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Imagine a potential industrial tenant visiting a property only to discover workers in hazmat suits in the midst of an environmental remediation project; or the impact of having a prospective tenant find building code violations or lingering evidence of flood damage. Not exactly the ideal scenario for a landlord looking to market its property, but not an unheard-of circumstance, either. The reason is that too often, surrender provisions in today's commercial leases are not adequately coordinated with the landlords' marketing needs, and lack adequate remedies to ensure compliance by tenants at the end of their lease terms. A continuing stream of rental income is the key to the success of any commercial property and it is critical for landlords to take proactive steps to protect the continuity of that income. Landlords can do just that by requiring tenants to comply with some of their typical “surrender” obligations well before the end of their lease terms, by viewing non-compliant tenants as de facto holdovers and invoking remedies traditionally applied when a tenant fails to move out at the end of its lease term.
Because it takes time to find a new tenant, commercial leases generally include a number of clauses designed to give the landlord the opportunity to minimize any interruption in that stream of rental income caused by the transition between tenants. For example, the landlord is usually permitted to post “for rent” signs and show the premises to potential new tenants during the last year of the term so the landlord can identify a new tenant before an existing tenant's lease expires. Also, the existing tenant is usually required to “surrender” the premises in good condition at the end of its lease term in order to minimize the time and expense for the landlord to prepare the premises for a new tenant. If the existing tenant does not vacate the premises at the end of its term, the landlord can usually declare the tenant a “holdover” in order to collect damages and charge the tenant a multiple (usually 150% or 200%) of its rental rate until the tenant vacates the property.
Inadequacy of Surrender Clauses: A Hypothetical Case
In many cases, however, surrender clauses are not well coordinated with the tenant's other obligations under the lease, and fail to adequately protect the landlord's ability to re-market the premises or pursue remedies. The following hypothetical may help to illustrate the inadequacy of many typical surrender clauses.
MFG Co. is a small manufacturing firm that has been leasing a building in an industrial park for several years. MFG's lease requires it to comply with all applicable environmental laws and to pursue remedial action diligently until any violation has been cured. MFG has been winding down its operations at the premises and intends to vacate by the end of its lease term. The landlord has identified a new tenant interested in leasing the premises once MFG has moved out. As part of its due diligence, the new tenant asks for a Phase I site assessment to confirm that there are no environmental problems with the premises. Unfortunately, the Phase I assessment reveals several potential problems. MFG has been using an industrial solvent in its manufacturing process. The solvent was stored in drums outside the premises, some of which appear to have leaked. There is also an underground storage tank on the property that has been out of use for several years. The Phase I recommends further investigation of the soil and groundwater near the drum storage and underground storage tank areas.
When the potential new tenant receives the Phase I report, it backs out of the deal. MFG denies that it has violated any environmental laws and claims that it is not responsible for further testing or remediation. Even assuming that the landlord can require MFG to pay for the additional soil and groundwater testing and any required remediation, and that MFG is an ongoing entity with assets that the landlord can reach if MFG fails to complete the remediation, the landlord has already lost half the battle. Because it did not anticipate the environmental problem, the landlord has squandered its opportunity to secure a new tenant prior to the end of the existing tenant's lease term and its stream of rental income will be unnecessarily interrupted for an extended period.
In this hypothetical, MFG's lease failed to address adequately the potential for environmental problems at the premises. If a landlord knows that a tenant's operations could have environmental implications, it must carefully consider the terms of the lease relating to the tenant's environmental obligations. Rather than take a passive approach ' requiring the tenant to cleanup the premises only if it receives notice of a violation ' the landlord should require the tenant to conduct periodic testing throughout the term so the condition of the property does not come as a surprise at the end of the term. If the tenant fails to perform the testing as required, the landlord should have the ability to perform the testing for the tenant and charge the cost as additional rent. Just as important, however, MFG's lease also ignores the critical issue of timing in relation to the landlord's marketing efforts.
Environmental Remediation
An environmental remediation can take a significant period of time to complete and is likely to scare away potential new tenants. (Remember the image of workers passing by in hazmat suits as a landlord tries to show a property to a potential tenant.) In order to ensure that remediation activities do not hinder efforts to re-market their premises, landlords should require that any remediation be completed well before the end of their tenants' lease terms.
Timing can be a critical factor in other contexts as well. For example, tenants are often required to repair their premises after a casualty such as a fire or flood. Surrender clauses generally do not specifically refer to repair of casualty damages, but they often do require that the tenant surrender the premises at the end of the lease term in compliance with all of the terms of the lease. As with the aforementioned environmental hypothetical, however, the timing of the tenant's obligation to repair any casualty damage may be critical to the landlord's efforts to re-market the premises. If the tenant fails to cleanup any smoke or water damage resulting from a fire or flood, the premises may not appear appealing to potential new tenants and, as a result, prevent the landlord from finding a replacement tenant. As with a tenant's obligation to cure environmental problems, a tenant's obligations to repair damages arising from a casualty and generally to maintain the condition and appearance of the premises should be satisfied well before the end of the lease term in order to aid the landlord's re-marketing efforts.
Non-compliant Tenants
Another critical issue for landlords to consider is whether their remedies against non-compliant tenants are sufficient to protect their stream of rental income. As the end of the lease term approaches, some of the landlord's traditional remedies ' such as terminating the lease ' will likely be of little value. Similarly, if the landlord is in danger of losing a new tenant, the forfeit of the prior tenant's security deposit may do little to make up for the lost rental income and will not provide motivation for the tenant if the cost to comply with the landlord's demands is greater than the amount of the security deposit. Leases often prohibit the collection of consequential damages and, depending upon the circumstances, actual damages may be difficult to prove. In fact, if the tenant's obligations are not clearly established in the lease, the landlord may not even be able to prove that the tenant is liable for the landlord's damages in the first place.
What Landlords Should Do
Landlords may avoid some of the problems discussed in this hypothetical by changing the manner in which they view tenants and their obligations as the end of the lease term approaches. In order for a landlord to re-market its property successfully under an existing lease, many of the tenant's obligations with respect to the condition of the premises should be addressed well before the lease expires so that the search for new tenants is not hindered by the condition of the premises or the existing tenant's late efforts to comply with its obligations. If a tenant fails to comply with such obligations within the time required, landlords should consider treating such tenants as de facto holdovers and applying holdover-like remedies.
Why? If a tenant's failure to maintain its premises as required hinders the landlord's ability to remarket the premises or delays the commencement of a new tenant's lease, the potential harm to the landlord is similar to the typical holdover scenario in which a tenant's refusal to vacate its premises interferes with the landlord's ability move a new tenant into the premises or gives rise to a defense against the payment of rent. In either case, the landlord's continuing stream of rental income is jeopardized. Adding the ability to charge holdover rent to the landlord's arsenal of remedies will help to ensure that a tenant is properly motivated to satisfy its obligations and that the landlord will be compensated for lost income resulting from the tenant's non-compliance.
In any context, a landlord's goal is the same: to ensure that it has the ability to market its premises successfully as the end of an existing tenant's lease term approaches and to ensure that the remedies available to it at the end of the lease term are adequate to protect its interests and to motivate the tenant to fulfill its obligations.
Conclusion
Requiring tenants to comply with their obligations as to the condition of the premises well before the end of their lease terms will help protect the ability of landlords to re-market their premises. Applying the de facto holdover approach can add some teeth to the remedies available to landlords at the end of the lease term. Although a novel approach, holdover remedies may be the most appropriate way to compensate the landlord for its damages and to motivate the tenant to fulfill its obligations. The ability of a commercial landlord to re-market its property is fundamental to maintaining the stream of tenant revenue. With foresight and a prudently crafted surrender clause, a landlord's right to re-market their property can be protected.
Paul R. Diamond and Dara Sahebjami are attorneys in the Business Transactions Department of Chicago-based Wildman Harrold. For 25 years, Diamond has concentrated his practice on corporate real estate representation, with an emphasis on handling all aspects of real estate holdings for U.S. and foreign-based multinational corporations. Sahebjami represents landlords and tenants in drafting and closing of office, warehouse, and industrial lease agreements, and counsels purchasers, sellers, and developers of commercial real estate in a broad range of matters. They can be reached at [email protected] and [email protected].
Imagine a potential industrial tenant visiting a property only to discover workers in hazmat suits in the midst of an environmental remediation project; or the impact of having a prospective tenant find building code violations or lingering evidence of flood damage. Not exactly the ideal scenario for a landlord looking to market its property, but not an unheard-of circumstance, either. The reason is that too often, surrender provisions in today's commercial leases are not adequately coordinated with the landlords' marketing needs, and lack adequate remedies to ensure compliance by tenants at the end of their lease terms. A continuing stream of rental income is the key to the success of any commercial property and it is critical for landlords to take proactive steps to protect the continuity of that income. Landlords can do just that by requiring tenants to comply with some of their typical “surrender” obligations well before the end of their lease terms, by viewing non-compliant tenants as de facto holdovers and invoking remedies traditionally applied when a tenant fails to move out at the end of its lease term.
Because it takes time to find a new tenant, commercial leases generally include a number of clauses designed to give the landlord the opportunity to minimize any interruption in that stream of rental income caused by the transition between tenants. For example, the landlord is usually permitted to post “for rent” signs and show the premises to potential new tenants during the last year of the term so the landlord can identify a new tenant before an existing tenant's lease expires. Also, the existing tenant is usually required to “surrender” the premises in good condition at the end of its lease term in order to minimize the time and expense for the landlord to prepare the premises for a new tenant. If the existing tenant does not vacate the premises at the end of its term, the landlord can usually declare the tenant a “holdover” in order to collect damages and charge the tenant a multiple (usually 150% or 200%) of its rental rate until the tenant vacates the property.
Inadequacy of Surrender Clauses: A Hypothetical Case
In many cases, however, surrender clauses are not well coordinated with the tenant's other obligations under the lease, and fail to adequately protect the landlord's ability to re-market the premises or pursue remedies. The following hypothetical may help to illustrate the inadequacy of many typical surrender clauses.
MFG Co. is a small manufacturing firm that has been leasing a building in an industrial park for several years. MFG's lease requires it to comply with all applicable environmental laws and to pursue remedial action diligently until any violation has been cured. MFG has been winding down its operations at the premises and intends to vacate by the end of its lease term. The landlord has identified a new tenant interested in leasing the premises once MFG has moved out. As part of its due diligence, the new tenant asks for a Phase I site assessment to confirm that there are no environmental problems with the premises. Unfortunately, the Phase I assessment reveals several potential problems. MFG has been using an industrial solvent in its manufacturing process. The solvent was stored in drums outside the premises, some of which appear to have leaked. There is also an underground storage tank on the property that has been out of use for several years. The Phase I recommends further investigation of the soil and groundwater near the drum storage and underground storage tank areas.
When the potential new tenant receives the Phase I report, it backs out of the deal. MFG denies that it has violated any environmental laws and claims that it is not responsible for further testing or remediation. Even assuming that the landlord can require MFG to pay for the additional soil and groundwater testing and any required remediation, and that MFG is an ongoing entity with assets that the landlord can reach if MFG fails to complete the remediation, the landlord has already lost half the battle. Because it did not anticipate the environmental problem, the landlord has squandered its opportunity to secure a new tenant prior to the end of the existing tenant's lease term and its stream of rental income will be unnecessarily interrupted for an extended period.
In this hypothetical, MFG's lease failed to address adequately the potential for environmental problems at the premises. If a landlord knows that a tenant's operations could have environmental implications, it must carefully consider the terms of the lease relating to the tenant's environmental obligations. Rather than take a passive approach ' requiring the tenant to cleanup the premises only if it receives notice of a violation ' the landlord should require the tenant to conduct periodic testing throughout the term so the condition of the property does not come as a surprise at the end of the term. If the tenant fails to perform the testing as required, the landlord should have the ability to perform the testing for the tenant and charge the cost as additional rent. Just as important, however, MFG's lease also ignores the critical issue of timing in relation to the landlord's marketing efforts.
Environmental Remediation
An environmental remediation can take a significant period of time to complete and is likely to scare away potential new tenants. (Remember the image of workers passing by in hazmat suits as a landlord tries to show a property to a potential tenant.) In order to ensure that remediation activities do not hinder efforts to re-market their premises, landlords should require that any remediation be completed well before the end of their tenants' lease terms.
Timing can be a critical factor in other contexts as well. For example, tenants are often required to repair their premises after a casualty such as a fire or flood. Surrender clauses generally do not specifically refer to repair of casualty damages, but they often do require that the tenant surrender the premises at the end of the lease term in compliance with all of the terms of the lease. As with the aforementioned environmental hypothetical, however, the timing of the tenant's obligation to repair any casualty damage may be critical to the landlord's efforts to re-market the premises. If the tenant fails to cleanup any smoke or water damage resulting from a fire or flood, the premises may not appear appealing to potential new tenants and, as a result, prevent the landlord from finding a replacement tenant. As with a tenant's obligation to cure environmental problems, a tenant's obligations to repair damages arising from a casualty and generally to maintain the condition and appearance of the premises should be satisfied well before the end of the lease term in order to aid the landlord's re-marketing efforts.
Non-compliant Tenants
Another critical issue for landlords to consider is whether their remedies against non-compliant tenants are sufficient to protect their stream of rental income. As the end of the lease term approaches, some of the landlord's traditional remedies ' such as terminating the lease ' will likely be of little value. Similarly, if the landlord is in danger of losing a new tenant, the forfeit of the prior tenant's security deposit may do little to make up for the lost rental income and will not provide motivation for the tenant if the cost to comply with the landlord's demands is greater than the amount of the security deposit. Leases often prohibit the collection of consequential damages and, depending upon the circumstances, actual damages may be difficult to prove. In fact, if the tenant's obligations are not clearly established in the lease, the landlord may not even be able to prove that the tenant is liable for the landlord's damages in the first place.
What Landlords Should Do
Landlords may avoid some of the problems discussed in this hypothetical by changing the manner in which they view tenants and their obligations as the end of the lease term approaches. In order for a landlord to re-market its property successfully under an existing lease, many of the tenant's obligations with respect to the condition of the premises should be addressed well before the lease expires so that the search for new tenants is not hindered by the condition of the premises or the existing tenant's late efforts to comply with its obligations. If a tenant fails to comply with such obligations within the time required, landlords should consider treating such tenants as de facto holdovers and applying holdover-like remedies.
Why? If a tenant's failure to maintain its premises as required hinders the landlord's ability to remarket the premises or delays the commencement of a new tenant's lease, the potential harm to the landlord is similar to the typical holdover scenario in which a tenant's refusal to vacate its premises interferes with the landlord's ability move a new tenant into the premises or gives rise to a defense against the payment of rent. In either case, the landlord's continuing stream of rental income is jeopardized. Adding the ability to charge holdover rent to the landlord's arsenal of remedies will help to ensure that a tenant is properly motivated to satisfy its obligations and that the landlord will be compensated for lost income resulting from the tenant's non-compliance.
In any context, a landlord's goal is the same: to ensure that it has the ability to market its premises successfully as the end of an existing tenant's lease term approaches and to ensure that the remedies available to it at the end of the lease term are adequate to protect its interests and to motivate the tenant to fulfill its obligations.
Conclusion
Requiring tenants to comply with their obligations as to the condition of the premises well before the end of their lease terms will help protect the ability of landlords to re-market their premises. Applying the de facto holdover approach can add some teeth to the remedies available to landlords at the end of the lease term. Although a novel approach, holdover remedies may be the most appropriate way to compensate the landlord for its damages and to motivate the tenant to fulfill its obligations. The ability of a commercial landlord to re-market its property is fundamental to maintaining the stream of tenant revenue. With foresight and a prudently crafted surrender clause, a landlord's right to re-market their property can be protected.
Paul R. Diamond and Dara Sahebjami are attorneys in the Business Transactions Department of Chicago-based
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