Without Careful Consideration and Counsel, Commercial Leases – Even For A Small Amount of Space – Can Lead to Big Headaches for Tenants
September 14, 2022 | Sherrard Roe Blog I Scott W. Fielding
As the COVID-19 pandemic ebbs, workers are flowing back into offices. Businesses that pivoted to remote work for the better part of two years want to bring their employees together again. That means companies need space to work, meet, welcome clients, provide storage, and otherwise facilitate ongoing operations. And most businesses looking for a home will ultimately choose to lease space rather than purchase it.
Since small commercial leases don’t involve as much capital investment or long-term commitment as fee simple ownership, prospective commercial tenants may approach a leasing transaction and proposed lease without the careful consideration they deserve. Similarly, businesses may enter into a small lease agreement without legal representation, fearing the legal costs involved or believing the landlord gave them a non-negotiable lease.
But being cavalier about the terms of a commercial lease or failing to consult counsel before signing on the dotted line is a mistake. Even commercial leases for a small amount of space can involve large and ongoing commitments, affirmative and negative covenants, and expenses that last many years. A business that does not consider the implications of commercial lease terms, even and especially provisions that seem like “boilerplate,” can find itself locked into a disastrous deal that will have them longing for the days of Zoom meetings.
Here are just a few of the essential issues tenants should consider when entering into a small commercial lease.
Personal Guarantee
Probably the most important legal point in any lease for a business owner (other than the amount of rent to be paid) is whether it will include a personal guaranty. This issue needs to be resolved at the outset – the term sheet or letter of intent stage – because a guaranty requirement will be a dealbreaker for some tenants. Even if a guaranty is involved, however, the tenant should consider negotiating limitations to the guaranty, maybe there is a cap, maybe it ends after a certain period, maybe the guaranteed obligations are more limited.
Tenant Improvement Costs and Allowances
As an inducement to enter into a lease, the landlord often provides the tenant an allowance for the buildout of its space, which may or may not cover the buildout cost. Because of the uncertainty in buildout costs, the tenant should consider completing enough design work to receive meaningful quotes from contractors for the buildout cost before executing the lease. The tenant should also carefully review and negotiate whether the tenant improvement allowance can be used for soft costs and costs of fixtures or equipment. The tenant should require the landlord to receive competitive bids for the construction work.
Rent Commencement Date
If the tenant handles the buildout – meaning the tenant engages the contractor to do the buildout- the tenant’s rent obligation will typically start on a fixed date, regardless of whether the tenant has completed its improvements. But if the landlord handles the buildout, the rent commencement date will likely be keyed to the date the landlord substantially completes tenant improvements.
Tenants need to consider whether they want the responsibilities involved in supervising a buildout and whether they need to be in their space by a specific date. If the tenant needs to be in the space by a set date, revisions to the lease are likely necessary to create a legal incentive for the landlord to meet that deadline (assuming it is handling the buildout). Additional issues related to rate abatement and other remedies if improvements do not proceed as promised must also be addressed.
Exit Issues (Assignment and Subletting)
Especially with a long-term lease, there may come a time when the tenant does not need all the space – or any of the space – it has leased or needs to reduce its costs for economic reasons. Accordingly, the right to assign or sublease the space – and the approval standard of the landlord regarding a proposed assignment or sublease – must be clearly set forth in the lease. This can be a complicated section of a lease agreement and a lawyer’s review (and discussion with the tenant) can provide real benefits to the tenant.
Operating Expenses
The lease can require the landlord to pay all operating expenses (a “gross lease”) or the tenant to pay all such costs (a “net lease”). However, operating expenses are usually shared between the landlord and the tenant, with the tenant responsible for its proportionate share of the increase in operating expenses over the same operating expenses in a base year (a “modified gross lease”). The lease should clearly define what constitutes “operating expenses,” how they are calculated, and whether there is any cap on the tenant’s obligations (or cap on the increase in controllable operating expenses). There are certain operating expenses, like most capital improvements, which should be excluded from operating expenses.
Notice and Opportunity to Cure Defaults
In addition to the obligation to pay rent, the typical lease includes many covenants, rules, regulations, and restrictions with which the tenant must comply. Since the breach of any of these provisions is a default (perhaps leading to a termination of the lease and a requirement that the tenant leave the building!!), the tenant should seek the right to receive notice from the landlord and a reasonable grace period/opportunity to cure before any breach becomes an “event of default” that allows the landlord to exercise remedies. The tenant should try to negotiate a duty to mitigate damages should the landlord call a default and exercise remedies.
There are other issues a prospective tenant needs to consider, including renewal terms and insurance requirements, subrogation rights, and non-disturbance agreements with the landlord’s lender, all of which are critical to protecting the tenant’s rights in the event of a physical or financial catastrophe. In addition, any lease can contain unexpected provisions – like a relocation right – which a review by a lawyer will uncover.
If you are considering entering into a commercial lease, make a wise business decision by engaging counsel to review. It will help protect your business investment and provide some peace of mind.
