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Legal protection in leasing.

Newspapers and trade journals are filled with never-ending stories about soft commercial real estate markets. In this buyer's market, tenants are negotiating for more favorable lease terms than ever before. Yet, the manager, torn between the need for tenants and the obligations of paying salaries, maintenance, and debt service, should carefully review the legal ramifications of each element in a lease negotiation.

Common points of negotiation

The rent concession and the work letter are two "common" inducements in lease negotiations, and therefore deserve our attention.

A rent concession is particularly attractive to tenants who must front moving expenses and other relocation costs. You, as a manager, may favor a rent concession because there is no immediate cash out of your pocket. Your risk is that, when the rent free period expires, the tenant will not be there to pay the rent, and you will have given away your space for nothing.

What can you do to protect yourself from this eventuality? First, know with whom you are dealing. While this may sound elementary, more than one manager has been caught without a thorough review of the tenant and its financial strength.

Are you dealing with the entity that you really think you are dealing with? In other words, you may hear the name of a well-known corporation and think you are dealing with that-entity, when in fact your tenant is a division, subsidiary, or affiliate with a similar sounding name, but no net worth.

There are simple devices such as additional security, a letter of credit, or a guarantee that provide legal recourse for nonpayment of rent. Most tenants will balk at the increase in security. Perhaps the letter of credit will be more palatable as it costs the tenant less to maintain than interest on the security.

A guarantee is another device to consider. A guarantee by an individual or by the "monied" entity may give you the necessary comfort to do the deal. Even guarantees which are limited to one year's rent, or to the first two years of the term, or through the completion of the tenant's improvements can make the difference as to whether or not you recover some of your costs.

If you need funds coming in immediately, then you can "reduce" the initial rent. For example, ff your agreed upon rent is $100 per year, then you can start at $90 and later jump to $110. Just be aware of the fact that an appropriate present-value analysis would require you to increase rent prior to one-half of the life of the term.

If you are leasing space in a shopping center, you can achieve a similar result by keeping the base rent low and protecting yourself with percentage rent that kicks in at a relatively low number.

Work letters

The other fairly common tenant inducement is the work letter, which many owners do not favor because it requires an immediate cash outlay. Not only that, but the funds expended may benefit only one tenant, which may or may not be credit worthy. Remember, when you improve the lobby or install high-tech devices, your funds will benefit every tenant in the building and make the building more attractive.

You can protect yourself with a strong lease clause that clarifies that all fixtures and improvements are the property of the owner. But you can go beyond that. The improvements you make should be usable by more than one tenant. Standard improvements including lighting fixtures, partitions, conference rooms, and HVAC systems all fall in this category.

Stay away from unique installations, such as a raised floor for a mainframe computer. Your clause should also stipulate a "building standard" installation to reduce costs. Limit the extent of your responsibility so that if the tenant wants more, the tenant pays up front for additional features.

Keep in mind, also, the alternatives of reimbursement or free rent for a tenant performing its own work. In either case, specify the types of items for which the reimbursement applies. Again, try to stay with items which will have a useful life beyond this particular tenancy and avoid soft costs such as architects' fees. Free rent, or an extension of a prenegotiated free rent period in lieu of tenant work, has the additional advantage of not requiring an outlay.

Longer lease terms

There are other, less obvious, alternatives to attract tenants. A promising tenant may find a long initial term very attractive due to the stability provided. For the manager, the only immediate cost would be some additional brokerage commission. However, such a long term could also have adverse consequences for ownership. It could reduce flexibility within the building. It could also conflict with future plans for the building as a whole. You may want to demolish or substantially rebuild the entire structure, for example.

You can maintain your flexibility within the building with a provision that entitles you to retain the right to relocate tenants to comparable space within the building. Basically you must be prepared to build out the new space and deliver a "turn key" operation, as your existing tenant will (quite correctly) not want to incur any costs or suffer any "down" time. But this cost may be justified for certain deals.

You can retain your ability to make substantial changes to the building in the future with a termination clause. This could be expensive, but you are better off striking the deal at the beginning of the term, when you have more leverage, than later when a savvy tenant can sense its power.

You should also design a lease clause which puts strict time limits on the tenant. The failure to comply could result in loss of compensation and possibly additional penalties for damages.

In addition, whether or not the tenant, vacates, you must be absolutely certain that the lease has terminated so that you can commence a proceeding you obtain possession.

Options to extend

In contrast to providing an initial long term some tenants may prefer an option to extend. This would be particularly appealing to a growth prospect that is not sure where it will be after the initial term.

The option has certain distinct advantages to the owner as well. Whereas, in the case of the long initial term, the rent is set at the time that the lease is executed, the rent during an extended term would probably be pegged to a fair market value. As the market tends to be low now, a "fair market" base rental will probably be higher in the future.

There may be many ways to determine fair market rent. You could look to the two or three most recent new tenancies within six months of the commencement of the extended term. However, this method, although inexpensive, requires a building with a large enough tenant base and consistent turnover to make sense.

The most common method of determining fair market rent is arbitration, which is unfortunately more time consuming and expensive. Again, the manager can protect him- or herself with an arbitration clause containing strict time limits as well as guidelines. For example, the arbitrators could be directed to consider the value of the space for the highest and best use.

You can also get extra mileage out of a fair market value by limiting the fair market value to the fixed rent and keeping the base years for escalations at their original levels.

Certain tenants may also find options for contiguous space or additional space elsewhere with the building as particularly attractive options. Try and limit the space and, if the space is accepted, clarify just when space is deemed to be available. For example, you will want to exclude spaces of renewal tenants.

Both of the above options may create problems for the manager. So many of the same techniques to limit the damaging effects should apply. Moreover, leases ought to clearly specify that the options may only be exercised within a limited period of time.

The tenant-ought to accept the space in "as is" condition, or certainly with as little work as possible. Finally, as with all tenant benefits, the tenant should be able to exercise them, only if the tenant has suffered no defaults.

Conclusion

Although tenants often hold the upper hand in today's soft markets, the property manager should still keep in mind that it is not worth giving away all legal rights and financial benefits just to gain a tenant.
COPYRIGHT 1991 National Association of Realtors
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Legal Issues
Author:Rimsky, Neil T.
Publication:Journal of Property Management
Date:Sep 1, 1991
Words:1407
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