In the Spotlight: The Right of a Landlord to Share in Consideration Received in Connection with Transferring Leased Property

In a commercial lease, it is common for a landlord to include a provision giving the landlord the right to obtain all or a portion of the rent or other consideration received by a tenant, pursuant to a sublease or assignment of the leased property. Because the landlord typically has a superior interest in the property, the landlord usually expects to benefit from increases in market rental rates or appreciating property values.

This article examines three common provisions used by landlords to obtain all or a portion of the excess rents or other consideration received by a tenant pursuant to a sublease or assignment: an express allocation of excess rents, a right to increase rent on an assignment or subletting, and a recapture clause. Additionally, this article discusses issues associated with the enforcement of these provisions and the landlord's ability to receive excess rent where the lease is silent on the issue.

Express Allocation of Excess Rents

The most effective and clearest method for a landlord to entitle itself to a portion of excess rents or other consideration derived from a sublease or assignment is to include a clause specifically accounting for such amounts, often in conjunction with the landlord's right to withhold its consent to a sublease. An example of such a clause follows:

Landlord hereby reserves the right to condition Landlord's consent to any assignment, sublease or other transfer of all or any portion of Tenant's interest in this Lease or the Premises upon Landlord's receipt from Tenant of a written agreement, in form and substance acceptable to Landlord, pursuant to which Tenant shall pay over to Landlord all rent or other consideration received by Tenant from any such assignee, sublessee, or transferee either initially or over the term of the assignment, sublease or transfer, in excess of the rent called for hereunder.

This provision appears straightforward, but it does not address all of the concerns that a landlord and tenant should have. Of great importance to both parties is what exactly is included in rent and other consideration. As a result, an allocation of profits provision like that above should only be the starting point for determining how excess profits will be shared, and the lease will likely require additional related provisions in order to deal fully with the issue.

A sophisticated tenant will likely argue that the amount of rent or consideration allocable to the landlord should exclude the tenant's costs and expenses incurred in procuring the subtenant or assignee (for instance, brokerage commissions and attorneys' fees), and that only the net profit should be shared. The tenant will also want to exclude consideration it receives for tenant's personal property (for example, inventory, movable trade fixtures, goodwill), since the landlord should only be entitled to share in the consideration arising from the real estate. Landlords will insist that any consideration for any real estate interest is paid to the landlord, for example payment made by the subtenant or assignee for the leasehold improvements installed in the premises.

Alternatively, since it is often difficult to determine what portion of the proceeds of the transfer of a lease was intended to cover tenant's property, landlords will sometimes agree to modify the provision to require the tenant to pay a fixed portion of the entire consideration, e.g., 75% or 50%. Sometimes, landlords will agree to require payment only of excess rent. Indeed, in some cases a landlord may not be permitted to share in any consideration other than excess rent. The California court in Ilkhchooyi v. Best, 37 Cal. App. 4th 395 (1995), found that California law prohibited a landlord from receiving a share of the consideration the tenant received on the sale of its business in the premises, and permitted only the sharing of excess rents.

Increase Rent on Assignment or Subletting

Another common lease provision is to require an automatic increase in certain items of rent upon an assignment or subletting. In retail leases, the increase is often based upon “effective rent,” i.e., the average minimum rent and percentage rent payable by the tenant over a certain period of time prior to the effective date of the transfer. Sometimes the rent increase is tied to CPI increases, in an attempt to reach a market rent.

Despite the likely negotiations and difficulty associated with agreeing on such provisions when a lease is signed, an express allocation clause or automatic rent increase are the most direct methods of memorializing the expectations of the parties in the event of a sublease or assignment at a rent higher than that in the original lease. Because of the certainty provided by rent allocation or increase clauses, landlords looking to capitalize on potential increases in market rental rates or property values should make a habit of including such provisions in all commercial leases.

Recapture Clause

A third type of provision that is often used to shift the profit on a lease transfer from a tenant to a landlord is a recapture clause. Under this type of clause, a landlord is entitled to reclaim the leased property after some defined event, which will often be a tenant's request for consent to assign or sublease. Thus, if the market rent exceeds the tenant's rent under the original lease, then upon the tenant's request for consent to the transfer, the landlord can simply terminate the tenant's lease and enter into a direct lease with the proposed sublessee or assignee. Such a provision is beneficial to a landlord, since it essentially entitles the landlord to all of the excess rent.

One downside of a recapture clause is that it could diminish a tenant's incentive to seek a sublessee at a market rental in excess of the lease rents, in contrast to a provision that allows the tenant to share in such excess rent. Additionally, since a recapture clause will typically result in the termination of the original lease, the original tenant will no longer be a party to the lease, and it is unlikely that the landlord will have any recourse against the original tenant if the new tenant breaches its obligations. As a result, in most cases, a recapture clause is likely to be less beneficial to a landlord than a rent allocation clause.

Both profit allocation clauses and recapture clauses have generally been enforced by the courts. Nonetheless, where either the terms of the lease or applicable law require the landlord to be reasonable when granting or withholding consent to an assignment or sublease, the landlord must be conscious of the potential pitfalls in refusing to grant consent. The Restatement (Second) of Property states that “the landlord's consent to an alienation by the tenant cannot be withheld unreasonably, unless a freely negotiated provision in the lease gives the landlord an absolute right to withhold consent.” Restatement (Second) of Property '15.2(2) (1976). Although this is not the majority rule, it is followed in some jurisdictions and has the potential to greatly influence a landlord's rights.

Thus, even in a lease that does not specifically require the landlord to act reasonably in granting consent to a sublease or assignment, the landlord may have an obligation to do so. In the context of rent allocation and recapture clauses, landlords must be aware that “[a] lessor acts unreasonably when he seeks to improve his economic position by withholding his consent to obtain a benefit not reflected in the terms of the original lease.” Toys “R” Us, Inc. v. NBD Trust Co. of Illinois, 1995 U.S. Dist. LEXIS 14878, at *110 (N.D. Ill. Sept. 29, 1995). In the Toys “R” Us opinion, the court went on to reference numerous other decisions supporting the proposition that “a landlord may not withhold his consent to a sublease in order to extract a higher rent.” Id.

This is extremely important in the context of a recapture clause, where a landlord is able to profit from excess rents under such a clause only if it withholds consent, terminates the lease, and then enters into a new lease with the proposed sublessee or assignee. The best way for the landlord to protect its ability to use the recapture clause as a profit-sharing vehicle is to retain its right to withhold its consent to an assignment or subletting in its sole and absolute discretion.

When the Lease Is Silent

An issue that has not been frequently litigated is how excess rents derived from an assignment or sublease are treated if the lease does not specifically account for such rents. A landlord will likely feel entitled to at least a portion of the excess rents, especially in situations where the landlord has made improvements to the leased premises, the landlord has reserved the right to consent to the assignment or sublease, or where the rent under the lease is dependent on the tenant's sales. Nonetheless, at least one court, in affirming summary judgment on behalf of the tenant, stated as follows: “[Landlord] is not entitled to any portion of subrents paid under the [sublease] because there is no evidence of an agreement between [tenant] and [landlord] for such payments. Where, as here, the contract terms are clear and unambiguous, the language of the contracts alone governs the intention of the parties.” RJV Corp. v. Supervalu, Inc., 223 Ga. App. 585, 594 (1996). Thus, if a landlord has an expectation of sharing in the excess rents derived from a sublease or assignment, it should memorialize such expectation in the lease.

Conclusion

Landlords have a legitimate and reasonable interest in ensuring that they benefit from increases in the market rental rates for their properties, and there are simple ways to protect that interest. A landlord can include a rent allocation or increase clause or a recapture provision in a lease, or may even choose to negotiate the splitting of excess rents at the time of an assignment or sublease. Negotiating the treatment of consideration and excess rents received from a sublease or assignment at the time that a lease is entered into benefits both the landlord and the tenant. It defines the benefit that the tenant will receive from arranging and negotiating a sublease or assignment; it minimizes the need for future negotiations between the landlord and tenant, and it assures the landlord that if market rents rise and the tenant decides to sublease or assign, the landlord will, at the very least, share in the appreciation of its property.

M. Rosie Rees is a partner and Sean M. Bahoshy is an associate at Pircher, Nichols & Meeks, a law firm with offices in Chicago and Los Angeles specializing in real estate law.

In a commercial lease, it is common for a landlord to include a provision giving the landlord the right to obtain all or a portion of the rent or other consideration received by a tenant, pursuant to a sublease or assignment of the leased property. Because the landlord typically has a superior interest in the property, the landlord usually expects to benefit from increases in market rental rates or appreciating property values.

This article examines three common provisions used by landlords to obtain all or a portion of the excess rents or other consideration received by a tenant pursuant to a sublease or assignment: an express allocation of excess rents, a right to increase rent on an assignment or subletting, and a recapture clause. Additionally, this article discusses issues associated with the enforcement of these provisions and the landlord's ability to receive excess rent where the lease is silent on the issue.

Express Allocation of Excess Rents

The most effective and clearest method for a landlord to entitle itself to a portion of excess rents or other consideration derived from a sublease or assignment is to include a clause specifically accounting for such amounts, often in conjunction with the landlord's right to withhold its consent to a sublease. An example of such a clause follows:

Landlord hereby reserves the right to condition Landlord's consent to any assignment, sublease or other transfer of all or any portion of Tenant's interest in this Lease or the Premises upon Landlord's receipt from Tenant of a written agreement, in form and substance acceptable to Landlord, pursuant to which Tenant shall pay over to Landlord all rent or other consideration received by Tenant from any such assignee, sublessee, or transferee either initially or over the term of the assignment, sublease or transfer, in excess of the rent called for hereunder.

This provision appears straightforward, but it does not address all of the concerns that a landlord and tenant should have. Of great importance to both parties is what exactly is included in rent and other consideration. As a result, an allocation of profits provision like that above should only be the starting point for determining how excess profits will be shared, and the lease will likely require additional related provisions in order to deal fully with the issue.

A sophisticated tenant will likely argue that the amount of rent or consideration allocable to the landlord should exclude the tenant's costs and expenses incurred in procuring the subtenant or assignee (for instance, brokerage commissions and attorneys' fees), and that only the net profit should be shared. The tenant will also want to exclude consideration it receives for tenant's personal property (for example, inventory, movable trade fixtures, goodwill), since the landlord should only be entitled to share in the consideration arising from the real estate. Landlords will insist that any consideration for any real estate interest is paid to the landlord, for example payment made by the subtenant or assignee for the leasehold improvements installed in the premises.

Alternatively, since it is often difficult to determine what portion of the proceeds of the transfer of a lease was intended to cover tenant's property, landlords will sometimes agree to modify the provision to require the tenant to pay a fixed portion of the entire consideration, e.g., 75% or 50%. Sometimes, landlords will agree to require payment only of excess rent. Indeed, in some cases a landlord may not be permitted to share in any consideration other than excess rent. The California court in Ilkhchooyi v. Best , 37 Cal. App. 4th 395 (1995), found that California law prohibited a landlord from receiving a share of the consideration the tenant received on the sale of its business in the premises, and permitted only the sharing of excess rents.

Increase Rent on Assignment or Subletting

Another common lease provision is to require an automatic increase in certain items of rent upon an assignment or subletting. In retail leases, the increase is often based upon “effective rent,” i.e., the average minimum rent and percentage rent payable by the tenant over a certain period of time prior to the effective date of the transfer. Sometimes the rent increase is tied to CPI increases, in an attempt to reach a market rent.

Despite the likely negotiations and difficulty associated with agreeing on such provisions when a lease is signed, an express allocation clause or automatic rent increase are the most direct methods of memorializing the expectations of the parties in the event of a sublease or assignment at a rent higher than that in the original lease. Because of the certainty provided by rent allocation or increase clauses, landlords looking to capitalize on potential increases in market rental rates or property values should make a habit of including such provisions in all commercial leases.

Recapture Clause

A third type of provision that is often used to shift the profit on a lease transfer from a tenant to a landlord is a recapture clause. Under this type of clause, a landlord is entitled to reclaim the leased property after some defined event, which will often be a tenant's request for consent to assign or sublease. Thus, if the market rent exceeds the tenant's rent under the original lease, then upon the tenant's request for consent to the transfer, the landlord can simply terminate the tenant's lease and enter into a direct lease with the proposed sublessee or assignee. Such a provision is beneficial to a landlord, since it essentially entitles the landlord to all of the excess rent.

One downside of a recapture clause is that it could diminish a tenant's incentive to seek a sublessee at a market rental in excess of the lease rents, in contrast to a provision that allows the tenant to share in such excess rent. Additionally, since a recapture clause will typically result in the termination of the original lease, the original tenant will no longer be a party to the lease, and it is unlikely that the landlord will have any recourse against the original tenant if the new tenant breaches its obligations. As a result, in most cases, a recapture clause is likely to be less beneficial to a landlord than a rent allocation clause.

Both profit allocation clauses and recapture clauses have generally been enforced by the courts. Nonetheless, where either the terms of the lease or applicable law require the landlord to be reasonable when granting or withholding consent to an assignment or sublease, the landlord must be conscious of the potential pitfalls in refusing to grant consent. The Restatement (Second) of Property states that “the landlord's consent to an alienation by the tenant cannot be withheld unreasonably, unless a freely negotiated provision in the lease gives the landlord an absolute right to withhold consent.” Restatement (Second) of Property '15.2(2) (1976). Although this is not the majority rule, it is followed in some jurisdictions and has the potential to greatly influence a landlord's rights.

Thus, even in a lease that does not specifically require the landlord to act reasonably in granting consent to a sublease or assignment, the landlord may have an obligation to do so. In the context of rent allocation and recapture clauses, landlords must be aware that “[a] lessor acts unreasonably when he seeks to improve his economic position by withholding his consent to obtain a benefit not reflected in the terms of the original lease.” Toys “R” Us, Inc. v. NBD Trust Co. of Illinois, 1995 U.S. Dist. LEXIS 14878, at *110 (N.D. Ill. Sept. 29, 1995). In the Toys “R” Us opinion, the court went on to reference numerous other decisions supporting the proposition that “a landlord may not withhold his consent to a sublease in order to extract a higher rent.” Id.

This is extremely important in the context of a recapture clause, where a landlord is able to profit from excess rents under such a clause only if it withholds consent, terminates the lease, and then enters into a new lease with the proposed sublessee or assignee. The best way for the landlord to protect its ability to use the recapture clause as a profit-sharing vehicle is to retain its right to withhold its consent to an assignment or subletting in its sole and absolute discretion.

When the Lease Is Silent

An issue that has not been frequently litigated is how excess rents derived from an assignment or sublease are treated if the lease does not specifically account for such rents. A landlord will likely feel entitled to at least a portion of the excess rents, especially in situations where the landlord has made improvements to the leased premises, the landlord has reserved the right to consent to the assignment or sublease, or where the rent under the lease is dependent on the tenant's sales. Nonetheless, at least one court, in affirming summary judgment on behalf of the tenant, stated as follows: “[Landlord] is not entitled to any portion of subrents paid under the [sublease] because there is no evidence of an agreement between [tenant] and [landlord] for such payments. Where, as here, the contract terms are clear and unambiguous, the language of the contracts alone governs the intention of the parties.” RJV Corp. v. Supervalu, Inc. , 223 Ga. App. 585, 594 (1996). Thus, if a landlord has an expectation of sharing in the excess rents derived from a sublease or assignment, it should memorialize such expectation in the lease.

Conclusion

Landlords have a legitimate and reasonable interest in ensuring that they benefit from increases in the market rental rates for their properties, and there are simple ways to protect that interest. A landlord can include a rent allocation or increase clause or a recapture provision in a lease, or may even choose to negotiate the splitting of excess rents at the time of an assignment or sublease. Negotiating the treatment of consideration and excess rents received from a sublease or assignment at the time that a lease is entered into benefits both the landlord and the tenant. It defines the benefit that the tenant will receive from arranging and negotiating a sublease or assignment; it minimizes the need for future negotiations between the landlord and tenant, and it assures the landlord that if market rents rise and the tenant decides to sublease or assign, the landlord will, at the very least, share in the appreciation of its property.

M. Rosie Rees is a partner and Sean M. Bahoshy is an associate at Pircher, Nichols & Meeks, a law firm with offices in Chicago and Los Angeles specializing in real estate law.