In my capacity as General Counsel for a commercial real estate developer for over ten years, I negotiated and drafted my fair share of retail leases. I zealously represented my developer-landlord client during the lease negotiation process in an effort to make any given lease as landlord-friendly as possible without overreaching or jeopardizing the deal.
Having recently joined a private practice law firm, I find myself in the unfamiliar position of now having the ability to provide representation to tenants in a retail lease negotiation. It’s enlightening how my years of exclusive landlord representation has enabled me to quickly identify those sections of the lease that tenants sometimes overlook without knowing how crucial they may become to the future health of their business. While it goes without saying that business points such as the rental rate and lease term are always of utmost importance, I would like to share what I believe are ten important legal areas that every tenant should consider when negotiating a retail lease. Each of the scenarios below is based upon lease issues that I have personally encountered in my practice. Presented in alphabetical order, and not in terms of relative importance, these areas are:
Assignment. [Scenario]: Tenant’s business has multiple locations, but the one located in Center A is underperforming. Tenant wants to close operations in Center A but there are still several years left on the lease term. Tenant finds a similar business that is willing to assume the lease through an assignment for its location in Center A. The lease, however, provides that all assignments are in the landlord’s sole discretion and the landlord then rejects the proposed assignment.
An assignment provision that grants a tenant the greatest flexibility is desirable. Ideally, a tenant would like to be able to assign its lease without any required consent of the landlord, and then be automatically released from any further liability under the lease upon the assignee’s assumption. Failing landlord’s agreement to a provision such as that, other assignment language options that a tenant may wish to consider are: (i) being granted the ability to assign without the landlord’s consent but with the tenant remaining liable under the lease; and (ii) requiring that the landlord’s discretion to approve/disapprove an assignment must be reasonable (and even better, then defining ‘reasonable’ in terms of specific criteria: similar type business, number of employees, financials, etc. so that the landlord’s approval becomes objective and not subjective).
Co-tenancy. [Scenario]: Tenant executes a lease in a center that is currently full, seemingly thriving, and anchored by a large retailer, entertainment venue, restaurant, etc. Tenant completes its build-out and is operating for a short while only to discover that the anchor tenant has ceased operations and closed its doors. Meanwhile, many of the smaller tenants who were relying on the anchor tenant to generate traffic for the center begin going out of business. In a relatively short period of time, the center becomes a virtual ghost town and Tenant’s business is now struggling too.
The inclusion of a co-tenancy clause may grant a tenant remedies, including reduced rent or the ability to terminate its lease with the landlord, if the center’s tenant occupancy rate falls below a certain percentage or a major tenant leaves the center. Terminating the lease and relocating its business is an expensive and not a perfect outcome for a tenant, but it’s often a better solution than remaining obligated for a full rental amount on a lease in a center that no longer attracts customers.
Cure Period for Tenant Defaults. [Scenario]: Tenant is operating a very successful business in the center. Tenant also executed a very favorable rent under a long lease term and current market rates are considerably higher now. Landlord would like very much to re-lease Tenant’s unit at the higher rental rate. Rent is due on the first of the month, and the lease provides for a five-day grace period. Tenant inadvertently fails to pay the rent by the fifth of the month. Upon its discovery of its error, Tenant tenders full payment of the rent to the landlord on the twentieth of the month. Landlord refuses the late payment and then seeks to evict Tenant.
A landlord attempting to evict a first-time offender tenant that is two weeks late with the rent is perhaps an extreme scenario, but a tenant should not want to put itself into a situation like that where there is uncertainty as to the outcome. A tenant should consider negotiating for the inclusion of a cure period in the lease that would enable the tenant to fix its default upon being notified of such by the landlord. Typical cure periods may range from three to thirty days, depending on the type of the default. Monetary defaults usually are awarded a shorter cure period.
Exclusive Use. [Scenario]: Tenant operates a gourmet coffee house and executes a lease in a center where there currently are no other restaurants or shops that serve gourmet coffee. Tenant is very successful in its first year of operations, with customers lining up for its coffee especially in the morning hours. This fact does not go unnoticed by the other restaurants who then all begin offering gourmet coffee service in the morning. The competition causes Tenant’s sales numbers to fall dramatically.
A tenant should consider negotiating for exclusive use language in its lease. In the above scenario, if Tenant had language to the effect that it was the only tenant in the center permitted to offer gourmet coffee, it would not have lost sales to competition. In the event that a landlord will not agree to completely ban other tenants from offering a specific item, a tenant could seek to have the landlord limit the amount of the item that other tenants may offer, i.e. no other tenant in the center may offer more than three different gourmet coffee flavors, or no other tenant may sell gourmet coffee between the hours of 6 A.M. to 10 A.M.
Guarantee. [Scenario]: Tenant, an LLC operating as a restaurant, executes a lease for space in a center. The lease is personally guaranteed, jointly and severally, by the two member owners of Tenant, namely Bob and Jim. A few years down the road, Bob wants to leave the restaurant business and sells his entire interest in the LLC to Jim. A year later, the business starts failing and is unable to pay its rent. Landlord serves a demand letter for payment of accelerated rent upon Tenant, and Jim and Bob, personally. Bob is furious with the landlord, stating that he is no longer an owner of the restaurant, and that he shouldn’t be liable for any delinquent or future rents. Bob’s guarantee was never released by landlord.
A personal guarantee of a lease can have serious ramifications if a tenant’s business is unable to meet its lease obligations. In the above scenario, Bob is personally still on the hook for the rent even though he is no longer an owner of Tenant. Owners of a tenant entity may want to negotiate for the exclusion of any personal guarantees. If the landlord is unable or unwilling to waive a personal guarantee requirement, the guarantor should consider seeking to mitigate its exposure by requesting that the guarantee be limited in terms of the number of years, maximum dollar amount, or both.
Landlord’s Work. [Scenario]: Tenant executes a lease for a unit in a brand new center that is still under construction. The Landlord’s Work exhibit in the lease lists ten specific items that landlord is providing to Tenant and states that everything else shall be Tenant’s responsibility to provide at Tenant’s sole cost and expense. Tenant assumes that even it is not specifically mentioned in the work list, the landlord will also be providing basic build-out items like a slab floor, ceiling, demising walls, etc. Landlord later tenders possession of the unit to Tenant and the tenant is shocked to learn that it is only receiving a grey shell (i.e. no slab floor, ceiling, interior electrical lines, and interior water lines). Tenant’s budget is now busted with the extra work it has to perform, causing Tenant to not have any excess working capital to cover its slow opening business numbers. A few months down the road, Tenant can’t pay the rent, and is evicted by the landlord.
A tenant should completely understand what the landlord is including as part of the landlord’s work, and should consult with its contractor prior to executing the lease if it does not. A tenant will want to negotiate for having the landlord include as much landlord’s work as possible, but also should specify the timing for completion of the landlord’s work and what the recourse will be for the tenant if the landlord fails to deliver the work timely.
Limitation of Landlord’s Liability. [Scenario]: Tenant A executes a lease where it is granted the exclusive use of being the only restaurant tenant that may be open for lunch in a center. One year later, restaurant tenants B and C in the center nevertheless start offering lunch service. Tenant A demands that the landlord stop tenants B and C from offering lunch service, but the landlord refuses to comply. Tenant A’s business fails on account of its reduced lunch numbers and then sues the landlord for breach of lease, lost profits, and other monetary claims. The landlord defends stating that the lease limits its liability not only to its interest in the center, but that monetary claims are excluded and Tenant’s only recourse is specific performance.
A sharp landlord will attempt to limit its liability as much as possible. In the above scenario, Tenant A’s sole recourse of making the landlord stop tenants B and C from serving lunch may take time and cost Tenant A money to do so. In that situation, the landlord has little to lose by dragging its feet. A tenant should therefore consider negotiating a requirement that the landlord has some monetary accountability for its defaults, whether that be through the tenant’s ability to set-off the rent, or by removing any language granting the landlord immunity from tenant suits for monetary damages.
Option Periods. [Scenario]: Tenant operates a successful business for many years only to find that when the end of its lease term arrives, the landlord elects to lease the space to another tenant or demands a new rental rate that is higher than Tenant can afford. Tenant is left scrambling to find another location, loses its investment in the fixtures and tenant improvements in the current location, and Tenant’s business will likely suffer as a result of being closed for a significant time period while relocating.
A tenant should consider negotiating to include options in the lease to extend its term. It’s far better to have the options in place and not use them, then to need the options and not have them. A tenant should consider that options to extend the lease be in the tenant’s sole discretion as to whether or not the options are exercised. Additionally, the rental amount or method by which the rent is determined for the option periods should be specified. Agreeing to a “fair market” rental rate for the option periods makes it challenging for the tenant to budget for in the future and leaves the tenant in a vulnerable position should market rental rates skyrocket in the future.
Permitted Use. [Scenario]: Tenant operates a tanning salon business and agrees to permitted use language in its lease that only provides for tanning services and related merchandise. Halfway through its lease term, tanning beds are found to have health risks and subsequently Tenant’s business sales plummet. Tenant decides to change its business and begins operating as a nail salon. The landlord places Tenant in default of the lease for operating outside of its permitted use.
A tenant should consider negotiating for the broadest permitted use language possible as market and other outside conditions may force a change in business concept. Limiting itself to a single type of product, cuisine or service will leave a tenant in a difficult place with its landlord if a change is wanted or becomes necessary. Language that permits the tenant to operate as any lawful business in addition to its initial intended use is preferable.
Repairs and Maintenance. [Scenario]: Tenant executes a 10-year lease in a center that is approximately 15 years old. Seven years into the lease term, the HVAC system fails and cannot be repaired. Until the system failure, Tenant was properly maintaining the HVAC system through a licensed HVAC maintenance company. The landlord demands that Tenant replace the HVAC system. Upon close examination of the lease, Tenant discovers that it is responsible for both HVAC repairs and replacement. The new HVAC system is very expensive and Tenant does not think that it is fair that it is solely responsible for replacing a 22-year old system, especially when there are only a couple years left on its lease term.
A tenant should pay close attention to the repairs and maintenance section of the lease. While it is typical that a tenant be responsible for maintenance and repairs of the HVAC, sprinklers and fire protection systems, the landlord may also require the tenant to replace such systems at the tenant’s sole cost. In the event that a tenant is unable to convince the landlord to remove the HVAC replacement requirement entirely from a lease, it should then consider negotiating for alternate language to remove the requirement in the event that the HVAC system fails in the last few years of the lease term, or perhaps an arrangement where replacement costs are divided among the landlord and the tenant.
A retail lease can often be a lengthy document that contains several sections that the average business person may not thoroughly understand. Moreover, when the landlord presents a tenant with a lease document, more often than not, the document has been drafted by the landlord’s attorney and is slanted in the landlord’s favor. It is highly desirable for a tenant to have its own real estate attorney review a retail lease and advise the tenant about potential areas of concern. Without identifying and negotiating a solution to those areas of concern, a tenant may later find itself in a position that will cause it substantial cost or grief.
Written by: Calvin F. Harding, Jr., Esq.