Common Tenant Pitfalls in a Commercial Lease
Are you a small business owner entertaining the thought of entering into a commercial lease for your operation? If so, leases can be pretty intimidating (and dreadfully boring), and there are several common pitfalls you should be aware of. We’ll address a few of the major ones here, but it is always best to seek legal counsel when reviewing and negotiating a lease. Anyway, here are a few of my favs:
- Ensure the Lease matches the Letter of Intent (LOI). All too often I see lease agreements where the provisions do not match what was originally negotiated in the LOI. Major deal points or basic lease provisions are typically agreed to at the LOI stage. These are things like square footage, rent (including CAM’s/operating expenses, percentage rent), rental abatement, lease term and renewal periods, tenant improvement allowance, tenant use, guarantor(s), security deposits and advanced rent, signage and real estate broker commission. Now, common sense would dictate that all of the negotiated terms would be reflected in the ensuing lease agreement, right? NEWP! There is a decent shot that the lease agreement you receive from your landlord will not accurately reflect all of the terms agreed to in the LOI. Be sure to match them up to confirm the lease sets forth what you actually bargained for!
- Use. A lot of leases will be very restrictive and narrow in a tenant’s use of leased space. For example, if you were to open a gym or yoga studio, the use would likely be strictly limited to only operating a gym or yoga studio and no other purpose. However, in my experience, a good portion of gym and/or yoga studio owners would also like to sell merchandise, apparel, supplements, smoothies, juices, etc. from their location. As a result, it is best to include these types of items within the defined use in your lease at the outset. In addition to defining your use, it is a good idea to request an Exclusive Use provision in your lease (if one does not exist) under which your specific business is the only of its kind that may exist in the center. This may be done at the LOI stage or during the lease negotiations.
- Term. Be sure that you can live with the term (length of time) of your lease. It is also a good idea to negotiate renewal or extension periods if you believe them to be necessary. This is especially important if you are obtaining a loan to finance the buildout of your space as most lenders require the lease term to at least match the term of the loan you receive.
- Operating Expenses (CAMs). As a tenant, you are likely going to be responsible for your share of the operating expenses for the whole building or center. This is typical, but you want to make certain that the amounts you are paying are correct. You can accomplish this by requesting in your lease that the landlord provide you with annual estimates of the operating expenses. It is standard practice for landlords to provide such estimates, but more importantly, you should request true and accurate statements each year of the actual amounts paid by landlord for operating expenses in the previous year. Most leases address the breakdown of operating expenses, but some do not do so in much detail, so it makes sense to negotiate with your landlord to submit the estimates and true and accurate statements so you know that you are not being over- or undercharged.
- Maintenance. Get a clear understanding of your maintenance obligations as a tenant. For example, one big ticket item is the HVAC equipment. It’s rare that a landlord will assume responsibility for maintenance, repair, or replacement for HVAC equipment which means these (often astronomically expensive) obligations typically fall on tenants. Sometimes you can negotiate a compromise on such responsibility, but if you cannot, at very least the landlord should represent and warrant in the lease that the HVAC equipment is in good working order when you take over the space.
- Guaranty. This is a BIGGIE! A personal guaranty is the scariest part of any lease. If you are a small business, you will almost certainly be required to sign a guaranty if you want the space. Your entity (LLC, Corporation, etc.) is typically the tenant and you, as the owner, would be the guarantor. This essentially obliterates any liability protection your entity might provide you personally, as to the obligations in the lease. That means YOU are PERSONALLY responsible for the lease in its entirety, and the landlord may legally pursue you and your personal assets to satisfy anyoutstanding amounts. Landlords are not very motivated to change the guaranty, so be sure to you have a full understanding of the guaranty before you sign it.
- Tenant’s Work & Liens. Most tenants will conduct at least some sort of buildout when entering into a new lease. Keep in mind that the landlord will generally have to approve plans and the contractors used for construction. More importantly, you as the tenant, will be responsible for any liens placed on the property by your contractors and/or subcontractors. This can be a nasty, expensive and burdensome situation, so it is always a good idea to seek the help of a construction control company to ensure the project is progressing as scheduled, payments are properly made, and lien releases are timely obtained.
- Damage. We could really get in the weeds on this one, but a couple major things to note: 1) if your space is damaged (fire, flood, whatever) the landlord’s responsibility to repair usually stops once the premises is restored to grey shell condition (bare walls and floor), which means you are responsible for restoring finishes as they were prior to the damage in addition to the replacement of any damaged personal property, fixtures and/or equipment (make sure you have good insurance!); and 2) Depending on the amount of damage the building sustains, the landlord will typically have a choice to either fix it, or terminate the lease (good idea here to try and negotiate a termination right if the building is substantially damaged). If they choose to repair the damage, make sure your rent is properly abated during the process.
- Relocation. Some leases will permit the landlord to relocate you somewhere else in the building or center. Typically, landlord is not responsible for the cost of the entire relocation, and may simply place you in a new grey shell space. Personally, I detest these provisions and always delete them. That is not to say that every landlord agrees with that, but you should get the space you originally negotiated for. NO RELO!
- Subordination, Non-Disturbance, Attornment (SNDA). You will see some sort of SNDA provisions in all leases (or you should). These can be lengthy and confusing clauses, but for ease of reference, the portion of the SNDA that protects tenants is the ND (Non-Disturbance), and sometimes landlords conveniently leave these provisions out. Non-Disturbance provisions protect your leasehold interest if the landlord is foreclosed on or otherwise transfers its interest in the center or building so that the new (or successor) landlord cannot boot you out when they take over.
- Assignment and Subletting. This is important, especially if you have any plans of selling your business. A few things here. First, you will always need a landlord’s approval to assign your interest in the lease, or to sublease any portion of your space to another person or entity. Second, if you do sublease any portion of your space, ALL of the rental you collect will likely have to be paid to the landlord, including, and especially, any amount over and above your rental rate (landlords are not in the business of allowing tenants to make money on their property). Third, you, as the original tenant under the lease, are generally going to be liable for the entire lease even if you assign or sublease the space, so it is a good idea, if you plan to sell your business and assign the space to the new buyer, to negotiate, up front, a release from your obligations under the lease and guaranty once the new buyer assumes them. You don’t want to sell your business only to be tied to the lease for another 3+ years!
- Landlord’s Remedies. Second only to the Guaranty, this is the worst part of the lease. If you do not default, this should be an issue, but hey, we’re all human, right? Just be aware that if you default, the landlord has a great many options to smite you with, including re-taking the space without actually terminating the lease, and keeping you on the hook for all rental and charges moving forward. Landlords do have a duty to mitigate damages to tenants by reletting the space ASAP after a default (good idea to make sure that is expressed in the lease), but you could still be responsible for all rent and charges up to that point, as well as the cost of real estate broker commissions, marketing and advertising of the space, and any cost for construction to make the space suitable for a new tenant (there may be other liabilities as well).
There are many, many more pitfalls and convoluted provisions to be aware of in commercial lease agreements, and reading these things is probably better than taking Ambien for insomnia. As a result, I implore you to consult with an attorney to review your lease agreement, if for no other reason than to obtain a better understating of what it is you’re signing. Please contact our firm with any questions or concerns related to commercial leases or purchases. Thanks for stopping by!