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UNDERSTANDING RETAIL LEASES

May 21, 2008
Article #17
Author: Unknown Author

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A lease is an agreement granting use or occupation of real property during a particular period in exchange for a specified rent. At common law, the lease was traditionally regarded as a conveyance of interest in land, subject to the doctrine of caveat emptor ("let the buyer beware"). The landlord was only required to deliver possession to the tenant; the tenant, in return, was required to pay rent to the landlord. Davidow v. Inwood North Professional Group, 747 S.W. 2d 373, 375 (Tex. 1988). The modern commercial lease, however, is a complicated instrument that spells out many aspects of the relationship between landlord and tenant, including tenant's use of the property, services that will be provided by the landlord, allocation of costs associated with maintenance of the leasehold, responsibility for utilities, improvements to the premises, insurance, assignment and subletting, events of default, remedies of the parties, expansion rights, and options to extend the lease term.

Commercial leases can be described in four categories: gross, modified gross, triple net, and absolute net. A gross lease does not require the tenant to reimburse the landlord for any of the expenses that the landlord might incur in operation of the premises. Under a gross lease, the tenant pays base rent and the landlord absorbs all costs for common area maintenance ("CAM"), real property taxes, landlord's insurance, and other charges associated with the operation and maintenance of the property. A modified gross lease typically requires the tenant to reimburse landlord for "pass through" costs over a stated expense stop or base year. For example, the tenant may be required to reimburse landlord for all CAM over $4.00 per square foot, or alternatively, the tenant may be required to reimburse landlord for all CAM in excess of base year 2005. In most situations, the commercial tenant will be asked to sign a "triple net" lease, which requires the tenant to reimburse landlord for CAM, real estate taxes, and landlord's insurance. The "pass through" costs included in a "triple net" lease can vary, and can include additional items other than just CAM, taxes, and insurance. Thus, a prospective tenant will be well served to review a proposed lease with counsel to ensure that tenant understands the nature and type of pass through costs it will be expected to absorb under the lease. Also, in certain circumstances, a landlord may utilize a "net" or "absolute net" lease, which requires the tenant to absorb ALL costs of maintenance and operation of the property, including capital expenditures and major repairs. Typically, an absolute net lease is utilized where the tenant is the sole and 100% occupant of the building - for example, a restaurant or an office building occupied by one tenant.

Commercial leases can be further described by the type of use associated with the property - office, retail, warehouse, pad, or "ground". An office lease is generally used in buildings intended for non-industrial business use. Retail leases are generally utilized for shopping malls and strip centers. Warehouse leases are generally seen for industrial or light industrial uses. Pad or ground leases are often used for restaurant premises or for premises where the tenant will be responsible for building and maintaining the structure. Texas law does not require a commercial landlord to utilize any specific form of lease, and the type of lease a prospective tenant may be faced with signing will vary by the type of building, intended use of the premises, and preference of the landlord.

The lease's duration and base rent are of primary importance to the commercial tenant. Usually, a commercial lease is for a term of 5 to 20 years with fixed escalations in base rent or escalations based on an economic index, like the consumer price index. Also, the tenant may be offered options to extend the lease term or expand into adjacent or other areas of the property. Depending on the property and the landlord, lease term and base rent may be negotiable. As a general rule, the larger the space tenant intends to occupy, the greater the flexibility the landlord will show in negotiating provisions in the lease. However, if a property enjoys a high occupancy rate, a landlord will be less likely to show leeway in negotiating the economic terms of the lease. Yet, I am reminded of two great adages of the commercial world: (1) everything is negotiable; and (2) if you don't ask, you won't know.

Also, a tenant should take care to read and understand the description of the premises contained in the lease. Most commercial leases are based on "rentable square feet", a number which is usually larger than "usable square feet". The tenant's rent and responsibility for reimbursement of pass-throughs (CAM, taxes, insurance, utilities, etc.) are normally based on the rentable square feet of the premises. Discrepancies in square footage and boundary lines should be resolved prior to execution of the lease, or the tenant could face unforeseen costs or potential litigation.

Many landlords offer a tenant "build out allowance" as an inducement to lease the premises. These sums, however, do not represent "free" money and landlord's payment of the allowance is tied to specific conditions in the lease. For example, if the tenant breaches the lease and abandons the premises prior to the end of the lease term, the tenant may have to repay the build out allowance, along with landlord's other damages. The tenant should make sure it understands when and under what circumstances the build out allowance will be paid.

Additionally, the tenant should understand his "lease commencement date" and "lease expiration date". The lease commencement date may or may not be on the date tenant occupies the premises. Also, the landlord may have promised the tenant a 60 month term but the lease could provide a fixed expiration date for a term of less than 60 months. Again, careful scrutiny of the lease is required.

In addition to base rent, the tenant customarily will be asked to pay "additional rent", which constitutes pass-throughs (CAM, taxes, and insurance) and any other charges that landlord might deem to include in your lease. CAM, pass-throughs, and other charges reimbursable under the lease are the primary source of tension in the modern commercial landlord/tenant relationship. The tenant wants the certainty of knowing what his rent and charges are going to be on a monthly and yearly basis. The landlord wants protection from unexpected rises in taxes or the costs of providing services to the property. The key: read your lease and KNOW every charge you will be faced with once your tenancy begins.

In the retail context, in addition to base and additional rent, the prospective tenant is often asked to pay landlord a percentage of tenant's gross sales on a monthly or quarterly basis. The landlord usually justifies these charges as a necessary component of compensating landlord for providing a vibrant mall or strip center for tenant to conduct business. In most commercially viable retail property, payment of percentage rent is unavoidable. However, the "breakpoint" and amount of percentage rent should be negotiated.

Another area of significance to the commercial tenant is the services that will be provided by landlord and reimbursement of landlord for those services. Similarly, tenant should understand those services that landlord will not provide, because tenant will be responsible for those services as an out of pocket expense. Further, unless the lease is gross, the landlord should identify the components that constitute the costs of operating the "common area" for which it seeks reimbursement through tenant's monthly CAM charges. The definition of CAM varies from lease to lease based on landlord preference, the type of property, and the negotiations of the parties. If a gross lease is not available, the tenant should negotiate the items to be included in CAM, the items that will not be included in CAM, and an annual cap or limit on expenses that landlord may attempt to pass through to tenant.

The landlord will normally want reimbursement for tenant's share of real property taxes and landlord's insurance costs. The lease should provide a definition of "tenant's share" or "tenant's proportionate share" based on the square footage tenant will occupy versus the square footage of the building. The commercial tenant must have a full understanding of all these provisions prior to signing the lease.

Key provisions in the commercial lease define the events of tenant's default and landlord's remedies for tenant's default. The tenant should also address what constitutes landlord's default and tenant's remedies. Tenant default provisions are usually defined by two categories: (1) economic defaults; and, (2) non-economic defaults. Economic default provisions deal with failure to pay rent, failure to pay for charges assessed under the lease, failure to pay taxes when due, etc. Non-economic default provisions typically refer to other provisions in the lease - use of the property, hours of operation, or failure to provide services required by tenant under the lease. It is essential that the tenant have a full understanding of (1) what constitutes an event of default; (2) tenant's right to cure, if any; and (3) landlord's remedies for tenant's default.

Assignment and subletting provisions are also important to the tenant. Texas law prohibits subletting without the consent of the landlord. Tex. Prop. Code §91.005 (2005). If the tenant desires to sell the business, merge with another business, or change the entity under which it conducts business, lease provisions regarding assignment and subletting will come into play. Many leases provide that the tenant may assign or sublet the premises with the consent of the landlord, which consent "shall not be unreasonably withheld". Obviously, the more flexibility the tenant has in its assignment and subletting provisions, the more flexibility the tenant will have in the conduct and prospective sale of its business.

The modern commercial lease will normally address landlord and tenant's responsibility for accidents and personal injury, casualty, damage to the building, and eminent domain. These provisions vary by jurisdiction, landlord, building, tenant, and use of the property. The tenant should review these provisions thoroughly with counsel to see if they meet the tenant's risk expectations with respect to the property.

The tenant may also seek options to extend the term of the lease. The option clause should state the number of options available to the tenant, the term of each option, the rent for each option period or the formula for determining rent for each option period, and the method tenant will utilize to exercise the option. Also, the tenant may want to include expansion rights associated with the premises, which can include a "right of first refusal", "right of first offer", or a general expansion right granted with respect to certain space or areas in the building or property.

In sum, the commercial lease will address, in great detail, the aspects of the relationship between landlord and tenant, and will vary by use, location, landlord preference, tenant bargaining power, and jurisdiction. In Texas, there are very few statutory regulations governing the landlord/tenant relationship, and most characteristics of that relationship will be defined by contract. There is no "standard" form of commercial lease and the provisions that can be included in the lease will be determined by the creativity of the parties and their counsel. As with any other contract, the tenant should KNOW WHAT IT IS SIGNING. The consequences of signing a "bad lease" can include unforeseen expenses and business failure.

                                                                                                                                                                                                                                                     

Mel Jones is one of the premier restaurant brokers in the nation having published hundreds of articles on buying and selling a restaurant and bar business, selling thousands of restaurants in CA., WA and AZ and building one of the most copied business models in the brokerage industry.  Mel started SellingRestaurants in 2004 with the one simple concept, give the buyers the information they need to make intelligent buying decisions without being pestered by a broker or hiding information, prepare the business for market by researching key details that make or break deals and educate the buyer on the buying process to create an intelligent buyer.  Prior to SellingRestaurants, Mel was a Chief Financial Officer for Universal Music Group, the largest music company in the world.  There he participated in more than $11.5 billion of merger and acquisition transactions.  He also work for top companies such as Nestle Foods, USA. He hold a Bachelors in Business Administration Finance as well as attened Law School at Gonzaga University.  Give Mel a call at 480.274.7000 or e-mail him at [email protected] if you have any questions. 

 


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