Why Tenants Get Stuck in Bad Leases and How to Avoid It

The following is a high-level guide for corporate tenants looking for space; it includes practical tips and common pitfalls found in many commercial leases.

Start Early. Begin the planning process as soon as possible, ideally one year in advance of occupancy. Engage a commercial broker specializing in tenant representation. Notwithstanding what landlords and their brokers might say, a well-qualified tenant broker will pay for itself. An effective tenant's broker will assist clients in understanding space requirements, the effective cost of the lease, and current market conditions (including typical tenant concessions), all of which can be invaluable tools against today's formidable institutional landlord.

Understand the Economics. Depending on the asset class, commercial leases contain myriad economic terms (other than base rent) that have a substantial economic impact on the cost of occupancy. Tenants too often focus solely on the base rent and the term of the lease. However, to get a full picture of the economics of a lease, a tenant must analyze move-in costs as well as ongoing expenses. Move-in costs include typical terms such as the amount of the security deposit, lease guarantees, free rent and tenant construction allowances. A well-informed tenant can structure a reduction in the move-in costs through concepts such as the burning off of security deposits over time, and the application of the tenant improvement allowance toward things such as moving expenses and furniture, fixtures and equipment.

The long-term operating costs of a lease are much more nuanced — and potentially more economically significant. Landlords, as a matter of policy, try to pass all costs of maintaining a building onto tenants — none of whom have any material control over the administration of these costs. This shift of costs from the landlord to the tenant is accomplished through a mind-numbing list of operating expenses. Tenants should exclude certain categories of expenses (e.g., structural repairs) from this list and, more importantly, impose caps on certain controllable expenses (e.g., the management fees paid to the landlord). Finally, a tenant should look specifically at lease compliance costs, including tenant insurance, generating audited financials, after-hours HVAC and parking. Caps and limitations on most controllable lease costs and expenses can be negotiated with landlords, but tenants frequently acquiesce, seemingly because these provisions are buried deep in the body of a lease.

Build in Flexibility. As a general rule, a landlord's primary goal in commercial leasing is an uninterrupted stream of rental revenue for the duration of the lease term. However, tenants can negotiate certain provisions that mitigate the inflexibility of the landlord's position. The most obvious, and often the most expensive to a tenant, is a termination option. Perhaps more important, and more often utilized, is the ability to assign or sublet.

The landlord's initial position in almost every lease is that the tenant cannot assign or sublease without the landlord's consent, which is typically conditioned upon specific net-worth standards, subjective use restrictions, and the right to any sublease/assignment profits. With that said, when a tenant encounters financial difficulty, a sublease is often the best tool to mitigate this stress. Accordingly, a tenant may remove or limit the restrictions (e.g., permitted use restrictions) imposed on the right to sublease or assign.

Finally, tenants can enhance the flexibility of a lease by securing valuable option rights in the form of expansion and extension options. Due to their long-term nature, any flexibility a tenant can secure enhances the overall value of the lease.

Don't Ignore the Non-Economic Terms. Every lease provision in a commercial lease is there for a reason. Unexpected issues arise in the ownership and operation of a commercial building, including environmental conditions, compliance with laws, indemnities, casualty and condemnation. Every pro-landlord lease form will attempt to limit the tenant's rights and remedies, and will in fact endeavor to impose liability upon the tenant whenever possible. To be covered against these provisions, a tenant should engage a commercial leasing attorney to review and relax the pro-landlord provisions. Like the tenant broker, the upfront lease-review costs will frequently pay for themselves over the long term.

Conclusion

The world of commercial leasing has evolved, and will continue to do so over time. While landlords have become seemingly more inflexible as the years progress, there is room to negotiate. Because of the sheer duration of a commercial lease, tenants are well-advised to enlist the help of brokers and attorneys who can round the edges off of today's pro-landlord lease forms.

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Mark Foster is counsel in the Los Angeles office of Snell & Wilmer. The views expressed in the above commentary are Foster's own. This article also appeared on Globest.com, an ALM sibling publication to this newsletter.