As published in Scotsman Guide's Commercial Edition, July 2012.
only because of the market’s volatility, but also as a result of a poorly negotiated lease. This, in turn, can make it difficult to refinance a property — whether it’s an office building, a mixed-use development or a shopping center.
That’s why commercial mortgage brokers must be knowledgeable of the lease provisions that can impact property values and advise their clients to carefully negotiate each of these provisions and quantify the cost of compromises, if any. This negotiation process should go beyond the typical points of rent and tenant-improvement allowance. Here are seven areas that your client — the owner who’s also the borrower — must negotiate properly to protect a property’s value.
1. Pass-through charges
When a cap must be placed on the increase of annual operating expenses, advise your client to cap controllable expenses rather than non-controllable expenses. In addition, include replacing major improvements in the common areas — like carpeting and wall treatments — as a pass-through expense. Other pass-through charges may include the cost of energy-efficient equipment, government-mandated safety improvements and the right to collect reserves for future major maintenance repairs.
One point to keep in mind when drafting a free-rent clause is to clearly state that the free rent does not include free pass-through charges.
2. Lease-cancellation rights
Tenants who are in the retail business often demand a lease-cancellation right. If your client decides to provide a cancellation right, place the following restrictions on the right:
The lease can be canceled only if the tenant’s sales do not exceed a certain dollar value in any of the first three calendar years of the lease;
A one-time cancellation right must be exercised within a 15-day period following the end of the third calendar year of the lease;
The lease is canceled 120 days after the landlord receives the cancellation notice; and
The tenant is expected to pay a cancellation fee, as well as the unamortized tenant-improvement allowance and lease commission.
A retailer may request the right to cancel a lease if another specific tenant vacates or if the occupancy of a shopping center falls below a certain percentage. If the landlord must agree to this request, your client can offer to convert the rent from a minimum rent plus a percentage rent to only a percentage rent until the space is re-leased or the property exceeds the required occupancy.
In this case, the landlord can place an additional condition that the tenant must give evidence that the vacating tenant or reduced occupancy impacts its business with a reduction in sales greater than 10 percent before exercising the co-tenancy provision.
If a tenant should be provided an exclusive right, a landlord must include the following requirements regarding that exclusive:
It does not apply to existing tenants, their subleases, assignees and licensees.
It should be limited to one or two years and, if practical, to a section of the shopping center.
A remedy is provided if the exclusive is violated. For example, the rent can be reduced by 50 percent or converted to percentage rent only until the exclusive right is no longer violated.
Commercial mortgage brokers should remind their clients that renewal options are a right for the tenant and an obligation for the landlord. That’s why options should be provided with discretion. For example, major tenants and tenants with extensive improvements and expensive equipment such as restaurants or medical and dental clinics can be provided with options. Otherwise, however, options should be limited.
When the option rent — the rent that’s applicable in the extension or renewal period — is stated as being based on a fair market value, there may be some disagreement about what that market value is. In this case, the involved parties should use so-called baseball arbitration to settle the dispute: The parties state what they each believe the market rate to be and the arbitrators choose the rate that’s closer to what they determine the market rate to be.
To ensure the arbitrators are using comparable buildings to determine the market rate, the lease should specify details of comparable buildings in terms of:
Description of classification;
Minimum and maximize size;
Size and general location of the space in these buildings; and
Geographic boundaries of these comparable buildings.
6. Expansion rights
When a tenant is given an expansion right, it should be a first right-of-offer rather than a first right-of-refusal. The right must be exercised within three days and a lease must be signed within 10 days from the time the tenant is notified that the space will be available. The rent will be the greater of either the rent that the tenant is paying on the current space or the market rent.
7. A use provision
It is to your client’s benefit to have the use provision as specific as possible. Stating a generic use provision like “general business purposes” simply allows the tenant to do anything zoning won’t object to. The result can be a landlord who loses control over the tenant mix of the property.
With these points in mind, your client can keep control of the property value and make sure that it generates the desired cash flow. More importantly, this will keep the property in a healthy position that can pass a lender’s due diligence if refinancing is requested.
Richard Muhlebach is a commercial broker in the Seattle area. He teaches lease negotiations nationally and internationally. Muhlebach co-authored 19 commercial real estate books, including The Leasing Process: Landlord and Tenant Perspectives, published by the Institute of Real Estate Management. Reach him at (206) 660-6902 and email@example.com.