More Commercial Lease Pitfalls for Tenants

In the second of a two-part article on negotiation hot buttons, the authors cover operating expenses, repairs, restoration obligations and regulatory compliance.

In the first part of our article, we highlighted four less apparent lease issues that tenant representatives should not miss during lease negotiations. This article continues with four additional issues, which, if not negotiated favorably in a lease, could result in avoidable tenant costs.

Operating Expenses

Often the building’s operating expenses are passed through to the tenant as “additional rent.” This may include the landlord’s operating expenses, real estate taxes and utility charges. During negotiations, the tenant should request evidence of the building’s operating expense and tax history for the past several years, so the tenant can understand the likely costs, and annual increases, it will incur during the lease term.

Further, during term sheet negotiations, the tenant should negotiate for a “base year,” which sets the benchmark upon which the operating expenses, including taxes, are measured against, so that the tenant only is responsible for paying its proportionate share of the increase in the building’s operating expenses over the amount incurred in the base year. The tenant should be mindful, however, that the base year is not artificially deflated. For example, if there is a major building renovation planned or in progress, that will not impact operating expenses until a succeeding year, and will create an artificially low base year. Additionally, it is typical to have operating expenses “grossed up,” i.e., calculating operating expenses based on a specified occupancy rate (often 95% is used) if the actual occupancy rate of the building falls below that level. It is important for the tenant to confirm the base year is likewise grossed up.

Leases often have long and detailed lists of what is included and excluded from the operating expenses that are passed through to the tenant. That alone could be the subject of a lengthy article. One key item, though, that should be excluded are capital expenses. The tenant should seek to exclude capital improvements or repairs entirely from operating expenses, with the fallback position that they can be included only to the extent the capital improvement lowers operating expenses in future years or is required by applicable law. This expense should be amortized and prorated over the useful life of the improvement in accordance with GAAP.

Repairs

The tenant should negotiate who — the landlord or tenant — is responsible for making repairs, including those made to the HVAC and other building systems, the structure, and common areas.

The landlord must be responsible for all structural issue issue repairs, as well as common area maintenance, which the landlord should perform in a manner consistent with the class and location of the building. Repairs of the building systems serving the leased premises, particularly HVAC, often require negotiation. Ideally, the landlord will be responsible for all maintenance and repairs, unless the damage is caused by the tenant. If this is not negotiated correctly, the tenant can be on the hook for costly HVAC repairs, including capital replacement. It would not be unusual for the tenant to be responsible for day-to-day maintenance, including an annual service contract, but replacement of the HVAC unit, or any material component thereof, should be the landlord’s responsibility.

Besides imposing the obligation to perform and pay for repairs on the landlord, the tenant should also negotiate for the remedy of a rent abatement if the landlord fails to perform and the tenant is unable to occupy the leased premises for its permitted use due to such failure.

Finally, the tenant should ensure that the landlord will perform its work in a way that minimizes interference with the tenant’s use and occupancy of the leased premises. If the tenant is able to negotiate for it, this means that the landlord will perform the work outside business hours.

Compliance with Laws

The tenant should confirm that it is not required to make any alterations to the leased premises to comply with laws (including bringing any elements of the building into compliance with the Americans with Disabilities Act) unless non-compliance with any laws is due to the tenant’s particular use (as opposed to office use generally) or alterations. Additionally, the tenant should have the landlord represent that the building is in compliance with all laws, that the tenant’s permitted use will not violate the certificate of occupancy and that the leased premises will be delivered in a manner and condition such that the tenant may perform its fit-out work and obtain permits to operate.

In the event the tenant will be commencing work in the leased premises, the tenant should require the landlord to provide any permits and certificates of occupancy that are required for the tenant to commence its work, and the tenant should have the landlord agree to cooperate with the tenant in obtaining permits and other governmental approvals.

Duty to Restore

The tenant’s duty to restore the leased premises can make it expensive for the tenant to terminate the lease or not agree to renew the lease term. It is imperative that the lease is clear as to what the tenant’s restoration obligations will be at the end of the term or upon surrender of the leased premises. The tenant should not be obligated to remove any initial tenant improvements that were outlined as part of the lease or any alterations by the tenant during the lease term for which the landlord has provided its consent. 

In the event the landlord will not agree to remove the tenant’s restoration requirements as a whole, two fallback options are to either (1) require that the landlord provide notice to the tenant at the time the alteration is approved outlining whether or not restoration will be required at the end of the lease term, allowing the tenant to factor in the cost of the restoration prior to installation of the alteration and (2) limit restoration to only “specialty alterations,” such as raised floors, water features, safes or executive bathrooms.

The tenant should also be sure that its restoration obligation excludes reasonable wear and tear, any damage as a result of a fire or other casualty and any damage that is the landlord’s obligation to repair pursuant to the lease.

Daniel Suckerman is senior counsel in Lowenstein Sandler’s Real Estate practice. He represents a broad range of clients in commercial real estate transactions, including acquisitions, leasing, financing, negotiation of joint venture agreements and matters relating to asset management.

Kimberly Lomot is counsel in Lowenstein Sandler’s Real Estate practice, where her work spans the full spectrum of commercial real estate, banking and commercial transactions.