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Analyzing and Negotiating Lease Clauses
 


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Lease Clause Analysis - Issues of Significance

Negotiating a lease needn't be a chore!  In fact, many landlords now recognize that providing "superior tenant service" begins by making the lease negotiation process as simple and efficient for tenants as possible.  As important as it is to arrive at a lease agreement that meets the needs of both tenant and landlord, long delays over minor details serve neither party. 
Increasingly, landlords are shortening the lease negotiation process through a system of alternate lease clauses that can be used to substitute for standard lease clauses as the situation warrants.  By making the effort to develop "standard" alternative clauses, the landlord's legal counsel can avoid having to write specific language each time an issue arises.
Tenants, at least initially, need only raise the issue or concern, rather than make specific requests with respect to changing lease language.  This is most easily accomplished by employing a checklist that covers the issues which typically need to be addressed, at least from the tenant's perspective. By using such a checklist, tenants can quickly review each negotiable clause in the landlord's standard form lease, with the issues and concerns then brought to the landlord's attention.
In this way, the landlord is given the opportunity to respond with specific language which speaks to each issue but remains sensible for that particular property. It is important to note that the use of such a checklist is meant to address the business points of the lease agreement and should only suppliment, not replace, a full review of the lease agreement by the tenant's legal counsel.
Let us stress, one more time, that tenants should always request a copy of the landlordís standard form lease agreement in their first Request For Proposal ("RFP"). In the second submission of the RFP, the tenantís response to the landlordís proposal should be expanded to deal with the issues of significance which have been identified during the initial analysis of that standard form lease.
By way of example, letís look at an excerpt taken from the 73-page "Lease Clause Analysis - Issues of Significance" which we make available in "Products & Resources". It deals with the issues surrounding the damage and destruction clause found in most every commercial lease.
 
Just as if you were a client, we need to advise you that these materials speak to a limited number of concepts and strategies in real estate leasing transactions. They are not intended to constitute an analysis of any limiting or qualifying laws or principles and they should not be construed as legal advice or opinion.

O.K!  Now... let's get into the good stuff! First, we'll look at the language that might be found in a typical lease. After that we'll talk in more detail about the issues and the negotiating positions that might be appropriate, from both the perspective of the landlord and the tenant.
It should be pointed out that while the sample lease language provided below isnít particularly landlord oriented, neither does it fully address all of the important issues that should concern a tenant.

7.01   Substantial Destruction. If the leased premises should be totally destroyed by fire or other casualty, or if the leased premises should be damaged so that rebuilding cannot reasonably be completed within ninety working days after the date of written notification by Lessee to Lessor of the destruction, this Lease shall terminate and the rent shall be abated for the unexpired portion of the Lease, effective as of the date of the written notification.

Explanation - Provides that upon "substantial destruction" of the leased premises, the lease is terminated. There is substantial destruction if the leased premises are so damaged they cannot be rebuilt within ninety working days after the destruction.

7.02   Partial Destruction. If the leased premises should be partially damaged by fire or other casualty, and rebuilding or repairs can reasonably be completed within ninety working days from the date of written notification by Lessee to Lessor of the destruction, this Lease shall not terminate, and Lessor shall at its sole risk and expense proceed with reasonable diligence to rebuild or repair the building or other improvements to substantially the same condition in which they existed prior to the damage. If the leased premises are to be rebuilt or repaired and are untenantable in whole or in part following the damage, and the damage or destruction was not caused or contributed to by act or negligence of Lessee, its agents, employees, invitees or those for whom Lessee is responsible, the rent payable under this Lease during the period for which the leased premises are untenantable shall be adjusted to such an extent as may be fair and reasonable under the circumstances. In the event that Lessor fails to complete the necessary repairs or rebuilding within ninety working days from the date of written notification by Lessee to Lessor of the destruction, Lessee may at its option terminate this Lease by delivering written notice of termination to Lessor, whereupon all rights and obligations under this Lease shall cease to exist.

Explanation - Provides that if the leased premises are partially destroyed, the lease is not terminated and Landlord shall make the necessary repairs with an adjustment in rent. This section covers the situation where the leased premises can be reasonably repaired within ninety working days after the destruction.


Now, let's take a look at the actual issues of significance that surround these clauses, as detailed in the "Lease Clause Analysis" report.  Please be sure and pay special attention to the verbiage highlighted in bold print since it will be used later on to develop a Lease Analysis Checklist.
 
 
DAMAGE AND DESTRUCTION - THE ISSUES

Virtually every commercial lease deals with the possibility of casualty damage. The tenant must know whether it can use the premises within a reasonable period after the damage, or whether it must make alternative leasing arrangements. The tenant must also know whether it will be required to spend additional funds to return to normal business operations.

A.  Triggering Events.

The extent or type of damage which triggers the casualty clause is of crucial consideration. The consequence of the damage is that the lease may terminate or, at least, that there will be a period of rent abatement or other significant modification of the rights of the parties.

  1. Some leases refer to damage by fire or other insured casualty. This is of obvious danger to a tenant since damage may occur from an uninsured or even uninsurable event. Accordingly, from the tenantís perspective, the triggering event should be any damage or destruction, whether insured or insurable, and most landlords would agree to this. This amounts, in part, to an assumption of a business risk, since the landlord may not be able to insure the rental stream for certain occurrences. For single, net-leased buildings, the risk is often passed on to the tenant.

  2. A great many leases permit rental abatement only where the damage or destruction is not due to the fault of the tenant. This is at variance with the notion of waiver of subrogation and the careful tenant will seek to eliminate this qualification. Otherwise, the tenant will have to be sure that its own business interruption insurance is sufficient to cover the risk.

  3. Where the tenant is at fault, however, the landlord might require that any applicable deductible amount be borne by the tenant. The tenant will want to resist this since it does not have control over the terms of the landlordís policy.

B.  Extent of Damage.

  1. The typical office lease casualty clause provides for an abatement of rent during the restoration period, but it is important for the tenant to focus not only on the damage to his own premises, but also to anything impacting the normal conduct of his business, such as access, building services and utilities, adverse effects on business due to construction activities or unsightly surroundings, smoke damage, and the like. Thus, the tenant will want the abatement period to apply so long as the premises are not useable for his business purposes. Even damage which is solely confined to other tenant space may have an adverse impact by reason of reconstruction activities - this could extend not only to common areas but to activities in other tenant space.

  2. The sophisticated tenant will also ask that the rent abatement period resulting from casualty be extended to include a fixturing period similar to that provided at the inception of the lease. The landlord will want to resist this grant of an additional contingent concession and should in any event require that the fixturing period be minimized by having it overlap with the landlordís reconstruction activities. The landlord should also be sure that its rental insurance will cover this additional period.

  3. Many leases also provide that if there is partial damage, there is a proportionate abatement of rent. Since an allocation on a square foot basis cannot adequately cover all situations (e.g. smoke damage, interference with access, etc.), a better approach is to have an equitable adjustment together with a dispute resolution mechanism such as arbitration. Another approach is to key the amount of abatement to the actual decrease in tenantís business activities or income.

C.  Decisions and Time for Repair.

  1. Some forms allow a landlord to terminate a lease if the damage cannot be restored within a specified period of time, typically on the order of 90 days. The exposure for the tenant or the landlord is that this could be used as a basis for arbitrarily terminating an unfavorable lease. The landlord will want to extend this period considerably, and the tenant will not want to grant a termination option to the landlord unless the landlord treats all affected tenants in a similar fashion.

  2. In a similar vein, many leases provide for an option of the landlord not to restore if insurance proceeds are inadequate or if the landlordís mortgagee refuses to allow the insurance proceeds to be used for restoration. Most smaller tenants will be forced to accept this, but the largest tenants will have sufficient leverage to shift this risk to the landlord; in essence, the landlord must undertake to fully insure and as part of the lease approval package, the landlordís lender will have to agree to this commitment. This is not an unfair approach and is the practical result in almost all cases.

  3. The tenant will necessarily need a right to terminate if the restoration period is excessive, and this is one of the major items of negotiation in the casualty clause. For major office leases, the period is usually set between four and twelve months. The argument for the landlord, in seeking as long a period as possible, is that few tenants will be able to move into substitute permanent space in less than six to twelve months. From the tenantís perspective, the uncertainty and exposure for delays may have a substantial adverse impact on its business; additionally, a casualty requiring an extended restoration period may by its nature be so substantial as to have an adverse impact on the building which may persist well beyond the restoration period.

  4. Careful drafting by the landlord will key the termination not to the actual time period for restoration but to a good faith estimate made promptly following the occurrence of damage. Under this concept, if the estimate proves greater than the outside limit, the tenant must make a binding decision and cannot terminate even if the actual time exceeds the estimate. This has the obvious benefit of protecting the landlord against making substantial customized expenditures I restoring the tenant space, only to find that an unanticipated delay will allow the tenant to terminate.

    1. A careful tenant might require a right to contest the landlordís estimate - speedy arbitration is a possible approach.

    2. The most sophisticated tenant will still be concerned about excessive delays beyond the estimate. Possible compromise positions include:

      • Allow termination after a specified time period beyond the estimate;

      • Provide for a sharing (50%-50%) of the unrecovered costs to the landlord of restoration fit-out in the case of termination;

      • Qualify any ultimate termination by force majeure language;

      • In all cases, have the landlord notify the tenant upon learning of an anticipated delay, in which case the tenant must be obligated to make a prompt decision so as to minimize the ultimate exposure of both parties, and so as to allow the landlord the ability to take steps to expedite reconstruction at extra cost.

  5. The relative rights of the landlord and tenant for repair and restoration are rarely specified with adequate precision. This is an area which is best handled after consultation with the partiesí insurance consultants. Many leases provide that the landlord will restore only those improvements which it initially constructed, or for which it furnished an allowance. The problem is that the tenant may have made its own installations, and it will be difficult to determine how the insurance proceeds can actually be allocated, especially if more than one tenant space is involved (the notion that space may be only partially rebuilt because of a specific dollar allowance is not necessarily consistent with replacement coverage insurance maintained by the landlord).

    1. The tenant needs to manage his insurance program so that the entire space can be restored to its former condition.

    2. Some landlords, as a matter of practice, insure the full value of all tenant space (excluding only furniture, trade fixtures, and the like) on the theory that this is the most efficient way to protect the entire building on a replacement basis. However, most landlords will not agree to this position in the lease; they are concerned that other tenants will object to a disproportionate inclusion of insurance premium increases through escalation provisions.

    3. Obvious inequities can result where certain tenants have obtained construction allowances and others have instead taken free rent or other lease concessions. The net economic package is the same, but the free rent tenant who has installed his own improvements would have an inequitable insurance or reconstruction burden.

    4. A compromise approach might be for the landlord to insure all improvements except those resulting in a significant premium increase or attributable to specified or excessive fit-out --- or the special component of the premium increase can be borne by the tenant in question.

  6. Landlords who agree to a specific obligation to restore or a specific obligation to insure may have an exposure to the tenant for breach of contract if they are unable to fulfill these obligations --- this could theoretically extend to damage to the tenantís business, relocation expenses, and the like. With respect to major leases, it is difficult for the landlord to avoid this contractual undertaking, but since all tenants are paying for insurance as part of their rent they are arguably entitled to be assured that this risk is covered.
All right, now that we have gained a fuller understanding of the issues, letís develop a negotiation checklist for damage and destruction clauses in general.  You will have noted that the key points were set out in bold type face so that they could be more easily identified.
Does the lease clause:
  • Refer to damage by fire or other insured casualty
  • Permit rental abatement only where the damage or destruction is not due to the fault of the tenant
  • Focus only on the damage to the tenantís own premises
  • Provide for the rent abatement period to be extended to include a fixturing period similar to that provided at the inception of the lease
  • If there is partial damage, is there a proportionate abatement of rent
  • Allow the landlord to terminate the lease if the damage cannot be restored within a specified period of time (e.g. 90 days)
  • Provide for the landlord to have the option not to restore if insurance proceeds are inadequate or if the landlordís mortgagee refuses to allow the insurance proceeds to be used for restoration
  • Give the tenant the right to terminate if the restoration period is excessive
  • Give the tenant the right to contest the landlordís estimate of the time required to restore
  • Deal with the issue of excessive delays beyond the estimated amount of time to restore
  • Provide that the landlord will only be required to restore those improvements which it initially constructed, or for which it furnished an allowance
    Using this checklist of potential concerns, we must now go back and take a look at the sample lease language (i.e. 7.01 & 7.02 above) and decide in what areas, from the tenantís perspective, it might be lacking.  The three items on the checklist that are highlighted in bold type face would be of concern to the tenant being asked to sign a lease containing our sample verbiage.
    All that's left now is to develop language for insertion into the RFP which will ask the landlord to modify the lease clause in a way that reflects the tenantís three concerns. This is a task that can easily be accomplished by again refering to the detailed information contained in the Lease Clause Analysis report.
    After reviewing the buildingís Standard Form Lease, we would request that the landlord make modifications as necessary to resolve the following concerns:
    Paragraphs 7.01 & 7.02: 1) Eliminate the qualification that rental abatement will only be permitted where the damage and destruction is not due to the fault of the tenant. This is at variance with the notion of waiver of subrogation.

    2) Expand the language so as not to focus only on damage to the leased premises, but also to anything impacting the normal conduct of tenantís business, such as access, building services and utilities, adverse effects on business due to construction activities or unsightly surroundings, smoke damage, and the like.

    3) Tenant will not want to grant a termination option to the landlord unless the landlord treats all affected tenants in a similar fashion.

    Wow!  Isnít this powerful stuff?  Using the checklist we just developed, you can quickly and easily review the damage and destruction provision of most any landlord's standard form lease and request the necessary changes.  If you are a landlord or if you represent a landlord, you now have the ability to appropriately respond to a tenant's concerns.
  • Have we, even once, crossed the line into ďproviding legal adviceĒ?
  • Are we negotiating with confidence that the tenantís interests will be well served by the revised provisions of the lease?
  • Have we requested any modifications that would be particularly onerous to the landlord?
    At this point you are probably asking yourself, ďWhere was this tool when I was negotiating my last lease?Ē  The above illustration demonstrates the type of artful negotiation that can only occur when you are fully knowledgeable about the pertinent issues. 
    While you're initial response might be to scuff at the importance of spending so much energy on the "Damage and Destruction" clause in a lease, this example only scratches the surface of the information made available in the "Lease Clause Analysis - Issues of Significance" report.  As an example, the report offers over 10 pages of similar in-depth commentary on the issues that surround operating expenses (versus the 3 pages reproduced above for damage and destruction).  Can you even imagine not having this detailed level of knowledge at your fingertips the next time you negotiate a commercial real estate lease?


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