Virginia Lawyers Weekly VA Lawyers Weekly
A well-drafted lease agreement will go a long way toward protecting a commercial landlord and ensuring that its expectations are achieved.
However, sometimes what may seem like a minor lease term can have very large financial consequences down the road.
Here is a discussion of a few pitfalls that can be avoided.
Leeway for late delivery of possession
It is common for delivery of the premises to be delayed due to an inability to secure labor or materials to build out the tenant improvements, or the failure of the current tenant to vacate at the end of its term.
No matter what the cause of delay, the landlord is exposed to a claim by the tenant for damages that it suffers. These could be exorbitant holdover rent that it must pay to its current landlord or loss of profits if it is evicted from its current premises and, therefore, cannot conduct business.
A well-drafted lease will give the landlord leeway on when it must deliver the premises and limit the damages.
Increase the rent on renewal to market
Options to renew the term of a lease should, and typically do, call for increased rent. This rent increase can be based on a stated percentage, an increase in the applicable Consumer Price Index, or CPI, or fair market value as determined by arbitration.
Because property values and corresponding rental rates in any given area may not increase at the same rate as the CPI, relying on the CPI can result in unreasonably low rent. Even a rent increase based on a stated percentage should be brought up to fair market value at least every five years.
Rent recovery: discount rate vs. interest rate
Many leases include a clause that allows the landlord, upon a tenant default, to immediately recover the discounted present value of all future rent. A common landlord mistake is to specify a discount rate that is the same as the rate of interest that applies to delinquent monthly rent — often as high as 18% per annum — believing that a higher discount rate will produce a larger amount owed by the tenant.
The exact opposite is true: the lower the discount rate, the greater the amount the tenant will owe; and the higher the discount rate, the lesser the amount the tenant will owe.
Consider possible redevelopment
Over time, leased property may become much more valuable if redeveloped for a different use. A strip mall may become a prime location for an office tower, or an undeveloped parcel leased for a cell tower may gain value if developed.
Even a lease to a small tenant cannot be terminated by a landlord (absent a tenant default), because a leasehold is a vested property right. Thus, even a small tenant has leverage to demand whatever payment it sees fit for termination of its lease — it does not have to be reasonable. For a property that is likely to be redeveloped, either a short term, or a right for the landlord to relocate the tenant or terminate its lease, should be included in the lease.
Repair and maintenance: Don’t leave a gap
We’ve seen leases that simply do not address which party has responsibility to repair and maintain certain components in good condition, such as HVAC, water, sewer, electrical and parking.
Without an express agreement to repair and maintain the improvements, a tenant’s only obligation is to not permit “waste” at the property.
Therefore, a clause should be included that provides that the tenant has responsibility for any item of repair and maintenance that is not expressly placed upon the landlord by the terms of the lease.
Tenant improvements: Who insures and rebuilds?
Because tenant improvements are often owned and maintained by the tenant, the landlord may believe that the tenant is responsible to insure and rebuild them after a loss. But leases often simply provide that the landlord will rebuild the building after a loss, without expressly addressing the tenant improvements.
The lease should specifically call out which party has responsibility to insure and rebuild the tenant improvements. No landlord — nor a tenant — wants to discover after a loss that it has responsibility to rebuild the tenant improvements and that it was not covered under its policy.
Avoid an insurer’s claim: waiver of subrogation
A waiver of subrogation clause is likely to confuse nonlawyers; however, it can be of critical importance. Without a waiver of subrogation, a landlord can be liable to pay for the loss that its tenant suffers that is attributable to the landlord, even if the loss is covered by the tenant’s insurance.
For example, if the landlord’s faulty wiring causes a fire that destroys all the tenant’s personal property (e.g., inventory, computers, and equipment), the tenant’s insurance company will pay the tenant for the loss and then be subrogated to the tenant’s rights against the landlord. That means the tenant’s insurance company will be able to recover from the landlord the amount it paid the tenant.
Don’t rely solely on additional insured endorsements
Many leases require a tenant to add the landlord as an “additional insured” on its liability policy. However, landlords should always obtain their own liability policy or require “an additional named insured” endorsement.
The “additional insured” endorsement only insures the landlord against claims that arise through the tenant. For example, a claim by someone who is injured or dies in a fire caused by the landlord’s faulty wiring would not be covered under the additional insured endorsement (assuming the tenant did not have responsibility for maintaining the wiring).
When you’re done, be sure you’re done
A well-drafted lease agreement will provide that, upon a sale, the original landlord is released of all liability. Many landlords believe that once they no longer own a property, they necessarily are relieved of the landlord’s obligations under the lease agreement (e.g., to repair), but that is not the case.
The new landlord has primary responsibility, but the former landlord remains liable unless the lease agreement provides for release upon a sale. If the new landlord is in bankruptcy, the tenant will find it much easier to collect from the former landlord.
Jonathon L. Goodling is a partner at Miller Nash LLP, where he handles commercial real estate and finance transactions. Contact him at 503-205-2522 or [email protected].
