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Hidden clues to successful lease negotiation.

A lease negotiation is often considered successful if it results in a commercially reasonable agreement for all concerned. But that does not come easily. The hurdles are many, ranging from financial considerations to matters of convenience.

Interestingly, many of the important sticking points in a lease negotiation are more emotional than financial in nature. It is the approaches that an owner or manager uses to isolate these psychological barriers that are key to a forward-moving interplay with a prospective tenant. Identifying and understanding the personal "hot buttons" can help to defuse explosive situations and contribute to closing a deal more expediently.

Every sentence in an office or industrial lease is prepared to favor the drafting party. Depending on the size of the transaction, there can be as many as 50 to 100 issues raised by the emphasis, or spin;' of the lease language. Trying to neutralize each sentence would expend a tremendous amount of time and energy. More importantly, the effort would result in a confrontational negotiation.

Experience tells us that the parties undoubtedly will come together fairly quickly on three-quarters of the issues, which means that only one-fourth of the comments raised by the drafting party will need to be dissected and examined closely. Of those, five to ten issues will typically be sticking points in the negotiation process. Some of these will be "hot buttons" for the party resisting the offered lease language.

The skilled negotiator should be able to spot those issues quickly and isolate them onto a checklist for discussion after the entire lease has been reviewed. Deferring the sticking points to the end of the negotiations allows the parties on both sides of the bargaining table to demonstrate their good faith effort to reach agreement on the majority of the issues. This initial agreement helps to build good will and minimize the potential for confrontation when the issues in contention are negotiated later. Setting the stage for compromise The property owner or manager must try to determine which of the sticking points are truly "hot buttons" for a tenant and how to fashion trades that will keep the deal on track. This takes time and effort. Research must be done on the prospective tenant's experiences in other buildings and other negotiations.

For example, an owner in a moderate temperature zone such as Southern California, where the median annual temperature is approximately 68 degrees, may not understand why a tenant from a region which has severe changes in the weather is extremely sensitive to specification for HVAC systems maintenance procedures and median temperature guarantees.

A typical compromise would be to attach the specifications for the heating, ventilating, and air conditioning system to the lease together with an appendix showing the manufacturer's recommended maintenance procedures. The owner can then agree to maintain the HVAC to the highest level of efficiency by complying with those procedures.

Although the clause does not guarantee anything but the commitment to purchase, install, maintain, and repair the air conditioning equipment, the tenant is given the assurance that ambient temperature ranges will be maintained in the building for the comfortable occupancy of the premises.

Confrontations on taxes

The issue of property taxes has always been a major sticking point in the lease negotiation. Protecting the tenant from increases in property taxes upon sale of a building can be a very emotional issue that might potentially derail a transaction.

The owner who is unwilling or unable to provide tax reassessment protection could still close a deal by being creative. A provision could be included in the lease which protects the tenant from tax increase excess when the building is sold for more than its commercially reasonable market value.

The only practical vulnerability to the owner in such a clause is a windfall sale to a third party who clearly pays over market, a situation which is highly unlikely to occur. However, if such a sale does take place, subsequent transactions of comparable parties may demonstrate to the tenant that the sale was not actually over market, but rather that the market had increased faster than the parties had expected.

The owner or manager could sweeten this line of negotiation with an offer to limit any tax increases to those which are clearly local and then agree to provide protection only from state or federal property taxes." Since individual states and the federal government assess taxes on the taxpayer's property taken as a whole, and not on a specific structure, the owner is taking little, if any, business risk while still appearing to make a property tax concession.

Every effort also should be made to show that tenants traditionally pay for local services such as street sweeping, police and fire protection, and school teachers' salaries through property taxes. These costs are included in the base-year, or expense stop.

A county traditionally was able to increase, as necessary, the property taxes over time, but now in many states, it cannot do so until the building is reassessed, which is essentially allowed only when it is sold. In California, increases in those taxes now are allowed, but are constitutionally limited to 2 percent per year until the building is reassessed.

If the budding is sold, it is unreasonable to require an owner to subsidize below-market taxes for the tenant. However, local market conditions often defy logic, and the subsidy may have to be maintained to be competitive.

Notwithstanding the equities and inequities described above, there is a situation which provides the tenant with a justifiable claim to property tax reassessment, or Proposition 13 protection as it is known in California. This occurs when an owner is achieving a rental rate equivalent to a comparable building in the area that had been recently sold and subsequently reassessed.

If the gross rent is the same but the tax element is lowered in one of the buildings, then the tenant has a valid claim for protection on the tax reassessment in the event the building in which the tenant is located is sold. The tenant is not protected from any increase due to the sale, but only for the difference between the original tax base of the comparable building and the original tax base of the owner's building.

Termination concerns

Another potentially deal-killing issue involves the, tenant's right to terminate the lease following damages to the space resulting from a fire.

Assume the representative of the tenant or the tenant has experienced a fire in another facility and therefore has been through the horror of a quick, temporary move to space which was ill suited for the tenant's needs. That representative is likely to fight tooth and nail for its client's right to terminate the lease if the owner cannot fully repair the premises in 60 to 90 days following a fire. The owner on the other hand, would want the option to terminate the lease only if it is projected to take longer than 90 days to repair the facility.

The role of the negotiator is to lead the parties to a solution which provides reciprocal options to terminate based on the reconstruction projections. The owner is entitled to the benefit of its bargain because it invested substantial amounts of money in readying the space for occupancy as well as paying indirect costs, such as brokers' fees and free rent. The tenant also needs to recognize that it probably would not have any immediate options following a fire which would be tailor-made for its operations.

The negotiator should walk the tenant down the critical path between the fire and the point in time when new alternative premises would be ready for occupancy. This would include the time required to find a broker, negotiate an exclusive representation agreement, find suitable sites, negotiate the basic terms of the lease, prepare and execute a lease, prepare working drawings for improvements to the new space, bid the work, build it out, and move in. In a best-case scenario, the time for that process would be six to ten months.

The original landlord is certainly entitled to an equal period of time to assess and repair the fire-damaged premises. This would include time for demolition, reconstruction of improvements, plus the actual construction period.

For most leases that would translate into at least six months during which the tenant would be in temporary, and most likely non-ideal, facilities. However, as indicated earlier, it would take at least that long for the tenant to find suitable alternative space. The tenant also should be required to select the original space rather than other alternative sites for occupancy, at least for the balance of the original term of the lease.

It might also be appropriate to point out that the most likely reason for the damage to the premises in the first place is the tenant's use and possession. In such a case, it is hardly equitable to use the tenant's negligence to remove itself from its lease obligation.

At what cost?

These examples are only to provide a sense of how sticking points can be massaged and the deal closed. But at what legal cost? As stated in the outset, a successful lease should be commercially reasonable for all parties, and that includes legal costs.

One technique for holding down costs would be to have the brokers and the principals meet prior to the introduction of attorneys into the mix. Together, they could weigh the respective leverage of the parties and commit their best efforts to meet a "budget" for each side of the negotiation. If both counsels are informed of this budget, the parties will be much more likely to end up with legal fees that fall within that guideline.

Legal fees tend to be "gaseous" and will fill any size vessel. It can be to the owner's or tenant's advantage to make the vessel the right size before asking the lawyers to fill it. The principals must expect that their respective counsel will ask them to confirm in writing that there is a budget and the amount of it and that as their client, they understand that they are requiring the lease to be negotiated under the burden of the budget. Amazingly, the attorneys will come close to the budget so long as their files confirm their instructions to work within that economic range.

I recently experienced the magic of budgeting when a client was leasing 30,000 square feet in a very soft market.

This would have provided the client with tremendous leverage to ask for a significant number of legal concessions from the owner, meaning a very large addendum to the printed lease.

Under the budget guidelines, I was authorized to provide to the representative of the owner a sanitized version of a recent successful lease negotiation. A cover letter pointed out the similarities between the buildings and the respective space for lease and also indicated that I was authorized to accept a lease with basically the same provisions.

The total legal fees for the consummated lease transaction were held to approximately one-sixth the total for other lease transactions of similar size.

Since both parties were cooperating in the same vein, it was a win-win situation. The owner approved a "market" level of legal concessions, and the tenant was well protected, all within budget.

Final note

Failing to properly diagnose the personal "hot buttons" of a prospective tenant could kill a deal or needlessly prolong a negotiation. However, if the parties are represented by knowledgeable professionals, from the brokerage, business, and legal perspectives and if the parties set commercially reasonable targets for the time and expense of the negotiation of the lease, the results should be a successful lease negotiation for all parties.

Richard C. Mallory is a senior partner in the law firm of Allen, Matkins, Leck, Gamble & Mallory. He is considered to be one of the top landlord attorneys in Los Angeles. He serves on the Planning Committee for the California State Bar's Real Property Practice institute and as a member of the Georgetown University Law Center Continuing Education Division.

Recently, Mr Mallory was asked by the Los Angeles chapter of the Building Owners and Managers Association to develop a signature lease contract that will be recommended for office space leases of under 5,000 square feet.

Mr Mallory graduated magna cum laude from the University of Southern California in 1966 with a B.S. degree in real estate and finance, He earned his J.D. degree from Stanford University in 1969

Negotiating the Work Letter

Commercial real estate owners and managers are losing tens of thousands of dollars in rent because most marketing representatives do not pay enough attention to the construction issues in a lease contract.

Work letter issues are "hot money" topics, equally important as rent concessions and pass throughs. Even the most subtle language lapses can result in the loss of two to four weeks or more of rent.

Considering today's rental prices, a small oversight may cost more than the legal fees to negotiate the entire lease.

Dove-tailing the completion of leasehold improvements to a tenant's move-in schedule is the ideal situation. And while the debate rages on over whether tenant- or owner-build work letters are the best suited to achieve this result, the key lies not in the vehicle, but in how well it is negotiated.

Presently, many of the more sophisticated tenants are insisting upon a tenant-build work letter. In return for losing control over the construction, the owner is entitled to negotiate a specific date for term commencement and start of rent payments, regardless of the status of the construction of the improvements. The date should only be extended for force majeure (acts of God, etc.) and owner delays which can be clearly defined.

Although an owner-build work letter helps ensure strict conformance to quality standards and provides the greatest protection against long delays in construction, it may be a financial albatross if not negotiated properly. It is the elements of substantial completion and the crafting of the tenant delay language that owners need to examine more closely.

The negotiation of substantial completion has three basic elements. The parties must agree to what constitutes substantial completion, who will determine when substantial completion has occurred, and which items on the "punch list" do or do not interfere with the tenant taking occupancy.

The generally accepted definition of substantial completion is based upon industry custom and standards of the American Institute of Architects.

But leases are not negotiated in a vacuum. At the very least, substantial completion should be defined as the point when the owner's contractor, after consultation with the tenant's architect or space planner, certifies that the improvements have been completed in accordance with the approved final working drawings. It may often require the issuance of a certificate of occupancy or other permits authorizing legal occupancy.

The most controversial element in the owner-build/term commencement negotiation deals with the definition of a tenant delay. Most tenants will concede that such things as repeated change orders constitute a delay.

The mere occurrence of an event which falls within the definition of a tenant delay does not necessarily mean that it caused a delay in substantial completion, however. Consequently, the more sophisticated tenant will contend that an event is a delay only when the construction progress is actually interrupted and the tenant receives notice of the problem.

These and other term commencement/work letter issues, such as the definition of base building shell and core and the differentiation between standard and nonstandard tenant improvements and leasehold allowances, need to be given the same kind of attention as rental rate and lease term. A well-drafted term-commencement provision is the best protection owners have against lost rent due to planning or construction delays.

It also will help to avoid ill will and friction at the beginning of a relationship. And in today's market, when tenants are at a premium, eliminating the finger pointing and the name calling can be crucial. -Richard C. Mallory
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Title Annotation:includes related article on negotiating work letters
Author:Mallory, Richard C.
Publication:Journal of Property Management
Date:Nov 1, 1990
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