In the Spotlight: Issues with HVAC

Normally, only retail tenants would have HVAC systems that exclusively only serve their premises, since office tenants typically share heating and air conditioning with the rest of the building.' However, for retail tenants, determining who is responsible for the maintenance, repair and possible replacement of these exclusive HVAC systems is often an issue ripe for dispute.

Exclusive HVAC Systems

It might be helpful first to have a brief primer on the basics of repair and maintenance. The old English common law for real property developed for agricultural purposes, with the land of primary importance and any physical improvements secondary. The lease was considered a conveyance of real estate from landlord to tenant for the specified term. As such, the tenant typically took the property completely “as is,” and the landlord usually had no responsibility for the condition of the property upon commencement or the maintenance of the property during the lease term. Courts in many states held that the landlord had no duty to keep the property in repair.

That said, the trend under modern jurisprudence for commercial real estate leasing has been to move away from treating leases as a pure conveyance and move towards applying contract law. As a result, depending on the jurisdiction, the landlord under a commercial lease may now be subject to maintenance requirements pursuant to certain
implied warranties (i.e., implied warranty against latent defects, implied warranty of fitness for a specific purpose, and/or an implied warranty of habitability). Because of the varying degrees of responsibility placed on the landlord absent an agreement between the parties, the language in the lease agreement becomes even more critical. For commercial leases, the courts first look to the lease in cases of dispute. As a result, lease forms have grown longer and longer as the response from landlords (who author the forms) to the greater implied rights given commercial tenants under common and statutory law. Note also that residential tenants are normally afforded much greater protection under local statutes; therefore, this article only relates to commercial real estate.

Lease provisions typically trump any applicable local law by providing that tenants are solely responsible for the maintenance and repair of HVAC systems exclusively serving their leased premises, but the landlord may have the obligation to turn the system over to the tenant in good working order. Landlords often verify that the tenants are properly maintaining their exclusive HVAC systems by requiring that the tenants enter into a service contract with a local HVAC company approved by the landlord.

Tenants normally accept this responsibility for maintaining the systems that exclusively service their premises. Often, the area of controversy is instead whether or not the tenant is forced to replace an aging HVAC system completely toward the end of their term. The tenant argues that the landlord (and thus, the new tenant taking over their space) would be unjustly enriched if the tenant installed a brand new HVAC system just prior to surrendering the premises to the landlord. Landlords reply that this risk is lessened by regularly servicing the systems, and that the tenants can always instead choose to keep the units running as opposed to purchasing a new costly installation.

One area of compromise for larger, more credit-worthy tenants, normally in the retail setting, is for landlords to agree to repay the tenant for the unamortized cost of the exclusive HVAC system installed during the last few years of the lease term. That is, the parties would agree in the lease document on the useful life the system (or agree to look to GAAP or IRS regulations), and the landlord would reimburse the tenant a portion of the cost of the replacement system, depending on how many years remained on its agreed-upon useful life. In some rare cases, the parties may agree that the tenant can instead remove the newly installed system upon the expiration of the term and take it with them to their new location. Normally, however, landlords would strenuously object to such a provision, arguing that it could damage their roof or structural integrity of the building. Landlords and tenants typically prefer the reimbursement approach.

Specialty Improvements

As mentioned above, the law is evolving to place greater obligations on landlords with respect to maintenance and repair. The landlords strike back by including onerous provisions in their commercial lease forms. Maintenance and repair of specialty improvements are no different. The form lease document, unless negotiated and revised by tenant's counsel, will provide that the tenant is responsible for any specialty systems installed by or for the tenant and exclusively serving the tenant. Tenants with complex data storage needs are often amazed to learn of the high cost of maintenance and repair. For example, some tenants may be surprised to learn of the expenses associated with older halon fire suppression systems that are increasingly obsolete, expensive to repair and even more expensive to remove.'

An even more contentious provision with respect to specialty improvements is the obligation to remove them at the expiration of the lease term. Generally, the typical landlord-authored lease form requires that the tenant surrender the premises in the same condition as received from the landlord, reasonable wear and tear excepted. Landlords are normally given the further flexibility to designate at their convenience which improvements can remain on the premises after expiration. From a practical standpoint, landlords are normally happy to allow the standard office leasehold improvements (e.g., interior office demising walls, cubicles, conference rooms, standard flooring, etc.) to remain on the premises upon the expiration of the term.

Even if such improvements were installed by or on behalf of the tenant, the premises are more valuable with those improvements in place and the landlord is saved the cost of paying for their installation again. But for the non-standard leasehold improvements, the landlord will normally require that the tenant remove those alterations and return the premises to the condition existing prior to the date of the lease. Exceptions include medical offices for certain purposes (dental offices, for example), where the improvements are costly and in demand, so landlords typically allow those alterations to remain.

Compromise Control

While landlords enjoy completely controlling the decision over what alterations stay, it is unfair to larger tenants not to know whether or not they are obligated to remove and restore improvements in connection with their surrender. Larger national tenants will insist on advanced knowledge. The following suggestions for compromise language should make sense for both parties.

First, for the initial tenant improvements installed prior to the commencement of the term, the lease or the work letter should clearly provide, as of the date of the lease, whether or not the tenant is obligated to remove the improvements at the expiration of the term. As discussed above, for typical office improvements, most landlords will agree that no removal is required.

Second, for alterations installed by or on behalf of tenant during the lease term, the lease should provide that the landlord must notify the tenant at the time it provides its consent to such alterations, whether or not those later alterations must be removed at the time of surrender. Such a provision, while still giving the landlord the ultimate say, at least protects the tenant by giving it plenty of advance notice for
planning and budgeting purposes.

Third, for larger tenants with more leverage, the parties could agree ahead of time which types of future improvements can remain on the premises. An example of this type of provision is as follows:

Notwithstanding the foregoing, so long as the requested Alterations (i) involve improvements to the Premises which are typical for first-class office buildings; (ii) do not involve changes to the Building Systems or the Building Structure; and (iii) do not involve the installation of raised floors, supplemental HVAC systems or any other “special equipment” in the Premises, Landlord shall not require Tenant to remove such Alterations upon the expiration or earlier termination of the Term which have been approved by Landlord.

Last, the tenant could push for language in the lease that any of tenant's network cabling can remain in the premises at expiration. Landlords increasingly object to such provisions, arguing that cabling quickly becomes obsolete as technology evolves and is of little use to the next occupant of the space.'

Conclusion

It would benefit both landlords and tenants to stipulate carefully in the lease the respective repair, maintenance and surrender obligations with respect to specialty leasehold improvements or exclusive HVAC systems. Disputes are more common when one party is surprised or the language is unclear.

John G. Kelly, a member of this newsletter's Board of Editors, is a partner with Bean Kinney & Korman, PC, in Arlington, VA.

Disputes over specialized tenant improvements or exclusive heating and air conditioning systems are common in commercial leasing. Landlords and tenants often argue over maintenance and repair obligations, or whether or not such specialized tenant improvements can remain on the premises upon the expiration of the term or if the tenant is obligated to remove the alterations at the tenant's sole cost. Landlords often require such alterations be removed and the premises restored to their original condition while tenants would obviously prefer not to have to incur such large move-out expenses. With respect to exclusive heating and air conditioning systems (HVAC), typically the argument between landlords and tenants is whether or not the tenant must incur significant expenses maintaining and/or replacing a defective unit toward the end of the term at its sole cost for the benefit of the subsequent tenant of the premises. This article discusses the typical approaches to these issues, and offers suggested compromise language for office and retail commercial leases.

Types of Improvements

“Specialized tenant improvements,” as used in this article, refers to those tenant improvements that go beyond the typical office/cubicle layout for office leases, or typical fixtures or build-outs for retail tenants. For example, a tenant with sophisticated data storage needs could have supplemental HVAC systems or advanced fire suppression systems. Larger multi-floor tenants could have interior stairwells or raised floors. Many commercial tenants have unique telecom needs with extensive cabling and wiring, and medical office tenants have various types of expensive build-outs unique to their specialty.

Normally, only retail tenants would have HVAC systems that exclusively only serve their premises, since office tenants typically share heating and air conditioning with the rest of the building.' However, for retail tenants, determining who is responsible for the maintenance, repair and possible replacement of these exclusive HVAC systems is often an issue ripe for dispute.

Exclusive HVAC Systems

It might be helpful first to have a brief primer on the basics of repair and maintenance. The old English common law for real property developed for agricultural purposes, with the land of primary importance and any physical improvements secondary. The lease was considered a conveyance of real estate from landlord to tenant for the specified term. As such, the tenant typically took the property completely “as is,” and the landlord usually had no responsibility for the condition of the property upon commencement or the maintenance of the property during the lease term. Courts in many states held that the landlord had no duty to keep the property in repair.

That said, the trend under modern jurisprudence for commercial real estate leasing has been to move away from treating leases as a pure conveyance and move towards applying contract law. As a result, depending on the jurisdiction, the landlord under a commercial lease may now be subject to maintenance requirements pursuant to certain
implied warranties (i.e., implied warranty against latent defects, implied warranty of fitness for a specific purpose, and/or an implied warranty of habitability). Because of the varying degrees of responsibility placed on the landlord absent an agreement between the parties, the language in the lease agreement becomes even more critical. For commercial leases, the courts first look to the lease in cases of dispute. As a result, lease forms have grown longer and longer as the response from landlords (who author the forms) to the greater implied rights given commercial tenants under common and statutory law. Note also that residential tenants are normally afforded much greater protection under local statutes; therefore, this article only relates to commercial real estate.

Lease provisions typically trump any applicable local law by providing that tenants are solely responsible for the maintenance and repair of HVAC systems exclusively serving their leased premises, but the landlord may have the obligation to turn the system over to the tenant in good working order. Landlords often verify that the tenants are properly maintaining their exclusive HVAC systems by requiring that the tenants enter into a service contract with a local HVAC company approved by the landlord.

Tenants normally accept this responsibility for maintaining the systems that exclusively service their premises. Often, the area of controversy is instead whether or not the tenant is forced to replace an aging HVAC system completely toward the end of their term. The tenant argues that the landlord (and thus, the new tenant taking over their space) would be unjustly enriched if the tenant installed a brand new HVAC system just prior to surrendering the premises to the landlord. Landlords reply that this risk is lessened by regularly servicing the systems, and that the tenants can always instead choose to keep the units running as opposed to purchasing a new costly installation.

One area of compromise for larger, more credit-worthy tenants, normally in the retail setting, is for landlords to agree to repay the tenant for the unamortized cost of the exclusive HVAC system installed during the last few years of the lease term. That is, the parties would agree in the lease document on the useful life the system (or agree to look to GAAP or IRS regulations), and the landlord would reimburse the tenant a portion of the cost of the replacement system, depending on how many years remained on its agreed-upon useful life. In some rare cases, the parties may agree that the tenant can instead remove the newly installed system upon the expiration of the term and take it with them to their new location. Normally, however, landlords would strenuously object to such a provision, arguing that it could damage their roof or structural integrity of the building. Landlords and tenants typically prefer the reimbursement approach.

Specialty Improvements

As mentioned above, the law is evolving to place greater obligations on landlords with respect to maintenance and repair. The landlords strike back by including onerous provisions in their commercial lease forms. Maintenance and repair of specialty improvements are no different. The form lease document, unless negotiated and revised by tenant's counsel, will provide that the tenant is responsible for any specialty systems installed by or for the tenant and exclusively serving the tenant. Tenants with complex data storage needs are often amazed to learn of the high cost of maintenance and repair. For example, some tenants may be surprised to learn of the expenses associated with older halon fire suppression systems that are increasingly obsolete, expensive to repair and even more expensive to remove.'

An even more contentious provision with respect to specialty improvements is the obligation to remove them at the expiration of the lease term. Generally, the typical landlord-authored lease form requires that the tenant surrender the premises in the same condition as received from the landlord, reasonable wear and tear excepted. Landlords are normally given the further flexibility to designate at their convenience which improvements can remain on the premises after expiration. From a practical standpoint, landlords are normally happy to allow the standard office leasehold improvements (e.g., interior office demising walls, cubicles, conference rooms, standard flooring, etc.) to remain on the premises upon the expiration of the term.

Even if such improvements were installed by or on behalf of the tenant, the premises are more valuable with those improvements in place and the landlord is saved the cost of paying for their installation again. But for the non-standard leasehold improvements, the landlord will normally require that the tenant remove those alterations and return the premises to the condition existing prior to the date of the lease. Exceptions include medical offices for certain purposes (dental offices, for example), where the improvements are costly and in demand, so landlords typically allow those alterations to remain.

Compromise Control

While landlords enjoy completely controlling the decision over what alterations stay, it is unfair to larger tenants not to know whether or not they are obligated to remove and restore improvements in connection with their surrender. Larger national tenants will insist on advanced knowledge. The following suggestions for compromise language should make sense for both parties.

First, for the initial tenant improvements installed prior to the commencement of the term, the lease or the work letter should clearly provide, as of the date of the lease, whether or not the tenant is obligated to remove the improvements at the expiration of the term. As discussed above, for typical office improvements, most landlords will agree that no removal is required.

Second, for alterations installed by or on behalf of tenant during the lease term, the lease should provide that the landlord must notify the tenant at the time it provides its consent to such alterations, whether or not those later alterations must be removed at the time of surrender. Such a provision, while still giving the landlord the ultimate say, at least protects the tenant by giving it plenty of advance notice for
planning and budgeting purposes.

Third, for larger tenants with more leverage, the parties could agree ahead of time which types of future improvements can remain on the premises. An example of this type of provision is as follows:

Notwithstanding the foregoing, so long as the requested Alterations (i) involve improvements to the Premises which are typical for first-class office buildings; (ii) do not involve changes to the Building Systems or the Building Structure; and (iii) do not involve the installation of raised floors, supplemental HVAC systems or any other “special equipment” in the Premises, Landlord shall not require Tenant to remove such Alterations upon the expiration or earlier termination of the Term which have been approved by Landlord.

Last, the tenant could push for language in the lease that any of tenant's network cabling can remain in the premises at expiration. Landlords increasingly object to such provisions, arguing that cabling quickly becomes obsolete as technology evolves and is of little use to the next occupant of the space.'

Conclusion

It would benefit both landlords and tenants to stipulate carefully in the lease the respective repair, maintenance and surrender obligations with respect to specialty leasehold improvements or exclusive HVAC systems. Disputes are more common when one party is surprised or the language is unclear.

John G. Kelly, a member of this newsletter's Board of Editors, is a partner with Bean Kinney & Korman, PC, in Arlington, VA.