Many times landlords and tenants don’t realize that their commercial lease is unclear, contradictory or out of date until it comes time to resolve a claim, whether it’s a case of liability or property damage.
The payout is then delayed as the insurance companies review the entire lease to try and determine responsibility, liability and how the policy should respond.
“The real world is this — when the landlord and tenants go to renew an option, they just want to renew it. They don’t want to look at anything else because they don’t want to open up opportunities for negotiation that could be detrimental to either party,” says Phil Coyne, vice president at ECBM.
Smart Business spoke with Coyne about how knowing what’s in your lease and fixing problems now will save you a headache later.
What is one of the biggest risk exposures involved with a commercial lease?
You can avoid significant risk by making sure the lease language doesn’t expand, broaden or increase the liability and exposure to the point where your insurance coverage either doesn’t apply or would be limited. Therefore, each party — tenant and landlord — needs to have an understanding of the intent of the lease and its language.
Also remember that it’s not only the insurance provisions that have an effect on the outcome of a claim, but also definitions, maintenance, landlord/tenant obligations, use of premise and indemnity provisions. The insurance section alone only outlines limits and coverage; it’s the other sections of the lease that outline responsibility and ownership.
If two insurance companies review the same lease, and there are questions, it delays the claim process. For example, who is responsible for or owns the improvements and betterments to the space? Is that the responsibility of the tenant or the landlord?
How can tenants and landlords best mitigate risk when drafting and negotiating commercial lease provisions?
By understanding the intent of the lease and its language, the tenant and landlord can mitigate a potential problem prior to a loss and have an understanding of how their policies will respond.
Therefore, both insurance brokers should have an opportunity to review the entire lease during negotiations. He or she can explain what each party is accepting and not accepting, and how your policy will respond in the event there is a claim.
Some important areas for discussion are:
- Who is responsible for what, such as common area, tenant space, maintenance and repairs.
- Who is responsible to insure these items?
The commonly discussed issues in the insurance section are limits, coverage, indemnity provisions and specific wording, but policies respond to the entire lease and its language in sections other than the insurance section.
How should a lease be updated when up for renewal?
Many times lease options are renewed without re-examining the entire lease’s language. There could be simple items such as a name change or an increase in the square footage, other times it can be a change in use and occupancy and therefore changes in various other sections need to be amended and addressed.
Although the landlord and tenant likely just want to sign a quick renewal, it is important that all parts of the lease are carefully reviewed and understood. This will ensure each side is in agreement on the terms prior to a loss instead of after a loss, as the latter could lead to delays or restrictions in coverage.
Phil Coyne is a vice president at ECBM. Reach him at (610) 668-7100 or firstname.lastname@example.org.
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Subleasing is a common method of occupying commercial property as opposed to executing a conventional lease directly with a landlord. The most common reason a tenant (sublessee) subleases space is to save money and time. Subleases are almost always priced well below the fair market rates for comparable properties, already built-out and often include furniture fixtures and equipment at no additional cost.
“Subleases are often a situation where ‘one company’s rain is another’s blue sky,’” says Robert Chavez, founder and CEO of Guardian Commercial Realty. “One company no longer has the need for a particular leased space but still has term remaining on its lease. Rather than pay an exorbitant buy-out fee or let the space lie vacant, the intelligent play is to market the space for sublease to a third party and offset some of the costs.”
Smart Business spoke to Chavez for more about what to consider before signing on for a sublease.
In what situations does a sublease make sense?
Most subleases are small to medium sized premises. Landlords are able to offer myriad space configurations and construction allowances to suit a tenant’s particular needs. However, tenants subleasing space (sublessors) are much more limited. While there may be a few exceptions, sublessors are only able to offer their space in its existing configuration because the cost to reconfigure or divide the sublet premises is prohibitively expensive. Any material changes to the space would defeat the purpose of subleasing it. Moreover, the sublessor is hemorrhaging money every month that its sublease remains vacant. Accordingly, they are motivated to price the space aggressively, sublease it quickly and cut their losses.
What risks exist for sublessees, and how can they be addressed?
While subleasing space may sound like a simple and mutually beneficial option, and it oftentimes is, companies are well advised to exercise caution and diligence in several key areas.
First, always ask to see the sublessor’s audited financial statements. Imagine spending the time and money to move into a new sublease space only to have the sublessor default on its master lease during the term. The underlying landlord may have the option to either terminate or materially alter terms of the sublease. The sublessee is then forced to vacate or renegotiate at less favorable terms. This is obviously not what the sublessee bargained for and could have very damaging economic and logistic consequences. While reviewing financial statements is not a guarantee that a sublessor will never default, it is nonetheless a prudent exercise that provides the sublessee sufficient information to make an informed decision. If the sublessor refuses to provide the information, that is likely a warning sign of bad things to come.
Next, make certain that you can pay rent to the landlord directly in the event of a default by the sublessor. This is often referred to as a Right-to-Cure Provision. Negotiating such provisions can be more complicated than they first appear. The landlord often wants the full rent as set forth in the lease as opposed to the discounted sublease rent. It is important to have a qualified professional negotiate this clause for you as the rationale and leverage points may not be obvious.
Be sure to request and review a copy of the underlying lease and any related addenda. Understand the obligations of each party, how they interrelate and how you can be adversely affected. The boring-but-important clauses like indemnification and operating expense escalations can be very significant.
Subleases also require more documentation than conventional leases. There is the sublease itself, the landlord’s consent agreement and the underlying lease, including any addenda. This will require extra time to negotiate and will involve multiple parties, as opposed to just two. The landlord’s consent alone can add up to a month of extra time waiting for the landlord to officially respond, so be sure to plan for it.
Last, it is a very good idea to request a copy of the sublease provisions from the master lease before commencing detailed business point negotiations. The sublessor will not likely provide the entire lease until a letter of intent (LOI) is agreed upon, but that may be too late. I have seen leases with subleasing restrictions so egregious that the sublease could not be consummated and months of previous negotiations were wasted. For example, some leases contain provisions prohibiting subleasing to existing tenants in the building, or to potential tenants that have recently submitted proposals to the landlord for direct space. It would certainly be nice to know what sublease restrictions exist before getting started.
Do you advise tenants to enter into a sublease?
Subleases can be a terrific value under the right appropriate circumstances and if properly negotiated. Just be sure to do your homework and consult with a professional so you get the full benefit of your bargain absent any surprises.
More next month on what you should be aware of if you are a tenant who needs to sublease its space.
Robert Chavez is the founder and CEO of Guardian Commercial Realty. Reach him at Robert.Chavez@GuardianUSA.net or (310) 882-2060.
Most commercial tenants believe that securing an option to extend their lease term upon expiration is important. They realize how inconvenient, perhaps even devastating, being forced to relocate their business can be if they need to remain in place. While a tenant may ensure that an extension option is included in their lease, they may not pay sufficient attention to the details of the actual provision because the “event” does not occur for five or 10 years and there are so many other controversial issues in the lease that must be negotiated.
“Extension options are typically the type of lease provisions that initially appear straightforward. They may ramble on for many paragraphs and can be quite tedious to review and understand,” says Robert Chavez, founder and CEO of Guardian Commercial Realty. “It can be very easy to gloss over important details or restrictions. It is even more difficult to identify missing provisions that are essential to a meaningful extension option. Accordingly, extension options can lead to big surprises when the tenant least expects them. Surprisingly, however, the majority of commercial tenants seldom formally exercise their extension options.”
Smart Business learned more from Chavez about why an extension option must be properly drafted when they are essential on the one hand, and why so many tenants elect not to exercise them on the other.
What are the essential elements of a meaningful extension option?
At a minimum, tenants should make certain the following issues are addressed in their extension option:
? Ensuring the notice period required is reasonable. A landlord may propose 12 -18 months prior written notice from a tenant to exercise its option. This is too long, as the tenant may not be able to project its needs so far in advance. A more reasonable time period is six to nine months.
? Formulating the new rental rate. The exact option rent is seldom specifically set forth in the lease provision. Along with other material business points, the landlord and tenant must agree upon the new rental rate. This is often the most controversial issue between the landlord and tenant when negotiating Extension Options. Some leases initially offer what appears to be a reasonable fair market value (FMV) compromise, only to also state that the option rent shall in no event be lower than the last month’s rent of the primary lease term. This is not reasonable, as it could force the tenant into an above-market rent rate.
? Defining fair market value. FMV should be a reasonable standard for both landlord and tenant to consider as a benchmark when determining rent and other material business points of the extension option. Moreover, FMV should be carefully defined in the option to minimize discrepancies between the parties. At a minimum, it is essential that tenants define FMV to include all concessions being offered in the market for similarly situated tenants. Why should a landlord not concede items such as rental abatement, tenant improvement allowances, moving allowances, parking concessions and the like if it is routinely given to a new tenant. A tenant should not be penalized for exercising its option. After all, the landlord also benefits from the tenant’s continued occupancy and cash flow as opposed to losing the tenant and then having to absorb the added expense and downtime to secure a new tenant. It is not unreasonable for a tenant to request 95 percent of FMV given that the landlord’s occupancy is secured and risk mitigated. This is all part of the negotiation.
? Arbitration terms. There may be instances where the tenant has exercised its option to extend and simply cannot come to acceptable terms regarding the new rent or other material business points with the landlord. In such instances, the parties must use one or more third parties to arbitrate these terms. It is essential that the tenant have a memorialized set of rules and guidelines that the arbitrators must abide by. While there are many forms of arbitration, baseball arbitration is popular. Each party agrees upon one neutral arbitrator. The landlord and tenant submit their respective terms to the arbitrator who must select either the landlords or tenants terms — period. The arbitrator cannot make any adjustments. They select whichever position they believe is most reflective of the market, or as otherwise defined under the structure of the extension option language in the lease. This process often brings the parties so close (since neither is inclined to overstate their position and lose) that they agree on terms before the arbitrator has to make a final determination.
When are options most important?
Tenants must exercise tremendous caution with Extension Options when they have: i) a ‘special use’ facility that would be expensive to duplicate, ii) a prime location essential to their business, iii) premises with substantial over-standard improvements, or iv) an industrial facility with heavy equipment that is prohibitively expensive to relocate. Landlords are well aware that they have tremendous leverage in these circumstances. Under these circumstances, tenants can be reluctantly forced into exercising an unsatisfactory option because it is simply too risky not to secure the space. This is one area where planning ahead is so vital. Failure to properly draft the extension option when the lease is being negotiated, long before the option is needed, can have massive economic consequences to a tenant.
On the other hand, traditional office tenants may not be so sensitive to a particular building, location or product type. For accountants, lawyers and other general office uses a building is a building provided it is substantially similar in quality and properly managed. Traditional office tenants seldom exercise extension options. They simply negotiate new terms separate and apart from the option. Note however, that there have been periods such as the dot-com era where the landlord market is so white-hot that office space is in short supply. While rare, the competition for space is so intense that landlords have had the luxury of selecting from a pool of tenants at exorbitant rates, and have even negotiated to participate in the profitability of the tenant’s business. In such a market it can be very comforting to know that your space can be protected by exercising your extension option.
Robert Chavez is founder and CEO of Guardian Commercial Realty. Reach him at Robert.Chavez@GuardianUSA.net or (310) 882-2060.
The commercial real estate market has been experiencing the kind of instability that requires due diligence from building owners and tenants alike.
A tenant may believe that, by signing a lease, it is assured its space as long as it upholds all stipulations of that lease. But in the event of a building foreclosure, tenants require additional protections to ensure that their investment in the leased space is not lost.
“Subordination, nondisturbance and attornment — or SNDA — provisions are something tenants should pay attention to in their lease in the event of a default by the landlord that leads to foreclosure,” says Cameron McCausland, partner and director of Transaction Management at Southfield, Michigan-based Plante Moran CRESA. “The tenant could end up with a lender for a landlord, who may not have to uphold agreements within the lease, or even the lease itself, if the tenant is not properly protected.”
If a tenant is relying on its location and on specific features of its space, this kind of interruption can not only be extremely disruptive to a business but could even lead to its demise.
Smart Business spoke with McCausland about SNDA and tenants’ rights in the event of a building foreclosure.
What are SNDA provisions in a lease?
In most commercial leases, SNDA provisions define the responsibilities of property owners, lenders and tenants if the owners should default. Distribution of insurance proceeds in the event of casualty or condemnation is also often included in SNDAs.
Commonly, SNDA provisions are overlooked by tenants when reviewing a commercial lease, as they contain a good amount of legalese. This is one of many reasons that a tenant representative should evaluate any lease before it is signed. If a tenant unknowingly agrees to SNDA provisions that are not favorable, it may end up waiving important rights should a property foreclosure take place.
How can a tenant be affected after a foreclosure?
Tenants need to pay attention to SNDA provisions in their leases to avoid the negative fallout should a lender take over and attempt to implement aggressive tactics. When the lender becomes the landlord, its primary objective will be to preserve or recover as much capital as possible, which can involve raising rent, failing to honor rental abatement periods, revoking tenant improvement allowances and even eviction.
The lender’s actions are often driven by market conditions. If rental rates are high in the current market, tenants are more likely to suddenly experience a rent rate hike, or can be evicted in favor of tenants that are willing to pay more. In a market where rental rates are low and vacancy rates are high, lenders will do whatever they can to preserve cash flow, including the aforementioned above-market rent rates and cancelation of building improvement allowances.
What can tenants do to protect themselves?
In situations where tenants plan to make significant investment in the premises and/or their particular location is crucial to operation, they will want to work directly with the lender on a nondisturbance agreement when a lease is executed. The nondisturbance agreement creates a direct contractual relationship between the tenant and the lender and provides that the lender will not disturb the tenant’s occupation of the leased premises, upholding the tenant’s rights in the lease.
How does the process of negotiating the agreement typically work?
If a tenant is paying below-market rent or is a noncredit tenant with a smaller lease, some resistance from the lender could be expected. Often, lenders will claim that they are under no obligation to enter into any agreements with tenants; landlords will sometimes become involved in the process to move the discussion along.
Tenants can expect to receive a form nondisturbance agreement from the lender, and negotiations will need to take place in order to reach an agreement that more thoroughly protects the tenant’s interests. Tenants should be prepared for a process that can take at least a month or two, or potentially longer. They should also be prepared to walk away from negotiations if favorable terms cannot be reached with the lender, particularly if they fall into the category of tenants who rely heavily on their location and premise specifications to conduct business.
Are there circumstances where a nondisturbance agreement is not necessary?
If a tenant requires flexibility in a lease, for example, if it finds the location is not ideal after some time passes or the rent is above market, or if the tenant needs to downsize, locking itself info an agreement may not be in its best interest. These are a few examples of situations where a tenant may want the freedom to terminate the lease in the event of a foreclosure.
It’s always in a tenant’s best interest to consult with a real estate professional before signing any lease, particularly as it relates to the many complex issues surrounding SNDAs and other binding lease terms.
Cameron McCausland is a partner and director of Transaction Management at Plante Moran CRESA. Reach him at (248) 603-5291 or Cameron.McCausland@plantemoran.com.
Have you ever referred a client to a trusted attorney? The attorney’s initial response is almost always the same: “Thank you very much, I appreciate the referral but I will need to run a conflict check before I can proceed.” Our legal system mandates that attorneys identify and disclose any conflicting interests they, or their law firm, may have between clients. Attorneys have a fiduciary relationship with their clients. They can find themselves in serious legal trouble by failing to research and disclose conflicts of interest.
Real estate agents also owe a fiduciary obligation to their clients. However, unlike the attorney example, their first reaction at the prospect of a new client is not to research a conflict check. They appreciate the referral, sometimes pay a referral fee, and move on to consummate the transaction and collect a commission. Often, there is no discussion surrounding the serious conflicting interests that occur when real estate brokerages represent both landlords and tenants
“Currently most commercial real estate firms, including the large national organizations, represent both landlords and tenants. They are referred to as dual-agency firms,” says Robert Chavez, founder and CEO of Guardian Commercial Realty. “While these firms actively market their services to tenants, the majority of their representation and upwards of 80 percent of their revenues come from landlord representation. This equates to billions of dollars annually. One has to wonder how a dual-agency firm can offer the highest standard of duty implied by law to both landlords and tenants — or sellers and buyers — when the interests of landlords and tenants are so diametrically opposed and such an enormous economic bias lies with the property owner.”
Smart Business learned more form Chavez about how tenants can find a real estate agent that will act with their best interests at heart.
Why the difference in behavior between the legal and brokerage communities regarding conflicts of interest?
Let’s start with the roots. Commercial real estate brokerage was founded in the late 1800s to facilitate property owners with the sale and leasing of buildings, property management, and other advisory services tailored to the property owner or landlord. The higher the lease rate or sales price, the higher the commission — so this relationship has worked very well for both the landlord and its broker over the years. Obviously the scenario does not bode so well for tenants and buyers.
How does this create a problem for tenants selecting a broker?
On one hand, dual agency firms pledge to property owners that they will negotiate and secure the highest rental rate or sales price with minimal concessions to a tenant or buyer. On the other hand, the same firm pledges to a tenant or buyer that it will negotiate the lowest possible rent or sales price and highest concession packages. This is just the tip of the iceberg, as there is much to negotiate with regard to mitigating risk, operating expenses, tax responsibilities, etc. Given the standard of care mandated by a fiduciary relationship, it is surprising that this scenario even exists.
Add to the mix that the nation’s largest dual agency firms are publicly traded. They are under tremendous pressure from Wall Street to show profits. When they do not, stock values generally plummet. Many of the agents also have retirement savings tied to the value of their companies stock. Now consider that much of the firms’ revenue come from commissions, and commissions are only paid once transactions culminate. This creates an environment where an agent can be pressured to conclude a transaction before negotiations have matured. Not exactly what the framers of fiduciary duty had in mind.
Do these dual agency firms acknowledge the conflict of interest?
The dual agency firms are certainly aware of this potential for conflict. One firm has even published in its annual report that ‘the failure or inability of the Firm to identify, disclose and resolve potential conflicts of interest in a significant situation could have a material adverse effect.’ Dual agency firms claim to compartmentalize their practice groups so as to act independently and avoid or minimize conflicts. Notwithstanding, their profits all flow to the same corporate entity for review and consideration by Wall Street.
So how does a commercial tenant or buyer of commercial real estate seeking expert assistance select a broker that will represent its best interests?
Real estate contracts are among the most expensive and long-term commitments most tenants will ever make. One mistake in this arena can cripple an organization for many years to come. Fortunately for the tenant or buyer, commercial brokerage firms known as ‘exclusive tenant brokerages’ have evolved. These firms distinguish themselves from their industry counterparts by electing not to lease, manage or own commercial real estate. True tenant brokerages only represent parties seeking to lease or purchase real estate for their own use. They develop specialty practices and focus their scope of services toward representing their clients’ best interest and never wear two hats.
Astute tenants take their diligence a step further and make certain to interview several tenant brokerages. They are boutique entities with many subtle and material differences. It is important to understand their area of expertise and know if the broker working on your account has the experience and time to professionally service your specific needs.
Robert Chavez is the founder and CEO of Guardian Commercial Realty. Reach him at Robert.Chavez@GuardianUSA.net or (310) 882-2060.
As the founder and CEO of Guardian Commercial Realty, Robert Chavez is frequently asked his opinion about the condition of the Los Angeles commercial real estate market.
“My response often surprises those who are not in the real estate industry,” he says. “They expect the health of office, retail and industrial markets will run parallel to the general economy. Accordingly, they are expecting my response to be one of doom-and-gloom during such a volatile financial climate. The answer, however, is a bit more complicated than that.”
Smart Business spoke to Chavez to get further insight into the current Los Angeles commercial real estate markets, and maybe even predict what the future has in store.
How can you explain the ups and downs of the Los Angeles real estate market in recent years?
Current Los Angeles rents are certainly much lower than they were during the 2007-2008 landlord market. That market was fueled by an artificial skyrocketing economy and East Coast investors buying large real estate portfolios and pushing exorbitant rental rates. For example, West Los Angeles and Century City rents rose from an average of $2.50/$3 per square foot in 2002-2005 to $5/$7 in some of the trophy buildings. Even micro markets like Sawtelle Boulevard, the domain of bargain West Side rents, rose from $1.50/$1.75 per square foot to more than $3 per square foot.
This spike was short-lived, however, and once the recession took hold rates dropped. Surprisingly, rates in most Los Angeles markets have not settled to their prior levels. The landlords that overpaid for their portfolios have fought desperately to maintain value and save face with their investment partners. Downtown Los Angeles in particular has become a much more expensive place to have an office.
Downtown landlords have successfully shifted from full-service gross leases to net leases with extremely high operating and tax expenses. This shift has helped camouflage a tenant’s true occupancy cost and, once the high parking costs are added, downtown is no bargain.
How has this impacted the current state of the market?
Ironically, the uncertainty of the financial markets has created inflated commercial property values in some markets. Large pension funds and private equity entities with billions of dollars to invest must place their capital. Reluctant to invest too heavily in the stock market, there has been a very high volume of bidders driving up sales prices. It is getting to the point of astonishing many industry experts. There are numerous reports of sales at prices well above what is supported by current rents. The large investors have the financial strength and ability to wait for markets to turn. They understand there has been virtually no new speculative commercial construction in the past five years and that any new construction will be extremely expensive given the high cost of labor, materials and government fees. They believe that once the economy finally recovers that tenant demand will quickly fill the existing supply of vacant space and landlords will be in the cat-bird’s seat to aggressively raise rents, reduce concessions and make big profits. It will be interesting to see just how far the speculation continues.
What can tenants do to better position themselves given their situation?
In the meantime, tenants still have a wide variety of attractive options. The market has been fairly stagnant for a few years and it is anyone’s guess as to when there will be a material shift. Many tenants with businesses in good standing and a favorable long-term outlook are committing to long-term leases as a hedge against escalating rents. This could result in tremendous cost savings and a real advantage against competitors that may be forced to sign leases in an expensive landlord market.
Tenants with real savvy are signing long-term leases with an option to terminate mid-term. Such forethought and flexibility could provide well-timed savings to the tenants who are patient and aggressive enough to secure such a lease.
What does the future hold?
Most real estate experts believe that higher rents will be the eventual outcome. Before the debt ceiling debacle, they were predicting a real estate turnaround in the next two or three years. Given what Wall Street has recently shown us, they may be extending their predictions.
Robert Chavez is the founder and CEO of Guardian Commercial Realty. Reach him at Robert.Chavez@guardianusa.net or (310) 882-2060.