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Typical Elements of a Commercial Lease Review:
Following is a transcript of a Podcast Interview of April 2018, where we explain some of what happens during a typical Commercial Real Estate Lease Review.
Craig Melby: Today, I want to talk about commercial real estate lease reviews. The process is pretty much the same whether it is an Office Lease Review, Shopping Center Lease Review, Restaurant, Medical or Industrial Lease Review. Except for a few specific items, for example Percentage Rent found in some retail leases, they all have the same basic elements, no matter the actual use.
When business owners call, they are not sure exactly what’s included in a lease review: How long does it take? What do you cover? (Am I getting my monies worth?) So, I’m here to tell you!
A good lease review should include the items we address below, whether it’s office lease, retail lease, industrial lease. As mentioned earlier – there are key elements common to any type of lease. While some of these may seem a bit of common sense, I can assure you that each one of these is an important item of discussion, and many times people have not really thought it through until we get on the phone.
Now, starting at the top of the lease. First thing we typically come to: WHO is the Tenant? Some clients start a separate entity for each location. And there’s pros and cons. I think it’s a good idea to have a separate entity. Like if you have five pizza restaurants, you might have XYZ Pizza of Dallas, LLC, and XYZ Pizza of Chicago, LLC, so you can still use the same trade name, same menu, same logo, all those things, but they’re separate entities.
You’ll want to talk to your CPA and attorney about this of course. For example, it makes your bookkeeping harder when they’re separate entities instead of just mixing and matching it all together. But maybe that’s an okay thing, you’re tracking expenses and income per location. That’s something to think about. And the other thing that my CPA explained to me was that, let’s say one of your locations got sued. Maybe someone claims to have hurt themselves in your store or office or something. And if that’s a single purpose entity and you were able to just fold up shop and keep your other entities alive and well, that’s good leverage to have when speaking to the opposing attorneys. Because a lot of these lawsuits are brought on by attorneys that work on a contingent basis, i.e. for a percentage of what they win. And if they did win something big and you alerted them that you would simply shut down the organization, then that takes a lot of incentive away. Now, you want talk to your attorney about this and see how right I am, or potentially wrong! And then call me and let me know. But that was the way it was explained to me. And if it is a single member LLC, and you lose a lawsuit and there’s a claim against the LLC, well perhaps as the managing member you can arrange it so there is never going to be any cash flow: any cash flow is going to go to the manager, in management fees. That’s the way my CPA explained it. The point is, it is interesting and something to think about, what entity you use on this lease, because it’s a big, important thing.
Speaker 2: Yeah. So basically, you can protect yourself and minimize the worst-case scenario.
Craig: Oh yeah. It’s very important and I’m always stressing to my clients that this is a big responsibility and with a detailed lease review with an expert, you can make the lease safer and more flexible depending on the things you do in the lease.
Of course, one of the advantages of using an entity that’s been around a long time and has many locations is, then it’s very likely you won’t even be asked to sign the lease personally. So that’s one advantage. And maybe you’ll have insurance to cover all these other things and it’s nothing to worry about. If you do have to then sign it personally, then of course as we talked before, we go to the back of the lease and look at the guarantee and then limit that by various ways that we’ve talked about in the past.
So that would be the very start of a typical commercial lease review: who’s on this lease? And then, usually the next item in the lease is the landlord saying, in very innocuous language, “you agree, you’ve accepted this space as-is. You’ve inspected it, you’ve accepted it. You’re taking it as is.” I know I’ve mentioned this before, but it’s amazing how every time I must advise the clients that that is not a good paragraph to leave in there or sentence. If nothing else, you just want to add a few words, which would be something like: you’re taking the space as is, “subject to building code violations or hidden defects for which the landlord will remain responsible” or something like that. Talk to your attorney. And those few words can save you massive amounts of money. I see all the time. What the tenant thought they were getting in this space was not what they got, and they had more repairs to do. And the lease is very clear. And because of the statute of frauds, which means that if it’s not in writing, it doesn’t matter, (which is a good thing, because otherwise people would be making all kinds of claims that you never agreed to).
You do want something to be true, that it’s got to be in writing or it doesn’t matter. The judge – they can’t consider intention or niceness or fairness – that doesn’t matter. What’s in the lease? It says you inspected it, you’re a sophisticated person. You took it as is. That’s your problem. So, it looks like a very simple thing and that’s one of the things that we look at and deal with as best we can. And sometimes we go round and round to keep it. A little give and take for the landlord. And it depends on how much leverage you have, how many other people want that space, what they’re willing to do, and all the other terms in the lease. There’s many ways to deal with that. But that’s just something that’s included in a commercial lease review that you want to look at. We see this issue pop up a lot, especially in shopping center leases.
S2: Yeah. I like that, because you don’t have to specify what all the mysterious things could be that will pop up later. You just add that, so that it can be handled fairly if you come to that point.
Craig: That’s right. And when it has happened in the past, we’ve gone back to the Landlord and said, “Hey, no fault of yours. But there are problems here that you didn’t know about, I’m sure. But now you have to fix them.” It’s nothing personal. They weren’t trying to cheat you. But these are Landlord problems, not Tenant problems. And so, it just depends what the lease says. You want to make sure the right words are in this word-filled document or you’re in trouble.
S2: Yeah. Because they own the building. It’s their responsibility, like you said.
Craig: Well, you would sure think. And sometimes I get a landlord that is very cocky about their space. And they have all sorts of people that want it. And it’s like, “No. You fix it. If there’s something wrong. You have to fix it, if not, I’ll lease it to somebody else.” Well, then you have a decision to make. But most landlords feel responsible for keeping their building to code, and life safety issues, and/or hidden defects or things like that. So, it’s easy to have some language put in there. Because they don’t think there’s anything wrong. You don’t think there’s anything wrong. Probably there isn’t anything wrong. But there might be. And it happens often enough.
S2: And if anyone had an inkling that there was going be something wrong, it would be the owner.
Craig: Yeah. You would think so. You would think so, but even…
S2: So, they’re keeping their mouth shut a little bit.
Craig: They could. It depends on the landlord whether you see that kind of thing or not. The landlord could just be in the dark also. Sometimes over time, building codes change. And between one tenant and another, now you’re not grandfathered-in anymore. Now the new tenant must meet newer rules and regulations. And so, you would like the landlord to take care of it or at least help take care of it. But that’s one of the things that a good commercial lease review will look at. Also, have you inspected the space, and have you picked out the right space? Let’s talk about ingress and egress, and visibility, and signage, and amenities, and parking, let’s talk about this. And I have had some clients that, after a while, even after negotiating a letter of intent, they decide, “You know what? I don’t even like this space, come to think of it.” And they move on to a different one.
S2: Yeah. Had a bad taste in their mouth.
Craig: The initial blush of this great location starts wearing off. And they think, “Well, you know, this isn’t quite right. And that’s not right. And maybe we can do better.” It’s like dating someone and then you start seeing some flaws, “You know, I’m not quite so interested anymore.”
S2: It happens! Okay, so it’s about “taking the space as is” paragraph must be fixed.
Craig: Yeah. It’s a small piece of a good office or retail lease review. So then, finally, we talk about rent. What are you comparing your rent to? Have you done the market study? What are other people paying? So, we chat about rent – it’s part of a proper commercial lease review. And then where it really gets complicated, and some people have no clue is, you start talking about lease commencement versus rent commencement. I look at it as being three separate time periods: There’s time before lease commencement. In other words, you can sign the lease, and the lease does not commence right then. So, there is some time that you would have to arrange permitting and planning and things like that that are off the books. And then there is a time after lease commencement, but before rent commencement. And then, there is when your rent commences. And then there is the free rent after that. For example,” Our rent starts in January 1st, but the first free months are free.” Or they’re discounted heavily, or you can ramp up what that rent is. So many times, it’s disaster when it’s all the same thing: You sign the lease, lease commencement, rent commencement. It’s all the same, start paying now. That’s not good. In a distant podcast we’ve done, I mentioned where some tenants I’ve heard of thought the space would be ready or they’d get their permit right away, they could do the work quickly and they were wrong. It took a long time to get their permit and do the construction, and it was a total disaster. Paying rent on a building before they’re even open is no fun at all.
S2: Yeah, so it’s not really expected that one would have to pay rent before they’re up and running. Is that basically understood?
Craig: Right, I don’t think so. So many times, the landlord will give you time to get your space in order. There’s almost always some free rent involved, and some discounted rent involved. And it’s just how you handle that. One example for instance, if you want three months free and you’re going to do a five-year lease, sometimes the landlord will say, “Well, okay, that’s fine but let’s make it a five-year and three-month lease. So, you’re still paying rent on five full years. Well, that’s fine. We got the benefits upfront. It’s free while we’re building out before the income starts coming in. By the way, depending on the other terms of the lease and who the tenant is and how soft the market is, you can get a year’s free. It just depends on what’s going on and it changes all the time and it could be changing now. I’m seeing little hints that the economy could be cooling down and soon enough it may be more of a tenant’s market than it is. Right now, it’s a landlord market and I’m seeing a lot of demand for space and a lot of competition for good space and things are filling up, so that’s all fine and good. I hope it stays that way, but I’m old enough to know it never does. There’s always cycles.
Craig: Then of course there would be what’s called the tenant improvement dollars, contributed by the Landlord. That’s not always included, although many times it is. Many times, the tenant doesn’t even know it exists and that must be added into the lease.
S2: Okay. Good to know.
Craig: And then there are things outside of the lease that we talk about. Expansion clauses and kick out clauses and what happens if the property doesn’t perform, as well as the landlord has predicted it will? Is that all your fault that not so much traffic came to the center? Like for instance, if it’s a newer office or shopping center and things just didn’t work out. So, it’s nice that it’s not all on your shoulders when you’ve been told something, and it didn’t happen.
Yes, it’s beyond your control.
Craig: Yes, and so, we have different types of suggested language and things for that in a lot of different ways. Then some of the typical things that we look at is, if the building’s damaged, how long does the landlord have to rebuild it before you can cancel a lease and go elsewhere? Because you’ve got a business to run, and many times that’s handled very poorly, so we look at that very carefully and many changes are made there.
Craig: There’s also the holdover clause, which few people think about and many times, it doesn’t impact anybody. But sometimes it impacts a lot, where if you are expanding into bigger space some day and your space isn’t ready for you, you must stay where you are longer than you expected. Many landlord leases are onerous in that. They can double your rent or more. And those are easily negotiated out.
Also, what finish-level is the space in? I did a lease review recently where the landlord is basically saying, “sign here, we’re delivering you the space. And it’s going start whenever we’re finished building it”. And so, I ask the tenant, what’s that space going to include, because this is a new building? He says, “You know, I have in my own mind what it’s going to be”. And I said, “Yeah, okay. Is it in writing? Is it part of the lease?” No. I said, “Well, it has to be, you know.” Because I can promise you that your vision for what the landlord’s going to deliver to you is not going be exactly what the landlord’s vision is. So, in this lease review, the most important thing in the lease as far as I’m concerned is, you need to attach a work letter or refer to the building plans or something, but you need it in there that “this is what is being delivered to you and it needs to be super detailed”. Are all the walls primed and ready for paint? Are they painted? Are they finished? What condition is the floor in? Is there a floor? There’s so many things that you need to look at carefully. And so, anyway, I was shocked that they were intending to do this lease without even describing what it was they were going to be receiving when this space was done.
Next was “what happens if the landlord has some delays. And it takes him two years to deliver the space to you, is that fine?” “No, that’s not fine, we need to get into business.” Well, it says here in this lease that you’re going take it when it’s ready. No limits. That had to be handled.
S2: Yeah, it’s because when you just meet someone, shake their hand to talk about things, you walk away thinking, “Okay. They’re a reasonable person, I am a reasonable person. This is going to be fine.” Like you are saying, what reasonable means to them is not what reasonable means to you.
Craig: Exactly. It may not be! You might have intended one thing, but if it’s not in writing and the builder starts running into trouble, well maybe he changes his mind and doesn’t want to provide so much, it would be a disaster waiting to happen. It would just be a disaster that you don’t need.
People don’t necessarily mean ill, but what I found, and this would be all of life is, you can’t trust people’s memory, you just cannot do it. You could trust people’s honesty and their intention but not their memory. I don’t trust my own memory! So, if I promise you that I’m going to send you some money in six months, we need to follow up with an email that says, “Hey, great talking to you, it’s my understanding that you’re going to send me $X in six months for whatever reason blah-blah-blah. That way I can go back to that email because I might think I never agreed to that, or I didn’t agree to that much money. Instead, OK, here it is, I did agree to that, here’s your money. Otherwise, I feel cheated when it was my own memory at fault!
Craig: So back to our subject. We also address gross rent versus net rent versus what are the expenses? Are they capped? What’s included? Are there things included that shouldn’t be included? Security deposits, when are they due? What’s the fair, right amount? What’s typically asked for and what really needs to be paid? Can it ever be credited back toward your rent? The Tenant’s use of the premises is also covered. Sometimes the tenants will like something that’s very, very specific that describes their use very clearly. Well, that’s not a good thing. That’s good for the landlord, but the tenant should have something broader, so they can change their offerings or their service in the future if they want to. That just gives them some freedom and flexibility, so we talk about that.
Craig: Also: maintenance. Who does what and why? Landlords typically like to have tenants take things and be responsible for them and many times there’s some changes we can make as far as what the landlords needs to maintain and where are the limits to what the tenant will do?
And the assignment clauses we talked about, if you are thinking someday you may want to bring in a partner or sell the business or other changes could happen, then it’s very likely that you need to adjust the assignment clause. Usually they’re very onerous and strict which gives landlord all authority, all power over what you do and sometimes it’s just too much. It’s like, “Hey, if I wanted to sell my business to someone smarter and richer and more experienced than me, then you need, then you should just let that happen.” Otherwise, it’s like, “No… ” I’ve seen it recently, where the landlord was, “Well, I get half of what you sell your business for that might be goodwill or asset.” And there are a lot of words in there, to the point where you could say, the half of the value of that business is because of your location, so you think you need that compensation. Right. Yeah. So, the landlord and… I think it’s overreaching by far to say, “Well, you sold your business that’s in my space and I take credit for the success of your business, so pay me some of that.” No, I don’t think so.
Well, that’s about it for now. I could go on forever, but I wanted to give people a feel for how a commercial lease review goes. I had someone call recently that asked if I did Dental Office Leases. But as you can see, these issues pertain to all leases, office, retail, industrial . . . all of them. I know, because I have done them all!
S2: Well, thanks. I think this lease review process you do on the phone is an incredible help, not only for negotiating advantageous terms but so that the renter understands the lease they’re working with so that they can better run their business. I think, merely just understanding it, is like a huge benefit to doing this lease review.
Craig: Well, I agree. When you sign this thing, you should know what you signed up for so there won’t be surprises if things happen. “Do I need to do this? Is that what I agreed to?” You don’t want that. You want it upfront knowing, if something breaks, you know right away, “Oh yeah, I have to fix that.”
Craig: I’ve said before, I’d never seen a landlord lease that is just right for the tenant. If you’re not making a lot of adjustments, you could be putting yourself at great risk, and that includes Landlords who say, “This is our standard lease we never make changes.” We always make changes.
S2: You always do? You’ve never not made a change?
Craig: We’ve never NOT made changes and failed to get them accepted by the Landlord. Now, I dealt with Walmart one time, when we were buying a closed Walmart, and they said, “Oh, you want the Walmart? Okay, here’s the contract we use, fill in the blanks, do not change a word.” And then I’m thinking, “Yeah right.” So, we changed some words. And they got back to us, “Did you not hear us the first time? You cannot change a word on this contract, you can fill in the blanks. That’s all you can do: price, who the buyer is, etc. If you want the building that’s the way it’s going to be.” Well, if you’re Walmart, I guess you can do that. But that’s the only time I’ve seen it. And that wasn’t a lease. That was a purchase.
Craig: I’m glad I happened to bring that up. Some of my listeners don’t realize I’m just as happy to do purchases. I get involved acquiring buildings for clients all the time. Mostly it’s leasing, because it’s just that the most prime real estate is for lease only, owned by a professional landlord and it’s such a complicated thing. So, that is where I spend most of my time, but I love to do acquisitions too. That’s no problem.
Okay, that’s cool. Then you could also advise people on renting versus owning. That’s interesting.
Craig: Sure, do it all the time.
S2: Well thanks, Craig.
Craig: You’re very welcome. I enjoyed it. I hope my listeners enjoyed it too.