Commercial Leases As an Asset of the Landlord and Tenant

So, why are we contemplating ways a tenant can “exit” a lease, when a tenant is supposed to think of the lease as an asset? The answer is that while new ventures and locations are entered with optimism, there may be a need for a number of reasons to set one's hopes elsewhere, while making the most of the existing lease. One way to make the most of the lease is to present it to a third party for assumption. If the lease has been negotiated with terms favorable to a tenant, it will be a more attractive document to a third party and, therefore, a valuable asset.

Unlike most terms of a lease, which are dealt with in a specific provision and only in that provision, the room to negotiate exit strategies arises in several lease provisions. Aside from a provision specifically addressing early lease termination (ie, based upon not achieving a certain level of sales, an absolute right to terminate at some date certain, or upon the death or disability of a principal of the business), business flexibility can be negotiated in, among other provisions, those dealing with assignment and subletting, use, trade name, continuous occupancy, and default.

Nearly all initial lease drafts prohibit the tenant from assigning the lease or subletting the premises without the landlord's consent. It is important not only to state that the landlord's consent may not be unreasonably withheld, delayed, or conditioned, but also to carve out exceptions to requiring landlord's consent at all. For instance, the lease should be freely assignable (or the premises subject to subletting) in the event of a transfer of the lease to the tenant's related entity. Additionally, the tenant should be allowed to assign the lease in the event of a sale of its assets, stock, or membership interests. The value of the later option to the tenant will depend on the breadth of the use and trade name provisions.

Broad use clauses (ie, not limited to tenant's initial use of the premises) and the ability to change the tenant's trade name will add flexibility when assigning the lease or subletting the premises. Naturally, the landlord will resist broad clauses. Landlords want to maintain a certain tenant mix. In a retail setting, it's best to discuss compromises, such as being able to change the use and trade name so long as it does not conflict with the use of any other tenant, or work with the landlord to develop a list of prohibited uses, leaving all other uses available to the tenant.

Market conditions may limit the pool of potential third parties to take over the lease by assignment or subletting, but the tenant may need to stop operations in order to limit losses. A lease with a continuous occupancy clause (or required hours of operation) and/or a provision placing the tenant in default for vacating the premises may subject the tenant to severe damages. Consider negotiating lease modifications such that the tenant can cease business with limited and defined exposure. For example, no default is declared so long as the tenant continues to pay the basic rent due under the lease.

Ultimately, the tenant must strive for a comfortable level of flexibility to meet current demands and anticipate future circumstances, realizing that one of its most important assets is the lease itself.

The Landlord's Perspective

Landlords, too, must view the lease as an asset during both the initial negotiation and renewal negotiations. Oftentimes, when the lease term is coming to an end and the parties want to negotiate an extension of the lease term, landlords are tempted merely to amend the lease time and time again to extend the term. Certainly that is the quickest method to keep the lease going, but after a series of amendments, the original lease may be 10 years or older. It may well be time to re-evaluate the lease and be sure it meets current-day standards and addresses issues that simply were not thought of 10 years ago.

Naturally, an uninterrupted rent stream is the most important item for a landlord to preserve in its lease, for its own well-being and also to satisfy its lender. (In fact, both landlords and tenants need to recognize that the invisible third party to the lease is the lender, who has its own reasons for considering the lease as an asset.) Landlords will want to be sure that the tenant does not have offset or deduction rights. Also, rent abatement provisions must be carefully and narrowly drawn. For example, if there is a service interruption, the tenant should not be entitled to an abatement of rent (suspension of rent payments) unless the interruption actually serves to deny the tenant use of the premises and continues for some period of time before the abatement is applicable. Also, if the lease allows the tenant to renew, the rent for the renewal term should be clearly spelled out.

Landlords should ask for several months' worth of rent as a security deposit. In rent structures that increase over the term of the lease, the landlord should set the security deposit at the highest rate under the lease. (As an aside, many landlords are considering the use of letters of credit rather than cash as a security deposit. While the law is evolving on this point, in some jurisdictions, this may allow the landlords to argue in a tenant bankruptcy situation that the letter of credit security deposit is not an asset of the tenant.)

The lease should provide that in the event the landlord has to use all or a portion of the security deposit to cure a tenant default, the tenant must immediately restore the security deposit. Additionally, the lease should provide that at the end of the lease term, the security deposit will be returned to the tenant only after the landlord has had a chance to inspect the premises to be sure they are in order and to confirm that all monies due have, in fact, been paid.

Landlords want to be sure that the tenant is obligated to carry adequate levels of liability insurance. Otherwise, the tenant's obligation to protect the landlord against certain claims becomes meaningless. It is not uncommon to require tenants to carry several million dollars in bodily injury and property damage insurance. Such high levels certainly were not typical years ago, and landlords need to be certain that the insurance levels are meaningful.

The assignment and subletting provision is always a highly negotiated matter between the landlord and tenant. The landlord will want to keep the tenant it bargained for and the tenant, as discussed above, will want the flexibility to assign (transfer) the lease or sublet (allow a third party to use) the premises. Landlords that agree to allow the tenant the right of assignment or subletting should not be tempted merely to say, as is the case in many older leases, that consent to an assignment will not be “unreasonably withheld.” Rather, the lease should provide standards by which clearly the landlord is not being unreasonable. For example, it shall not be considered unreasonable for the landlord to deny an assignment request if the new tenant is not credit worthy or does not have experience in the business operated from the premises.

Many older leases do not contain a waiver of jury trial. If the landlord finds the need to take the tenant to court, the landlord wants a quick determination of the issues. Jury trials will delay proceedings and, most often, make the proceeding more costly to the landlord.

Approaching Negotiations

According to Webster's Dictionary, “negotiate” means “to confer with one another to arrive at the settlement of some matter; to deal with some matter that requires ability for its successful handling; to arrange or bring about through conference, discussion and compromise; to complete; to accomplish.” Perhaps tenants and landlords should remind themselves of this definition prior to every lease negotiation. Protracted lease negotiations negatively impact deadline and delivery dates important to the parties and increase everyone's cost.

One key to successful negotiation is that the landlord and tenant each recognize that what they want may actually be more than what they need. The parties should identify deal breakers at the beginning of the negotiation. This process will cause lease provisions to fall into one of two categories: the “wants” and the “must haves.” Recognizing which provisions fall within which category will allow both parties to begin negotiations with a specific framework. Having that framework in mind will set the focus and tone of the negotiations, increasing the likelihood of successful and quick results.

Tenants and landlords should view the lease as an asset of their business. A lease cannot be entered taking into account only those conditions existing as of the date of execution. The terms of the lease will bind the parties for a considerable period, and it is important to draft the lease carefully up front in order to accommodate current and future circumstances. This article addresses the lease as an asset from the tenant's perspective, then from the landlord's perspective, and finally suggests how to approach negotiating potentially conflicting ideas about how to preserve this “joint” asset.

The Tenant's Perspective

The importance of business flexibility (also known as exit strategies) to any tenant, particularly retail tenants entering a new venture or a new location, is critical. Discussing those strategies during a lease negotiation, while at the same time trying to build a good relationship with the landlord, feels awkward.

So, why are we contemplating ways a tenant can “exit” a lease, when a tenant is supposed to think of the lease as an asset? The answer is that while new ventures and locations are entered with optimism, there may be a need for a number of reasons to set one's hopes elsewhere, while making the most of the existing lease. One way to make the most of the lease is to present it to a third party for assumption. If the lease has been negotiated with terms favorable to a tenant, it will be a more attractive document to a third party and, therefore, a valuable asset.

Unlike most terms of a lease, which are dealt with in a specific provision and only in that provision, the room to negotiate exit strategies arises in several lease provisions. Aside from a provision specifically addressing early lease termination (ie, based upon not achieving a certain level of sales, an absolute right to terminate at some date certain, or upon the death or disability of a principal of the business), business flexibility can be negotiated in, among other provisions, those dealing with assignment and subletting, use, trade name, continuous occupancy, and default.

Nearly all initial lease drafts prohibit the tenant from assigning the lease or subletting the premises without the landlord's consent. It is important not only to state that the landlord's consent may not be unreasonably withheld, delayed, or conditioned, but also to carve out exceptions to requiring landlord's consent at all. For instance, the lease should be freely assignable (or the premises subject to subletting) in the event of a transfer of the lease to the tenant's related entity. Additionally, the tenant should be allowed to assign the lease in the event of a sale of its assets, stock, or membership interests. The value of the later option to the tenant will depend on the breadth of the use and trade name provisions.

Broad use clauses (ie, not limited to tenant's initial use of the premises) and the ability to change the tenant's trade name will add flexibility when assigning the lease or subletting the premises. Naturally, the landlord will resist broad clauses. Landlords want to maintain a certain tenant mix. In a retail setting, it's best to discuss compromises, such as being able to change the use and trade name so long as it does not conflict with the use of any other tenant, or work with the landlord to develop a list of prohibited uses, leaving all other uses available to the tenant.

Market conditions may limit the pool of potential third parties to take over the lease by assignment or subletting, but the tenant may need to stop operations in order to limit losses. A lease with a continuous occupancy clause (or required hours of operation) and/or a provision placing the tenant in default for vacating the premises may subject the tenant to severe damages. Consider negotiating lease modifications such that the tenant can cease business with limited and defined exposure. For example, no default is declared so long as the tenant continues to pay the basic rent due under the lease.

Ultimately, the tenant must strive for a comfortable level of flexibility to meet current demands and anticipate future circumstances, realizing that one of its most important assets is the lease itself.

The Landlord's Perspective

Landlords, too, must view the lease as an asset during both the initial negotiation and renewal negotiations. Oftentimes, when the lease term is coming to an end and the parties want to negotiate an extension of the lease term, landlords are tempted merely to amend the lease time and time again to extend the term. Certainly that is the quickest method to keep the lease going, but after a series of amendments, the original lease may be 10 years or older. It may well be time to re-evaluate the lease and be sure it meets current-day standards and addresses issues that simply were not thought of 10 years ago.

Naturally, an uninterrupted rent stream is the most important item for a landlord to preserve in its lease, for its own well-being and also to satisfy its lender. (In fact, both landlords and tenants need to recognize that the invisible third party to the lease is the lender, who has its own reasons for considering the lease as an asset.) Landlords will want to be sure that the tenant does not have offset or deduction rights. Also, rent abatement provisions must be carefully and narrowly drawn. For example, if there is a service interruption, the tenant should not be entitled to an abatement of rent (suspension of rent payments) unless the interruption actually serves to deny the tenant use of the premises and continues for some period of time before the abatement is applicable. Also, if the lease allows the tenant to renew, the rent for the renewal term should be clearly spelled out.

Landlords should ask for several months' worth of rent as a security deposit. In rent structures that increase over the term of the lease, the landlord should set the security deposit at the highest rate under the lease. (As an aside, many landlords are considering the use of letters of credit rather than cash as a security deposit. While the law is evolving on this point, in some jurisdictions, this may allow the landlords to argue in a tenant bankruptcy situation that the letter of credit security deposit is not an asset of the tenant.)

The lease should provide that in the event the landlord has to use all or a portion of the security deposit to cure a tenant default, the tenant must immediately restore the security deposit. Additionally, the lease should provide that at the end of the lease term, the security deposit will be returned to the tenant only after the landlord has had a chance to inspect the premises to be sure they are in order and to confirm that all monies due have, in fact, been paid.

Landlords want to be sure that the tenant is obligated to carry adequate levels of liability insurance. Otherwise, the tenant's obligation to protect the landlord against certain claims becomes meaningless. It is not uncommon to require tenants to carry several million dollars in bodily injury and property damage insurance. Such high levels certainly were not typical years ago, and landlords need to be certain that the insurance levels are meaningful.

The assignment and subletting provision is always a highly negotiated matter between the landlord and tenant. The landlord will want to keep the tenant it bargained for and the tenant, as discussed above, will want the flexibility to assign (transfer) the lease or sublet (allow a third party to use) the premises. Landlords that agree to allow the tenant the right of assignment or subletting should not be tempted merely to say, as is the case in many older leases, that consent to an assignment will not be “unreasonably withheld.” Rather, the lease should provide standards by which clearly the landlord is not being unreasonable. For example, it shall not be considered unreasonable for the landlord to deny an assignment request if the new tenant is not credit worthy or does not have experience in the business operated from the premises.

Many older leases do not contain a waiver of jury trial. If the landlord finds the need to take the tenant to court, the landlord wants a quick determination of the issues. Jury trials will delay proceedings and, most often, make the proceeding more costly to the landlord.

Approaching Negotiations

According to Webster's Dictionary, “negotiate” means “to confer with one another to arrive at the settlement of some matter; to deal with some matter that requires ability for its successful handling; to arrange or bring about through conference, discussion and compromise; to complete; to accomplish.” Perhaps tenants and landlords should remind themselves of this definition prior to every lease negotiation. Protracted lease negotiations negatively impact deadline and delivery dates important to the parties and increase everyone's cost.

One key to successful negotiation is that the landlord and tenant each recognize that what they want may actually be more than what they need. The parties should identify deal breakers at the beginning of the negotiation. This process will cause lease provisions to fall into one of two categories: the “wants” and the “must haves.” Recognizing which provisions fall within which category will allow both parties to begin negotiations with a specific framework. Having that framework in mind will set the focus and tone of the negotiations, increasing the likelihood of successful and quick results.