Often the single largest expense facing a commercial enterprise after payroll is the rental cost of the lease for the space utilized by the enterprise. In negotiating a lease, the business owner faces a pressing need to both choose the correct location and to build those various office improvements so as to conform the space to business needs.
In California, the prospective business tenant is often at a severe disadvantage in the negotiation. The market is quite often in favor of the landlord/owner and the landlord is usually far more sophisticated and experienced at lease negotiations. Indeed, quite often the landlord utilizes the services of a professional broker, lawyer or management company to handle the negotiations and these professionals, who negotiate hundreds of leases a year, are capable of creating a lease which appears attractive but may be actually filled with clauses that are disadvantageous to the business owner.
The situation can be dangerous for the business owner not only because of "tricky clauses" but because of such legal doctrines as "business fixtures" and "strict liability." Under the doctrine of business fixtures, the lessee can lose all ownership rights to equipment and improvements installed on the property while, ironically, strict liability imposes severe personal liability upon the lessee should potentially dangerous or contaminating materials be stored or disposed of incorrectly which effect the property or surrounding property. A three year lease can result in a judgement lasting twenty years or more hundreds of times greater than all the lease payments combined.
Once moved in with inventory and/or equipment installed at considerable expense, many business tenants soon discover that the cost of a move to a new location could equal the entire value of a business. More than one of our clients has actually closed down their operation rather than face the economic consequences of the end of their lease. As one of those clients said to this writer, he had never realized that the real owner of his business all along had been the landlord!
It is thus vital for the business owner to carefully and fully negotiate the terms of a commercial lease prior to committing to the expense of the move and build out. Since the average commercial lease is over fifteen pages long, with small print and extremely complex provisions, it is equally vital to obtain adequate legal and tax advice during the negotiations.
This article will briefly outline those aspects of commercial leases most commonly encountered in the negotiations and discuss the more common errors business owners make when entering into these long term multi hundred thousand dollar commitments.
KEY TERMS OF COMMERCIAL LEASES
Business owners of any sophistication know that such basic terms as rental, cost of improvements, parking, and rights to renew the lease are critical terms of any negotiation. However, many business owners do not take time to consider the slightly more subtle but equally vital clauses common to these types of leases:
1. Escalation Clauses: Expense Pass Through Clauses:
It is now common for Landlords to impose upon tenants any increase in costs associated with inflation by a Cost of Living Clause which increases (but seldom decreases) rental based on increases in the cost of living in the surrounding area, often including increases in taxes, utilities and even cost of labor for janitorial service. (Often called "triple net" or "net, net, net" leases since the landlord gets the rental net of all such expenses which are always paid directly or indirectly by the tenants.) What is less obvious is that landlords often insert clauses which increase those expenses associated with the maintenance and even the improvements of the common areas, roofs, air conditioning, etc. Thus, in addition to facing increased rent based on inflation, tenants may find themselves facing increased rental or an assessment based on improvements that the landlord elects to make, whether or not the tenant considers the improvements worthwhile. Common examples are installing security systems, landscaping, new parking facilities, or air conditioning. Expensive improvements, which are amortized and depreciated by the landlord over ten or fifteen years, may also be decided upon by the landlord and the tenant may find its rental radically increased by such decisions since the costs will be passed through to the tenant in the escalation clauses.
Normally the tenant in a multi tenant building will be allocated a percentage of the increases based on percentage of space occupied. The formulas used by the landlord can be quite complex and great care must be taken in examining the plans and layout of the building to determine if the allocation is correct. Attempts should also be made to create some limits or criteria for improvement allocation to the tenant since the result of such clauses is to allow a third party, the landlord, to control your own expenses. Consider: if the landlord determines that the landlord wishes to sell the building in five years, thus begins a program of improvements to increase the price, a net, net, net lease results in the tenant, via increased rental, paying for the improvements...while the landlord ultimately gets the increased price for the improved property.
Clearly, the tenant must seek some protection in the lease clauses to limit such expenses...and since economic motivation will not hinder the landlord (since the improvements cost the landlord nothing and increase the value of the property) the sole remedy to protect the tenant must be found in restricting such actions of the landlord in the lease.
2. Condemnation and Inverse condemnation
If the public (federal, state or local government) elects to utilize part of the space for the "public good" such as building a road or public structure, the premises may be "condemned," that is taken by the government, or "inversely condemned," (made impossible or more difficult to use by the governmental changes) in which case under a court procedure the users of the premises are allowed compensation both for their loss of use and the effects on their businesses of the alteration. These judgements are often extremely sizable since the cost of the move and the effect on the interrupted business are normally an element of damages. Clearly it is the tenant using the premises who quite often suffers the greatest loss.
However, many leases provide that the lease is automatically terminated with no recovery going to the tenant if such condemnation occurs...despite the fact that otherwise, with no such lease provision, the government would normally allocate a portion of the compensation to the tenant...often the largest portion. The allocation of a portion of the condemnation judgement to the tenant is only fair since it is the rental interest that is most directly affected by the condemnation; but the courts have held such clauses eliminating such awards and giving the entire judgement to the landlord are fully enforceable if the tenants are foolish enough to sign such a lease.
Condemnation, in whole or part, occurs far more often than one would think. A common occurrence is a change in a road way which makes access to premises more difficult, thus reduces customer access. The condemnation clauses in the lease are usually quite complex and often ignored by the hurried neophyte tenant. They should not be.
3. Hazardous Wastes and Inappropriate Use
The laws concerning use, storage and disposal of "hazardous waste" or dangerous materials such as explosives or flammable materials are becoming increasingly stringent and the effects of improper disposal and storage can be catastrophic both for the property and for the landlord and tenant who may face fines and even imprisonment if the laws are not adhered to strictly. Such apparently innocent substances as diesel oil, cleaning solvents, and flourescent light ballasts must be stored and disposed of properly, often at great expense. Ignorance of the law is no excuse and one may be held accountable for errors of employees or tenants or subtenants based solely on their status of tenant or landlord, even if directions were given to the subtenants to dispose of the product legally. (This is called "strict liability" in that no negligence is required to impose liability...if you violate the law, you are liable, even if you were not negligent, even if it was "not your fault.")
Perhaps a few examples will suffice to warn the reader of the ramifications.
One construction client stored used ballasts from inside of flourescent lights that he had removed from a building he was renovating in his warehouse for a month then took them to the dump. He did not know that a special permit was required to store and dispose of those ballasts (which contain PCBs, a carcinogen) and faced criminal liability and massive fines for his innocent disposal of forty five of the lights. The landlord, appraised of the unsafe storage of the ballasts, faced his own suit from the government and possible closure of the premises by the government due to the possible pollution of his soil. The landlord threatened his own suit against the tenant and termination of the tenancy which would have put our client immediately out of business.
Once attorneys fees, the fine, and costs of cleanup were incurred, the tenant found that the price for the storage of forty five ballasts was about two thousand dollars each! Then his landlord attempted to impose a termination of his leasehold interest based on a violation of the lease prohibiting storage of hazardous wastes! The lease offered the tenant some protection and the landlord grudgingly, backed down.
Even more remarkable, another client, a landlord this time, discovered a sixty year old twenty gallon storage tank buried in his back yard apparently used to store diesel fuel and unused for decades. He was the sort of business owner who would do things by himself so he promptly dug it up and put it in his old pickup truck and removed it to the city dump. A neighbor saw a small drip of diesel leak from the old tank onto the soil as our client loaded the small tank into his truck. The neighbor reported same to the police. The fine was in excess of twenty thousand dollars; the cost for removing the soil to a depth of ten feet was in excess of fifteen thousand dollars. Our client’s tenants threatened to sue since their use of the premises was interfered with by the cleanup required...but, once again, a good lease provision protected the client.
Most leases impose harsh penalties for improper storage or disposal of waste, including loss of tenancy. Often uses that require hazardous waste permits for disposal are prohibited in the lease. Such innocuous activities as dry cleaners, photo studios, offset printing, etc. are actually businesses which regularly use hazardous waste materials and the provisions in the lease dealing with this aspect must be carefully reviewed.
4. Subleasing and Assignment Rights
The ability to sublease (grant to another the right to use the premises for paying you rent while you remain liable on the underlying lease) and assign (grant to another the lease and you are no longer liable for the underlying lease) are powerful and useful tool for the lessee since they allow the lessee to remove itself from the burden of a leasehold no longer useful and also to benefit by renting appreciating property at a higher rate to sublessees.
Most commercial leases allow such subleasing if the subtenant is reasonably acceptable to the lessor which means the sublessee must be financially sound. This is not a heavy burden since under a sublease the tenant remains liable to the landlord for the rent and state of the premises and if a subtenant breaches the lease one can expect the landlord to look to the original tenant, not the subtenant, for relief.
Recently, due to remarkably escalating rents, landlords have been altering the leases such that if any sublease occurs, any profit above the original lease rental payments must go entirely to the landlord or the landlord has the right to take back the premises entirely if the tenant wishes to vacate, even if the tenant has found a subtenant. This, of course, means that the risk of a falling rental market is entirely with the tenant since any increase in rents goes to the landlord while any decrease in rental values does not release the tenant from having to pay the already negotiated rent.
Nevertheless, the ability to sublease is a crucial provision and many jurisdictions require the landlord to reasonably consent to subtenants who are financially secure.
5. Eviction Clauses and Other Remedies Available to the Lessor
Quite often the longest part of the Commercial Lease is the powerful remedies available to the Landlord should the tenant fail to pay rent. Normally, they include the right to evict; the right to seek damages for lost rent, in addition; the right not to evict and to force the tenant to pay the rent whether the tenant has abandoned the premises or not; the right to retain any deposit made on the premises.
Despite these onerous clauses, the California courts have normally held that while the landlord is certainly entitled to evict a nonpaying tenant and to seek damages, that the landlord is also required to "mitigate" damages by seeking to replace the tenant with a new tenant as soon as possible. The new tenant must be commercially reasonable to the landlord but the landlord is required to actively seek a replacement tenant by all reasonable means. (This duty to mitigate damages is a common requirement in any breach of contract situation. See article on Contracts on this website.)
The eviction action available to a landlord is not the standard year long litigation one finds in American litigation but a special proceeding, called "unlawful detainer" by which the landlord has priority in obtaining a courtroom and a trial for the sole purpose of retrieving the property from the tenant. Most unlawful evictions actions take less than three months from start to finish.
Unlike residential evictions, in which the landlord is often faced with a hostile court and a large number of statutory protections of tenants, the commercial tenant is relatively unprotected by the law, the courts assuming that a business tenant is quite able to look after its own interests and needs no special scheme to protect it from being evicted. Thus commercial evictions are not rare with courts routinely allowing landlords to seize the premises and all inventory and fixtures therein. Commercial landlords are able to enforce the powerful tools for eviction and collection contained in their leases and the prospective tenant must read and understand the clauses before executing the lease.
It is also common to have a clause awarding attorneys fees to the landlord if eviction proceedings are necessary. In California, a one sided attorneys clause is automatically rewritten by statute (CCP1717) so that it is read to state that the prevailing party in any litigation, including evictions, is granted attorneys fees.
6. Extensions of The Lease Term
An option to renew at the end of the lease term is obviously of great value to the tenant since it allows the tenant the choice to move or stay without the cost of moving. Many landlords offer such options, but on closer scrutiny the lease terms merely say the parties will negotiate "in good faith" for future rental and if they can not agree, the lease ends.
This is not a true legally binding option since the landlord can always insist upon terms the tenant cannot accept. Such a clause is virtually useless and the sort of platitudes given to children who confuse words of comfort with solutions to problems.
A true option either sets the rental and terms of the renewal, giving the tenant the right to accept them, or has a set formula for setting the new rental based on objective standards not solely in the control of the landlord. Such an option must be sought by any intelligent tenant and not confused with words that sound comforting but grant no real rights. Typical objective terms are rental based on the cost of living of the area added to the previous rent; increases based on a set percentage; or fair market value set by objective experts, such as real estate brokers or certified appraisers.
As with most law, the most efficient way to obtain legal power is not after suit is filed but in the preparation of the documents, contracts and leases that allow quick and inexpensive enforcement of rights. Nowhere is this more important than in the area of leasehold negotiations. The reader is invited to review the articles on this website on the areas of Contracts; Litigation; and Arbitration for discussion of relevant aspects of the lease to be considered by the negotiators.