Commercial Leasing 201

So you’ve read Commercial Leasing 101….

In the blog post Commercial Leasing 101, I spoke to what a triple net lease was and the importance of understanding operating costs (and what operating costs are). In this post, I’ll be providing and explaining clauses that are typically found in offers to lease that both a landlord and tenant should understand.

Definitions

As in almost any contract you’ve come across, capitalized words or terms are words used to refer to a statement, a noun or a verb. The reason they are used is because the same statement, noun or verb will be referred to again in the document and it is easier to “define” it rather than to keep using the same terminology. Another reason is if edits or changes are made to the document, then only the definition needs to be changed rather than every instance it is used in the document. The most common example is that XYZ Company Ltd. is defined as the “Landlord”, or the “Tenant”. Say you wanted to use a different company, if you never defined it, you would have to change every instance where XYZ Company Ltd. is mentioned but if it is defined, the change is made at the start and that’s it. Everywhere else in the document Landlord or Tenant is used so no further edits are required.

Another example is when a statement is used and you want to summarize it with one word(s). Here’s an example we use:

“Hazardous Material” means any substance which is or may become hazardous, toxic and dangerous to persons or property in quantities or forms which violate any applicable environmental laws or regulations, including, without limitation, any substance declared from time to time to be hazardous, dangerous or toxic in violation of any applicable federal, provincial or municipal law, bylaw, regulation or other enactment.

Rather than repeatedly referring to “any substance that is hazardous or toxic that violates any federal, provincial, or municipal environmental laws or regulations”, I can simply say Hazardous Materials throughout the document and that is what it is referring to. Further, I might tweak the definition and that is the only spot in the document I need to do so.

Caution is needed when understanding definitions. It may seem obvious and I believe a lot of people tend to glaze over them but if you drill down into the definition, you might catch something that is important. Sometimes you see “nested” definitions where the defined term uses other defined terms as part of the definition. It all needs to be scrutinized. The single most important definition in a commercial lease is how the “Operating Costs” are defined. More on this can be read in Commercial Leasing 101.

Options to extend

An option to extend, or a renewal option as it is more commonly known as, is a tenant’s option to extend the term of the lease with a predetermined set of parameters. Typically, they are worded that all other terms and conditions of the lease remain the same except for the term, the basic rent, and any inducements (tenant improvement allowance, free rent, etc.) that were provided at the beginning of the lease. This allows to forego another round of negotiations. Usually the tenant has to give notice to the landlord at lease six months in advance of the expiry of the original term and if the two parties can’t agree on a basic rent for the renewal term, then it will go to arbitration.

These clauses are almost always found in leases but it is important to note that they are for the sole benefit of the tenant. The reason is because only the tenant can unilaterally exercise the option, the landlord has no say in it. It is for that reason that, from a landlord’s perspective, it is better to never have an option to extend in the lease. If the landlord doesn’t want the tenant occupying the space, or the landlord has a better tenant to take its place, then once the lease ends that’s it, the tenant has to vacate the space. However, if both parties want to continue the relationship then they will do so. A landlord doesn’t want to incur the costs of vacant space and a tenant doesn’t want to incur the costs of relocating.

Often both parties do not treat an option to extend how it is intended. A tenant will express its willingness to extend the lease but only if they know what the rent will be ahead of time. This defeats the purpose of the option as the landlord wants to know the tenant is exercising its option before discussing rates. Further, you will often find changes the tenant or landlord want to see to the lease which more or less constitutes an amending agreement and becomes a lease negotiation in itself. The tenant needs to keep in mind that once they exercise their option, they can’t pull out later if they don’t like the rents that are proposed. By exercising the option, you have now committed to the extension of the term.

Conditions Precedent

Conditions precedent are events that need to occur or become satisfied before the party or parties can commit to the lease. Usually the landlord or tenant has to obtain approval of a third party such as a bank or a municipality. Or further due diligence needs to be conducted such as the financial viability of the tenant, or whether it is possible to modify the premises to suit the tenant’s needs. Whatever the reason, conditions precedent provide either party to back out of the contract in the event the condition can’t be satisfied.

A common misconception is that a party can simply not waive a condition and get out of the contract. Both parties have a duty to act in good faith and use all reasonable or sufficient steps to satisfy the condition. From a legal paper I’ve read:

“It is not necessarily the case that the failure to satisfy or waive a condition precedent will automatically result in the termination of the contractual obligations and the refund of any deposit monies. Whether a condition precedent will provide the “automatic out” will depend upon how the condition is drafted and what steps, if any, the party for whom the condition exists has taken. Not taking any steps to satisfy a condition precedent may result in legal obligations, both in terms of forfeiture of deposit, and even more seriously, a suit for damages under the contract.”

Landlords and Tenants Work

These are clauses that outlines work to be done to a leased premises to provide it in a state necessary for the tenant’s use. Either the landlord or the tenant can perform the work but typically it falls on the tenant to complete it unless the work changes structural or base building systems. The clauses need to outline who is responsible for what work and who will pay for it. Most importantly, they need to be detailed, precise, and when it will occur. It is all too easy for misunderstandings or misinterpretations to occur from landlord or tenant work clauses.

For example, it is simply not sufficient to say “the landlord shall provide all utility rough-ins”. What utilities? Where are they going to be brought to? What size? And so on. A past lease I was involved just about went to court because it came down to the definition of “roughed-in”. The property was an existing building but was originally built for a single user but was now being split up into multiple premises. As such, electrical, gas, water, and sewer all had to be run to each unit that was being created. The landlord was to bring these utilities to the premises in question and provide the “rough ins”. The landlord did so but because the building was existing, the floor slab had to be cut in order to bring the water and sanitary into the premises. The floor was left with the expectation that the tenant was responsible for re-pouring the cement slab. The tenant, believing that the industry standard for new premises is that the landlord is responsible for pouring the floor slab, didn’t believe they should be responsible for it. But because the schedule wasn’t detailed enough, the landlord had preformed its obligations by providing the roughed-in utilities. The offer was silent on who was to pour the slab.

Tenant Improvement Allowance

When new construction on a premises is required, usually the landlord will provide a tenant improvement allowance (TIA) to the tenant which is cash the landlord gives to put towards the cost of construction into the premises. New developments will be given to the tenants in a “shell” condition which means the exterior and demising walls will be erected, boarded, taped, sanded and ready for paint; the floor slab will be poured; and all utility rough-ins will be brought to a location determined by the landlord. All work to be completed past this point becomes the responsibility of the tenant. Since it is the landlord’s property, and the landlord has a mutual interest in seeing the construction of it and the tenant succeed, they will contribute a predetermined TIA to the tenant.

Typically the TIA is not paid ahead of time; the tenant is reimbursed after it has completed the construction, provided receipts and evidence that all bills have been paid, the lien period has passed, and the tenant is open for business. Institutional landlords and large corporate developers will encourage TIAs to be paid as it usually coincides with a higher lease rate. This in turn creates higher property values as a result of the higher income being collected.

Stay tuned for Commercial Leasing 301…..