Representing Tax-Exempt Organizations in Lease Negotiations

Whether it is the proposed landlord or the proposed tenant, a tax-exempt organization's motives for entering into the lease negotiation may be very similar to the desires that motivate typical for-profit organizations or individuals. For example, a start-up tax-exempt tenant may have determined that the relatively lower up-front cost of leasing will allow it to move forward with its operations more quickly than waiting until it has enough cash or reasonably priced financing (or both) to build its own space. Or, the tax-exempt organization may have decided that the lower up-front costs of leasing will allow it to create a cash reserve to provide greater flexibility and more security in a tough economic climate. Finally, a tax-exempt landlord may have chosen to make space available for lease as a result of an unexpected reduction in its own operations or funding sources.

On the other hand, tax-exempt tenants and landlords may have other unique motivations for leasing space, which are particular to their mission or vision. For example, a tax-exempt tenant's main grant source might permit the allocation of grant funds for rental payments, but prohibit their use for debt service. Or, the tax-exempt tenant may have decided to lease rather than own space because it does not have the additional resources and skills to devote to managing the upkeep and operation of the property. This may be especially true if the tax-exempt tenant's mission is not real estate-related.

Unlike its for-profit counterpart, a tax-exempt landlord may not be offering space for rent primarily for the purpose of generating income. For example, a tax-exempt landlord that owns more space than its current operations require may be motivated to lease space to another tax-exempt organization out of a desire to share a portion of its space with a tax-exempt tenant whose mission complements its own. Similarly, it may desire to share space with a tax-exempt organization which serves a population similar to its own. Or, a tax-exempt landlord may desire to lease space in an attempt to bring greater stability and investment to the neighborhood in which it works.

Client Preparation and Expectations

While a typical for-profit client may have experience with lease negotiations or the benefit of an experienced broker, often the tax-exempt organization will not have this advantage and may, therefore, rely more heavily upon its attorney. In addition, representing a tax-exempt organization often means representing a group of decision-makers rather than an individual decision-maker. Thus, helping the tax-exempt organization both to develop realistic expectations about the lease negotiation process and understand the role of the attorney in that process will help the attorney to manage and meet client expectations effectively. In addition, having such a discussion early in the negotiation process can have the added benefit of helping the client identify areas in which it may have more leverage than it initially thought.

Whether representing a tax-exempt landlord or a tax-exempt tenant, it is likely that the client will have an even greater desire than its for-profit counterpart to avoid the time delay and costs associated with protracted lease negotiations. Tax-exempt organizations ' especially those that are newly established ' typically have even less capacity than similar for-profit clients to spend money on legal fees for lease negotiations. Therefore, when representing the tax-exempt organization in lease negotiations, one cost-management strategy that may be employed is to identify early in the process those issues of greatest importance to the client and to focus negotiation efforts on those issues. Of course, if this strategy is used, it is important to discuss with the client the risks associated with such a strategy (e.g., the more limited focus may result in some issues not being fully considered). Further, it is still important to raise all concerns and risks with the client throughout the negotiation process, even if those concerns are outside of the areas identified by the client as being of greatest importance. Effective representation always includes good communication with the client throughout the negotiation process to determine whether the areas initially identified by the client as being of greatest concern have changed.

Market Conditions

As with all lease negotiations, it is essential to help a tax-exempt client understand the particular market conditions specific to the lease (e.g., the economic climate, the availability of similar spaces, the local customs, the amount of rent being paid, the size of the space, the length of the term, and so forth) and the impact of those conditions on the client's potential negotiation leverage.

One important practical and inexpensive step that a tax-exempt tenant can take before substantial legal fees are incurred is to perform basic fact-gathering about the premises. For example, the tax-exempt tenant can investigate whether the entity that the client believes owns the premises does, in fact, actually own the premises and can obtain a copy of the certificate of occupancy. This is especially important in situations where a tax-exempt tenant may not have enough leverage to get a representation and warranty from the landlord in the lease as to ownership of the premises. In addition, the tax-exempt tenant can investigate zoning and other local ordinances applicable to the premises to ensure the landlord is not prohibited from leasing the premises and to confirm that the tenant's proposed use will be permitted.

Financial Considerations and Exit Strategies

Like their for-profit counterparts, tax-exempt landlords and tenants should consider issues related to creditworthiness and exit strategies in lease negotiations. While many of the same considerations apply, there are some unique circumstances which should be considered.

First, the decision to lease space to a tax-exempt organization is, in many ways, similar to the decision to lease space to a for-profit entity. Because tax-exempt organizations typically are run by volunteer board members and do not ordinarily have an easily identifiable individual willing to undertake the risk involved in signing a personal guaranty for the lease, it is unlikely that a landlord will be able to obtain a personal guaranty. Therefore, a landlord and tenant should be prepared to deal with this risk in some other manner. For example, the parties could agree upon a larger security deposit, which is reduced over the term of the lease as the creditworthiness of the tenant is established and the risk of non-payment is reduced.

Second, the parties should consider how a tax-exempt tenant's unexpected loss or decrease in funding could impact its ability to pay rent and other expenses under the lease. If the tax-exempt tenant has enough leverage, it may be able to persuade the landlord to provide it with a termination right triggered by such changed circumstances. Or, the parties may be able to negotiate a shorter initial term with several short renewal periods to allow the tenant to re-evaluate its operational needs and available funding and avoid over-extending its commitments. A landlord that has already taken into account the economic risks of leasing to a tax-exempt tenant may not necessarily oppose these types of provisions, especially because the failure to include such rights will likely do nothing more than leave the landlord with a defaulting, often judgment-proof and sympathetic tenant.

Alternatively, a tax-exempt tenant might attempt to mitigate the risk of the loss of its funding by negotiating the right to sublease or assign with the broadest permitted use clause acceptable to the landlord. In this way, the tax-exempt tenant can maximize the universe of potential sublessees or assignees that would be available to it in the event the tax-exempt organization is faced with a need to reduce or change its operations as a result of unexpected funding changes.

Conclusion

When one or more parties to a lease is anticipated to be a tax-exempt organization, effective lease negotiations require consideration of the tax-exempt organization's motives for entering into the transaction, the expectations and available resources of the tax-exempt organization, and creative exit strategies. Representing a tax-exempt landlord or tenant in lease negotiations can present special challenges, but can also make for a very personally rewarding experience.

Dana Malkus formerly practiced as an associate with Lewis, Rice & Fingersh, L.C. in St. Louis, where she focused her practice on real estate and general corporate matters. Ms. Malkus is now an Assistant Clinical Professor of Law at Saint Louis University School of Law, where she supervises students performing transactional work in the Law School Clinic, and teaches a related clinic class.

When a real estate attorney is asked to assist a client with lease negotiations, the proposed landlord and tenant typically are individuals acting in their separate capacities, or taxpayer entities such as corporations, partnerships, or limited liability companies. However, nearly every real estate attorney will, at some point, find him- or herself involved in lease negotiations in which the landlord or the tenant is a tax-exempt organization. While many of the same principles that apply to lease negotiations between taxpaying individuals or entities also apply to lease negotiations involving one or more tax-exempt organizations, there are some additional considerations the real estate attorney should consider when assisting a client in such negotiations.

In “Tax Issues for Real Estate Leasing by Tax-Exempt Organizations,” the first in a series that appeared in the March 2009 issue of this newsletter, Michael Huft and Nina Knierim explained some of the tax considerations that tax-exempt landlords should consider when leasing real estate to third-party tenants. Other articles followed; the final article will appear in an upcoming issue. The primary issues examined in those articles were how to structure the lease payments or the relationship with the developer of the land to avoid having payments to the tax-exempt organization subject to tax for engaging in an business unrelated to the organization's exempt purpose. This article provides an overview of some of the other issues to be considered in lease negotiations involving one or more tax-exempt organizations. Specifically, effective lease negotiations require consideration of the tax-exempt organization's motives for entering into the transaction, the expectations and available resources of the tax-exempt organization, and viable exit strategies.

Understanding Motivations

Whether it is the proposed landlord or the proposed tenant, a tax-exempt organization's motives for entering into the lease negotiation may be very similar to the desires that motivate typical for-profit organizations or individuals. For example, a start-up tax-exempt tenant may have determined that the relatively lower up-front cost of leasing will allow it to move forward with its operations more quickly than waiting until it has enough cash or reasonably priced financing (or both) to build its own space. Or, the tax-exempt organization may have decided that the lower up-front costs of leasing will allow it to create a cash reserve to provide greater flexibility and more security in a tough economic climate. Finally, a tax-exempt landlord may have chosen to make space available for lease as a result of an unexpected reduction in its own operations or funding sources.

On the other hand, tax-exempt tenants and landlords may have other unique motivations for leasing space, which are particular to their mission or vision. For example, a tax-exempt tenant's main grant source might permit the allocation of grant funds for rental payments, but prohibit their use for debt service. Or, the tax-exempt tenant may have decided to lease rather than own space because it does not have the additional resources and skills to devote to managing the upkeep and operation of the property. This may be especially true if the tax-exempt tenant's mission is not real estate-related.

Unlike its for-profit counterpart, a tax-exempt landlord may not be offering space for rent primarily for the purpose of generating income. For example, a tax-exempt landlord that owns more space than its current operations require may be motivated to lease space to another tax-exempt organization out of a desire to share a portion of its space with a tax-exempt tenant whose mission complements its own. Similarly, it may desire to share space with a tax-exempt organization which serves a population similar to its own. Or, a tax-exempt landlord may desire to lease space in an attempt to bring greater stability and investment to the neighborhood in which it works.

Client Preparation and Expectations

While a typical for-profit client may have experience with lease negotiations or the benefit of an experienced broker, often the tax-exempt organization will not have this advantage and may, therefore, rely more heavily upon its attorney. In addition, representing a tax-exempt organization often means representing a group of decision-makers rather than an individual decision-maker. Thus, helping the tax-exempt organization both to develop realistic expectations about the lease negotiation process and understand the role of the attorney in that process will help the attorney to manage and meet client expectations effectively. In addition, having such a discussion early in the negotiation process can have the added benefit of helping the client identify areas in which it may have more leverage than it initially thought.

Whether representing a tax-exempt landlord or a tax-exempt tenant, it is likely that the client will have an even greater desire than its for-profit counterpart to avoid the time delay and costs associated with protracted lease negotiations. Tax-exempt organizations ' especially those that are newly established ' typically have even less capacity than similar for-profit clients to spend money on legal fees for lease negotiations. Therefore, when representing the tax-exempt organization in lease negotiations, one cost-management strategy that may be employed is to identify early in the process those issues of greatest importance to the client and to focus negotiation efforts on those issues. Of course, if this strategy is used, it is important to discuss with the client the risks associated with such a strategy (e.g., the more limited focus may result in some issues not being fully considered). Further, it is still important to raise all concerns and risks with the client throughout the negotiation process, even if those concerns are outside of the areas identified by the client as being of greatest importance. Effective representation always includes good communication with the client throughout the negotiation process to determine whether the areas initially identified by the client as being of greatest concern have changed.

Market Conditions

As with all lease negotiations, it is essential to help a tax-exempt client understand the particular market conditions specific to the lease (e.g., the economic climate, the availability of similar spaces, the local customs, the amount of rent being paid, the size of the space, the length of the term, and so forth) and the impact of those conditions on the client's potential negotiation leverage.

One important practical and inexpensive step that a tax-exempt tenant can take before substantial legal fees are incurred is to perform basic fact-gathering about the premises. For example, the tax-exempt tenant can investigate whether the entity that the client believes owns the premises does, in fact, actually own the premises and can obtain a copy of the certificate of occupancy. This is especially important in situations where a tax-exempt tenant may not have enough leverage to get a representation and warranty from the landlord in the lease as to ownership of the premises. In addition, the tax-exempt tenant can investigate zoning and other local ordinances applicable to the premises to ensure the landlord is not prohibited from leasing the premises and to confirm that the tenant's proposed use will be permitted.

Financial Considerations and Exit Strategies

Like their for-profit counterparts, tax-exempt landlords and tenants should consider issues related to creditworthiness and exit strategies in lease negotiations. While many of the same considerations apply, there are some unique circumstances which should be considered.

First, the decision to lease space to a tax-exempt organization is, in many ways, similar to the decision to lease space to a for-profit entity. Because tax-exempt organizations typically are run by volunteer board members and do not ordinarily have an easily identifiable individual willing to undertake the risk involved in signing a personal guaranty for the lease, it is unlikely that a landlord will be able to obtain a personal guaranty. Therefore, a landlord and tenant should be prepared to deal with this risk in some other manner. For example, the parties could agree upon a larger security deposit, which is reduced over the term of the lease as the creditworthiness of the tenant is established and the risk of non-payment is reduced.

Second, the parties should consider how a tax-exempt tenant's unexpected loss or decrease in funding could impact its ability to pay rent and other expenses under the lease. If the tax-exempt tenant has enough leverage, it may be able to persuade the landlord to provide it with a termination right triggered by such changed circumstances. Or, the parties may be able to negotiate a shorter initial term with several short renewal periods to allow the tenant to re-evaluate its operational needs and available funding and avoid over-extending its commitments. A landlord that has already taken into account the economic risks of leasing to a tax-exempt tenant may not necessarily oppose these types of provisions, especially because the failure to include such rights will likely do nothing more than leave the landlord with a defaulting, often judgment-proof and sympathetic tenant.

Alternatively, a tax-exempt tenant might attempt to mitigate the risk of the loss of its funding by negotiating the right to sublease or assign with the broadest permitted use clause acceptable to the landlord. In this way, the tax-exempt tenant can maximize the universe of potential sublessees or assignees that would be available to it in the event the tax-exempt organization is faced with a need to reduce or change its operations as a result of unexpected funding changes.

Conclusion

When one or more parties to a lease is anticipated to be a tax-exempt organization, effective lease negotiations require consideration of the tax-exempt organization's motives for entering into the transaction, the expectations and available resources of the tax-exempt organization, and creative exit strategies. Representing a tax-exempt landlord or tenant in lease negotiations can present special challenges, but can also make for a very personally rewarding experience.

Dana Malkus formerly practiced as an associate with Lewis, Rice & Fingersh, L.C. in St. Louis, where she focused her practice on real estate and general corporate matters. Ms. Malkus is now an Assistant Clinical Professor of Law at Saint Louis University School of Law, where she supervises students performing transactional work in the Law School Clinic, and teaches a related clinic class.