. are in good working order, or in need or maintenance or repair. As stated below, most commercial leases require the tenant to maintain the premises and to incur the cost of any needed repairs or maintenance. Yes…commercial tenants are often required to maintain at their sole expense the roof, the electrical, the air conditioning system, etc...
Maintenance, Utilities, and Code Compliance.
Most commercial lease agreements contain multiple nasty little surprises for unwary California commercial tenants, and the sections that deals with maintenance, utilities and code compliance are no exception. Without an express provision in the lease, the landlord does NOT have a duty to maintain or repair the premises. In fact, it is not uncommon for a commercial tenant to discover that s/he is responsible for upgrading a bathroom to be handicap compliant, replacing an old air conditioning system, or a 10-year old leaking roof. Before leasing commercial space it is extremely important to have a licensed contractor inspect the space; if the contractor discovers any deficiencies the tenant can insist that the landlord assume the cost of repair and/or replace such systems prior to commencement of the lease. A tenant may also request the lease be amended to specifically set forth the landlord's maintenance and repair obligations.
The tenant can also demand that the landlord provide written warranties that the premises are code compliant (e.g. Americans with Disabilities Act).
Access, Hours and HVAC Hours.
All commercial tenants should require that the landlord state in the lease when the building, or unit, will be accessible to the tenant as well as clients and customers. In addition, the tenant should require the landlord to state in writing the normal hours of operation for such items as common area lighting, security, HVAC (air conditioning), etc...
Will your business require a Sign, Banner, or Window Dressing. If so, make sure your planned advertising method is mentioned in the lease as acceptable to the landlord.
Landlord’s Right of Entry.
A Right of Entry Clause gives the landlord the right to enter the Premises on an as-needed basis. While a landlord should insist on the Right of Entry at any time in the event of an emergency, the tenant should require the landlord to provide a reasonable notice period of at least 72 hours for normal repairs. It may also be possible to negotiate when non-emergency repairs are made (e.g. evenings, after 2:00pm, etc..).
Both landlords and tenants would be wise to pay particular attention to the insurance clauses in their lease. Due to the rising cost of insurance it is important that the landlord be selective in the types of insurance required and the amount of coverage. All commercial landlords should still require the tenant to obtain and maintain a comprehensive general liability (CGL) policy and casualty policy issued by a AAA rated insurance company with the landlord named as an additional insured. Insurance should also be kept to a level which does not trigger co-insurance (an amount that exceeds the value of the property). Is $2 Million Dollars really necessary? The only way to answer this question is to examine the property, the number of tenants, and the type of business operated by the tenant. In many cases, $1 Million Dollars (or less) should be sufficient. Landlords should also reconsider the requirement that their tenants maintain employer liability insurance. In its place, landlords would do well to examine their own premises and the business of the prospective tenant to determine if any additional endorsements should be added to the CGL policy based on risks associated either with the premises, or the tenant's particular business.
Option to Renew.
Many leases grant the tenant the right (option) to extend (renew) the lease providing the rent is changed during the extended term(s) to fair market rental at that time. Unfortunately these clauses have been deemed invalid under California law and render the option to renew useless. It is therefore prudent for the tenant to insist on an option to renew with a fixed price for any rental increase, which can be tied to some metric such as the consumer price index.
Right to Sublet and Assign.
An assignment transfers all of the tenant's interest in the lease. A sublease transfers only a part of the tenant's interest in the lease (e.g. a section of the premises, or just part of the remaining term of the lease). Although most commercial leases contain terms that restrict the tenant's ability to enter into an assignment and/or sublease (prohibited absent the landlord's consent), this is a very important provision for both the landlord and tenant to negotiate and revise. Landlords who are predisposed as a matter of principle to retain as much control as possible should strongly consider revising this language because a subtenant is much preferable to a vacant property and a bankrupt tenant. As a safety precaution, tenants should insist that the landlord accept a sublease and an assignment if the tenant finds a qualified tenant (appropriate references, fico score and deposit) with such qualifications actually set forth in the lease.
Although most landlord's will accept a clause that permits a sublet subject to the approval of the landlord, with such approval not to be unreasonably withheld or delayed this is not necessarily sufficient from a tenant's perspective. From a tenant’s perspective, the lease should automatically permit a transfer to an affiliate, a corporation, or a limited liability company without the landlord’s consent. In addition, some tenants would be well served to negotiate broader terms such as a prequalified tenant with a sufficient FICO score and security deposit. A steadfast commercial landlord in a booming real estate market, however, may desire to eliminate the tenant’s right to sublet and may even want to add an addendum to provide for recapture rights that give the landlord the right to terminate the lease if the tenant seeks to assign or sublet (especially if the tenant stands to profit from the transfer).
Going Dark Rights.
"Going dark" rights allow the tenant in a strip mall, or other retail space, to close their store or get a large rent reduction if a major business in the shopping center (e.g. Ralphs or Target) goes out of business or leaves the shopping center.
Every commercial tenant should try to negotiate a cancellation right with a fair payment to the Landlord if one or more specified events occur (e.g. death of the tenant, collapse of the business, etc.). For the small business owner it is almost essential to negotiate such an exit clause and a reasonable commercial landlord should be willing to accept such a clause so long as it provides for a reasonable payment.
Some tenants may also want to consider having the landlord add a "pet clause." It is becoming all the more popular for not only owners, but also employees, to bring their pets to work.
Breach of the Lease.
By The Tenant. If a commercial tenant fails to pay rent or breaches a material term of the lease (e.g. fails to maintain the requisite insurance), the landlord can bring an civil suit for eviction, the balance of the rent owed for the entire term of the lease, and consequential damages. Although the landlord has a duty to mitigate damages (search for another tenant), quite often the damage award is enough to force many tenants into bankruptcy.
Long term lease commitments made in the last several years are now undergoing reevaluation as tenants are finding themselves unable to make their monthly rental payments. Such tenants are being forced to weigh whether to shut the doors, face the eviction process, and possibly declare bankruptcy and landlords are facing an ever increasing number of vacancies and uncollectible debts. Both landlords and tenants should therefore consider the possibility of a lease modification (rent reduction, term reduction, space reduction, subletting agreement, etc...).
Landlords should be aware that some tenants may be able to turn the tables on the landlord if they formed a single member limited liability company, or a corporation, whose sole purpose was to lease the premises. If such a tenant did not execute a personal guarantee and the LLC or corporation maintained itself properly (followed the corporate formalities including the preparation and execution of annual and special minutes) the tenant will effectively be able to use the threat of bankruptcy to secure a reasonable rent reduction. If the corporation/LLC was properly maintained and if no personal guarantee was executed the tenant's personal credit will go unscathed.
By the Landlord. Tenants faced with the possibility of eviction can seek to mitigate their losses by bringing a defense such as: (1) Landlord failed to perform a specific obligation; or (2) Landlord breached the "covenant of quiet enjoyment" by interfering with the tenant's use of the premises (e.g. failure to provide critical services such as electrical, plumbing, air conditioning, elevator services, etc.). While such defenses may mitigate the damage award, they often will not suffice as a defense to the eviction itself.
Needless to say this article only provides a brief overview of some of the issues involved in a commercial lease. At bottom, a tenant should only commit to the least timeframe possible (get a two year lease with a three year option vs. a five year lease). Remember options don’t cost you but give you the right to continue in the space. Second, document the promises or assumptions made by the landlord, agent, or management company (i.e. the big anchor store will stay, or will move in, no competing store will be allowed to lease space in the building or center, amount of foot traffic, average utility costs, average operating expenses, etc.). Third, negotiate a cap on all aspects of the rent (base rent, annual increases, common area charges, property tax increases, etc). Forth, try to negotiate the inclusion of an exit clause. Finally, always remember that there are many options out there and you should always be ready to walk away if the terms are not acceptable.
If you would like the assistance of counsel, we are available to draft, review, negotiate and/or revise a commercial lease, and to prepare letters or notices. Please feel free to call us at 818-849-5206 or Send Us An Email. If you just have a few simple questions, please schedule a low cost telephone consultation by completing our Telephone Consultation Request Form and Melissa Marsh will call you back at the time you select. We are based in Sherman Oaks and Los Angeles.
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© 2009 Melissa C. Marsh. All Rights Reserved.