Tenants should make provisions for bankruptcy.

Tenants should make provisions for bankruptcy 

Business looking for great deals on office space in this soft economy should take steps to protect their lease deal from the landlord's bankruptcy, real estate brokers and attorneys say.

Non-disturbance agreements, in which the lender on the property agrees to honor the lease if the building owner goes into bankrupcy, are becoming more and more common in large lease deals around Los Angeles County.

Without such an agreement, the lender can kick the tenant out of the space, explained Michael Meyer, a real estate attorney in the Los Angeles firm of Pillsbury, Madison & Sutro.

Meyer said he has been advising tenant clients to get non-disturbance agreements on large lease deals. It used to be that his insistence was met with "amusement," Meyer said.

Tenants and landlords were often annoyed "to have a deal held up by a lawyer who was insisting on a non-disturbance agreement, when nobody could remember when a project had been foreclosed upon," Meyer said. Now, things have changed.

"When tenants go to the marketplace now they drive a very aggressive deal," said Howard Sadowsky, executive vice president and regional manager of Julien J. Studley Inc. in Los Angeles. "Just because you negotiate a very good deal doesn't mean the landlord is going to keep his end of the bargain," Sadowsky said.

Sadowsky said that commercial office building bankruptcies are a reality in Los Angeles County. Sadowsky and other brokers said that bankruptcies may occur more on the Westside, where there are a lot of first-time, entrepreneurial building owners, than in downtown Los Angeles where there are more established, institutional building owners.

In addition to a non-disturbance agreement, tenants should also be protected from spending thousands of dollars on tenant improvements which the landlord promises to pay for in the future, Sadowsky said.

In most large office lease deals these days, the landlord will pay the tenant $40 to $50 a square foot for tenant improvements, such as drapes, carpeting, lighting and other amenities, said Dennis Ellman, an attorney with Greenberg, Glusker, Fields, Klaman & Machtinger in Century City. The payment for contractors who make the improvements can be arranged different ways.

"Too many tenants are relying on the landlord's promise to reimburse them for the improvements," Ellman said. But when the landlord goes bankrupt "the tenant is left holding the ball." That can run into millions of dollars, Sadowsky noted.

Sadowsky said he once had a client who signed a lease and spent money on tenant improvements, money that the landlord was supposed to repay him.

"In the process of building out the space, the landlord refused to pay for the tenant improvements," Sadowsky said. "This tenant took two floors, 50,000 square feet times 50 bucks a foot," Sadowsky said.

To further complicate matters, the tenant was in the process of moving out of his old space and subleasing it, Sadowsky said. "Now the tenant is in-between and he had a very good deal," he said.

Ellman said that one way for tenants not to get stuck with the bill for improvements is to have the landlord's bank issue a letter of credit. The letter is a promise by the bank to pay for the improvements in the event that the landlord renegs on its agreement.

However, many banks do not easily issue letters of credit since issuing the letter itself will cost the bank money, Ellman said.

Meyer advises that tenants get a provision in the lease agreement in which the landlord's lender agrees to pay for outstanding tenant improvement that the bankrupt landlord defaults on.

Bob Pohl, senior sales consultant with Coldwell Banker in Century City agreed tenants should hold firm on getting a non-disturbance agreement. However, small businesses may have a difficult time getting a non-disturbance agreement, because some banks have a size requirement on leases where they will give such agreements, Pohl said.

"The larger the size (of the office space) the more likely you are to get one. A full-floor tenant is likely to get one," Pohl said.

Another potential problem with landlord bankruptcies is that a lease-takeover agreement may not be honored by the landlord's lender, Meyer said. A lease-takeover agreement is one in which the landlord agrees to pay the rent on the tenant's old space, if the tenant moves out before the old lease expires.

Meyer said he fights to get lenders to agree to either pay the old rent, or deduct the amount of rent from the tenants lease. "You have to fight to get it," Meyer said. However, "now tenants are saying, `we won't sign the lease unless we get it,'" Meyer said.

Another concern is that financially troubled landlords will let the building services lapse to save money. "The danger is the building quality will deteriorate. It may not by the first class building it was when you moved in," Pohl said.

Leases should address building upkeep, Pohl said. He added there should be consequences for the landlord if the care of the building is not adequate, such as free rent for the tenant if the air conditioning goes down.

Good brokers will tell tenants which developers and building owners are in financial trouble, Pohl said. He added that if he suspects that a landlord is in financial trouble, "I'll run a TRW on them."

John Duffy, a real estate attorney with the Los Angeles law firm of Pillsbury, Madison & Sutro, said that it is true that top commercial brokers are often aware of the financial circumstances of landlords, but notes that sometimes brokers often represent both tenants and landlords. "When the broker represents both parties in a deal, both parties should be careful how they get the information," Duffy said.

Ellman said that tenants have the right to ask questions about the financial stability of the landlord. "The mere fact that the landlord owns a $600,000 building does not mean that the landlord is financially stable these days," he noted.

PHOTO : Leasing: Tenants should insure their leases remain in force