COMMERCIAL LEASE PITFALLS & 25 QUESTIONS TO ASK BEFORE YOU SIGN A LEASE
Alan Whitson, RPA
Today’s soft commercial real estate market has created many opportunities for savvy companies, yet, with opportunity comes risk. And it’s a situation that most managers will soon face. Because every year seven percent of the nation’s commercial real estate leases expire; and according to a recent NACORE study almost 80 percent of major US companies are planning to relocate or expand their facilities within the next three years.
Even companies not looking for space must be careful. Many buildings that are now renting for less than $25 a square foot were built based upon projected rents of $30 to $45 a square foot. Forcing landlords to become increasingly creative in finding ways to maximize their cash flow.
A common trap for tenants is the annual increase in operating costs or “pass throughs.” Originally designed to protect the landlord against increases in utilities, property taxes and operating expenses. Now, landlords see pass throughs as a profit center.
While operating costs vary by geographic area, in most major U.S. cities they run from $7 to over $9 per rentable square foot per year. Overcharges of a $1 or more per rentable square foot are common.
When multiplied by the term of a tenant’s lease and the number of leases in a landlord’s portfolio this amount can grow to an astonishing figure. As we uncovered for one client. Their landlord had understated the base year operating expenses by $250,000. Then overstated the building’s square footage by 25,000 square feet when adjusting the operating costs to 100 percent occupancy. A nickel here, a nickel there and presto – an extra million dollars in the landlord’s pockets!
Even for small tenants this can mean substantial extra costs. During a lease review for a 3,500 square foot branch office, we found the landlord had overcharged $9,500 for operating costs in the first two years of their five year lease. Overcharging tenants 10 to 15 percent is not uncommon, but here it was 38 percent! In the audit, we found another item that allowed us to negotiate a rent reduction of $60,000 for the remaining three years of their lease.
PITFALLS, LAND MINES AND BOOBY TRAPS
Lurking inside almost every tenant’s lease are loopholes, traps, major ambiguities, and dozens of issues that were never discussed. Buried among the legal rights and obligations are hidden costs, unreasonable risks and outright mistakes that could have expensive consequences. From the tenant’s standpoint they are poorly drafted. The language is unclear and important clauses omitted.
Even the most sophisticated of companies, architects, attorneys and experienced real estate professionals can overlook the most basic item. That’s what happened to a major financial services firm that leased several floors in a major office building. After moving in, they learned that their gross lease didn’t include janitorial service. It was irrelevant that gross leases in that city’s first class buildings usually included cleaning services. “If it ain’t in writing, you don’t get it,” was the landlord stand. The firm is now paying an extra $100,000 a year for cleaning.
The need for landlords to fill their buildings in this weak market has given many tenants the opportunity to cut their rent and move into new buildings. Still, for the unprepared there are some very costly pitfalls.
When the developer of a Times Square high rise offered a major New York law firm a lease that was $10 per square foot less than their old lease, they moved into 423,000 square feet at Broadway and 47th Street in late 1990. Yet,unable to lease any of the other 33 floors of the 42-story high-rise near Times Square in Manhattan, the project soon became financially strapped. As the grime slowly built up on the windows, other signs of deferred maintenance appeared. Elevators were slow to arrive, landings were bumpy and call buttons didn’t work. The heat was out for weeks in the early spring of 1991 and work stopped on the building’s exterior. Then, the partnership that owned the building declared bankruptcy. In 1994, the building was finally sold for half its construction costs.
Since foreclosures have become a fact of life, your landlord today may not be your landlord tomorrow. That’s why so called boilerplate issues like subordination, non-disturbance and attornment are important to tenants. When lenders take back a building – they can legally tear up leases and evict the tenants. That was the case when a North Carolina bank took back an office building in Nashville and evicted 15 tenants. Why would a lender evict rent paying tenants? By giving the tenants the boot, the bank could then sell the four story building to a major tire manufacturer, that was relocating its headquarters to the area, and get a “non performing loan” off their books and keep the government off its back.
AVOIDING THE LEASE FROM HELL
Landlords are in the business of leasing space. They have calculated every angle far before any negotiations with help from: asset managers, attorneys, financial analyst, property managers, real estate brokers, risk managers, architects, space planners, engineers and contractors.
Tenants, on the other hand, often do not have the financial, professional or personnel resources commanded by the landlords. Despite their expertise and success in their core business, they are in foreign territory and outnumbered when it comes to dealing with the maze of fine print and legalisms in a lease.
A lease is a very complex document that often contains hundreds of small agreements. Sometimes, just changing one or two words can be the difference between a fair lease clause and trouble.
Here are a 25 questions from the book; “327 Questions To Ask Before You Sign A Lease.” They can be used to find costly loopholes and uncover potential problems when negotiating a new lease. You also can use them to review your existing leases. A review can expose thousands of dollars in overcharges for operating expenses, tax assessments, errors in calculating CPI adjustments, security deposit interest, and lots more.
All the questions can be answered either yes or no. A no answer is a red flag, warning you to take steps to protect yourself. The idea of using a check list may seem simplistic. Yet, it is a very effective tool for making sure nothing is overlooked and prevent problems.
1. Does the lease specifically state the square footage of the premises?
2. Is the total rentable square footage of the building specifically stated?
3. Is the tenant’s pro rata share based on total square footage in the building instead of the square footage leased by the landlord?
4. Do the base year expenses reflect full occupancy or adjusted to full occupancy (for example, the base year real estate taxes are low because they are based on an unfinished building)?
5. Must the landlord provide a detailed list of expenses prepared by a certified public accountant (CPA) to support the increase?
6. Does the lease clearly give the tenant the right to audit the landlord’s books and records?
7. Is any increase in operating expenses due to of another tenant’s “particular use” excluded from operating expenses?
8. If the tenant’s use is limited to the use stated in the lease and no other use. Does the lease provide for: “except concerning an assignment or subletting, in which event any change in use required by the transferee shall be subject to the prior written consent of the landlord, which consent shall not be unreasonably withheld or delayed?”
9. Is there a dollar limit on the tenant’s obligation to make changes to the premises to comply with all municipal ordinances and state and federal statues after the commencement date?
10. If the landlord becomes aware of any hazardous substances, hazardous materials or hazardous wastes in the building or the premises is the landlord required to give the tenant prompt notice?
11. Are the janitorial service standards specified in an exhibit, such as emptying waste baskets nightly, washing the exterior windows once a quarter?
12. If the services are interrupted, does the lease define the remedies available to the tenant; money damages, rent abatement or lease cancellation?
13. Is the landlord, required to complete or correct the “punch list” items within 30 days or be in default?
14. If the landlord does not meet its responsibilities for repair and maintenance, can the tenant make the repairs upon 10 days notice (or without notice in an emergency), and deduct the costs of the repairs from the rent?
15. Does the lease say any repairs, alterations or other improvements required by any governmental authority that is required of the building in general, or similar buildings or uses in the area of the building, shall be done at the sole cost and expense of the landlord?
16. If the landlord fails to notify the tenant of the assessment (or reassessment) in sufficient time to permit the tenant to contest the assessment, can the tenant exclude any increase resulting from the assessment from the taxes the tenant pays?
17. If the tenant is seeking to sublease only a portion of the premises is the landlord precluded from recapturing the entire premises?
18. Is the landlord required to obtain non disturbance agreements from current and any future lenders?
19. Is the landlord required to subordinate its contingent interest in the tenant’s personal property and fixtures to the tenant’s lenders?
20. Does the lease say any lease modifications requested by a lender cannot alter the basic business terms (rent, location, term)?
21. Can the tenant use an umbrella or blanket insurance policy that also covers other premises owned or leased by tenant?
22. Is the waiver of subrogation unlimited, instead of limited only to the amounts of insurance proceeds received?
23. Does the lease clearly define how disputes are decided?
24. Is everything the tenant negotiated, such as free rent, increased tenant improvement allowance, caps on operating expenses increases, stated in the lease and its exhibits?
25. If the lease is subject to mortgagee approval, is the lease automatically void, if the tenant does not receive written notice by a certain date that the lease has been approved?
Real estate often represents a firm’s largest single financial commitment, and its largest annual expense other than payroll. It can have a major impact on earnings for many years. Avoiding just one trap can save thousands or maybe millions of dollars each year. In today’s economy, one cannot afford to be caught unprepared. The stakes are just too high.
Alan Whitson, RPA is CEO of the B. Alan Whitson Company, a Newport Beach California firm that serves the real estate needs of many well known organizations. He is the author of numerous articles, books and software packages on corporate real estate and economic development. For more information or to order books or software, contact B. Alan Whitson Company at (714) 955-1200.
