Written by: Gary D. Buchman
Commercial Tenants often request that Landlords accept a Letter of Credit in lieu of a cash security deposit. This blog examines the benefits and burdens of each from both the commercial Landlord and Tenant perspectives.
Cash Security Deposit:
First of all this represents cash out of Tenant’s pocket. Generally a cash security deposit is mingled with Landlord’s funds. Tenant’s security may be subject to the financial soundness of Landlord and the bank in which Landlord deposits its funds.
The only true negative for the Landlord is that the funds are Tenant’s funds and a petition in bankruptcy by Tenant is likely to freeze the security for disposition by the Bankruptcy Trustee.
Letter of Credit:
A Letter of Credit is the obligation of the Bank that issues the Letter of Credit and bankruptcy of Tenant will not impede Landlord’s ability to reach the proceeds of the Letter of Credit.
The Letter of Credit should be carefully drafted to permit the Landlord the right to draw down the proceeds (all or a portion) upon presentation to the Bank of a demand for payment in the amount to draw on, together with a certification by Landlord that it is entitled to draw on the Letter of Credit pursuant to the Lease. The Letter of Credit should also provide that it is renewable for consecutive annual periods; and that upon notice of nonrenewal at least thirty (30) days prior to expiration date of the Letter of Credit, Landlord may draw on the Letter of Credit. The Letter of Credit should expire no earlier than thirty (30) days after the expiration of the lease term.
The Letter of Credit and the Lease should each provide that the amount drawn down be replenished by the Tenant with a replacement Letter of Credit for the full amount. The Lease and Letter of Credit should expressly provide that its application is not a limitation on Landlord’s damages, or liquidated damages, or rent for the last month of the term of the lease.
The Letter of Credit should permit transfer to Landlord’s transferees. Landlord should also have the right to cause Tenant to replace the Letter of Credit with a Letter of Credit from another bank acceptable to Landlord in the event that Landlord becomes concerned about the stability of the Issuing Bank.
Complexity is the only true negative of the Letter of Credit. The Letter of Credit benefits Tenant who may still earn interest on the funds subject to the Letter of Credit.
Here is an example lease provision providing for a Letter of Credit.
Gary Buchman is Partner in the firm's Real Estate Department.
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Written By: Gary Buchman
Most retail leases are so called triple net leases, in which Tenant pays its proportionate share of Insurance, Real Estate Taxes and Common Area Maintenance, in addition to Base rent.
By contrast, most office leases are modified “gross” leases, in which Tenant pay its proportionate share of Operating Expenses (including Insurance) and Real Estate Taxes over the “Base” amount (usually the calendar year of Term Commencement for Operating Expenses, or the fiscal year in which the Term commences for Taxes) for Operating Expenses and Real Estate Taxes.
In both circumstances Tenant must be vigilant to ensure that Operating Expenses and CAM costs are reasonable, appropriately incurred, and properly reimbursable by a tenant (rather than a landlord) of Property. For example:
(A) The costs of capital repairs and/or replacements is not something a tenant should reasonably be expected to pay. Landlords generally are willing to amortize such “capital” costs over the useful life of the “capital” item for Federal Income Tax purposes, and to include only each year’s amortized amount in CAM or Operating Expenses. In some instances, landlords are willing to exclude entirely the replacement of certain capital items such as a roof or the repaving of a parking lot.
(B) Increases in “Controllable Expenses” should be capped at some reasonable number, typically three percent (3%) per annum. Controllable Expenses should include all expenses other than snow plowing and removal, Insurance, Real Estate Taxes, and utilities. From a tenant’s perspective this should not be on a cumulative basis. This creates an incentive on landlords to minimize Controllable Expenses and to properly manage the Property.
(C) Other typical exclusions from CAM and/or Operating Expenses include:
(1) cost of any service directly to and paid directly by any tenant (outside of such tenant's Operating Expense payments);
(2) the cost of any items for which Landlord is reimbursed by insurance proceeds, condemnation awards, a tenant of the Building, or otherwise to the extent so reimbursed;
(3) ground lease payments (if any);
(4) costs incurred by Landlord due to the violation by Landlord (or any tenant) of the terms and conditions of any lease of space or by violation of any law, code, regulation, ordinance or the like, which costs would not have been incurred but for such violation;
(5) bad debt expenses and interest, principal, points and fees on debts or amortization on any ground lease, mortgage or mortgages or any other debt instrument encumbering the Building and property on which the Building is situated;
(6) marketing costs, leasing commissions and/or attorneys' fees in connection with the negotiation and preparation of letters, deal memos, letters of intent, leases, subleases and/or assignments, space planning costs, and other costs and expenses incurred in connection with lease, sublease and/or assignment negotiations and transactions with present or prospective tenants or other occupants of the Building;
(7) costs, including permit, license and inspection costs, incurred with respect to installation of improvements made for tenants or other occupants in the Building or incurred in renovating or otherwise improving, decorating, painting or redecorating vacant space for tenants or other occupants in the Building;
(8) costs incurred to obtain or upgrade a LEED certification or similar rating for the Building or Property (though such monitoring and maintenance costs required to maintain such a rating or certification once obtained may be included in Operating Expenses);
(9) rentals and other related expenses for leasing an HVAC system, elevators, or other items (except when needed in connection with normal repairs and maintenance of the Building or in the event of an emergency) which if purchased, rather than rented, would constitute a capital improvement not included in Operating Expenses;
(10) expenses in connection with services or other benefits which are not offered to Tenant, or for which Tenant is charged directly, but which are provided to another tenant or occupant of the Building without charge;
(11) electric power costs or other utility costs for which any tenant directly contracts with the local public service company;
(12) costs (including in connection therewith all attorneys' fees and costs of settlement, judgments and/or payments in lieu thereof) arising from claims, disputes or potential disputes in connection with potential or actual claims, litigation or arbitration pertaining to tenants of the Building;
(13) costs incurred in connection with the original construction or any future expansion of the Building or real property;
(14) costs incurred to comply with laws relating to the removal of hazardous materials or to remove, remedy, treat or contain any hazardous materials existing prior to the lease;
(15) advertising and promotional expenses;
(16) charitable or political contributions; and
(17) art work.
In order to give real teeth to these exclusions the tenant should also negotiate for the right to audit the CAM or Operating Expenses. The intent is to create a lease whereby the landlord is reimbursed for its actual reasonable costs of operating the property in an efficient manner. The CAM or Operating Expense provision is not intended to be a profit center for the landlord, nor is it intended to provide the landlord reimbursement for its capital investment in the property.
Written By: Jane Thomassen
In exchange for creating a retail environment that increases the revenues of a tenant’s store, a landlord often negotiates for “percentage rent” in addition to the fixed rent due under a lease. “Percentage Rent” is the tenant’s payment of a percentage of its gross sales from the premises over and above a specified annual dollar amount or breakpoint. While the percentage rental rate and breakpoint will vary depending on the type of business being operated by the tenant, the amount of fixed minimum rent will take the percentage rent formula into consideration.
The amount of actual percentage rent payable depends upon the tenant's financial success at the premises. Therefore, a tenant under a percentage rent lease should be required to make all efforts to maximize gross sales at the store. Additionally, the lease should include tenant reporting requirements and landlord audit rights to ensure the accuracy of the reported gross sales.
In order to realize the benefits of a percentage rent lease, landlords should include the following lease provisions:
1. Retail Restriction Limit. During the term, the tenant shall not engage in any business within a certain geographical radius of the premises similar to or in competition with the tenant's operations at the premises. The distance of the radius will depend on the location of the premises. For example, the radius may only be a few blocks in an urban location and several miles in a suburban location. If the tenant violates this provision, the gross sales from the violating store should be included in the tenant’s gross sales.
2. Continuous Operation by Tenant. Tenant shall operate 100% of the premises during the term with due diligence and efficiency to produce the maximum amount of gross sales. Minimum hours of operation should also be required. In the event the tenant is not open for business during the days and hours required under the lease, the percentage rent breakpoint should be proportionately reduced or tenant should be required to pay 150% of fixed rent for each day that it is not open, which increased amount shall be deemed to be in lieu of percentage rent.
3. Definition of Gross Sales. The definition of “gross sales” should include all sales by the tenant and any sub-tenants from the premises, whether by mail, telephone, or on-line. Exclusions from gross sales should be limited. Standard exclusions include returns and refunds upon transactions included in gross sales, the amount of actual fees paid to credit card companies and taxes paid to the taxing authority. A frequently negotiated item is whether sales of gift certificates are included in gross sales upon sale or redemption thereof.
4. Records and Statements. Tenant should be required to prepare and keep at the premises adequate books and record showing gross sales for each month during the term of the lease and report gross sales to landlord on a monthly and annual basis. The annual gross sales statement should be certified by an executive officer of the tenant or be an audited statement prepared by an independent certified public accountant.
5. Audit Rights. Landlord should have the right to audit the tenant’s records of gross sales. If landlord's audit shall disclose an understatement in gross sales for such period of three percent (3%) or more, then the tenant should be required to immediately pay landlord any percentage rent due on such deficiency together with interest and the cost of such audit.
These types of landlord oriented provisions will give the landlord the rights and remedies necessary to maximize percentage rent.
Written By: Geoffrey Smith
While larger lending institutions may have experience with sophisticated commercial real estate loan transactions, community or regional lenders often do not and may not be aware of the many pitfalls that can arise from commercial leases which often form a significant portion of a lender’s collateral package.
Care, therefore, is needed when reviewing commercial leases. Below is a brief summary of some frequently found provisions in commercial leases that require a lender’s close scrutiny.
Termination Rights. An obvious concern is the effect a tenant’s termination rights may have on a borrower’s ability to meet debt service obligations. An early termination of a lease can bring the unpleasant surprise of a monetary default under the loan. A tenant’s termination rights could emanate from several sources: a landlord could breach a restrictive use covenant; not complete leasehold improvements timely; not make major repairs; or not restore the demised premises soon enough after a casualty.
Going Dark. What are landlord’s rights if a tenant closes its doors and ceases operations? A tenant “going dark” may have nothing to do with actions or omissions of the landlord. Although the tenant typically has the obligation to continue paying rent, its collectability may be in doubt. The lender also needs to think about the potential impact a “going dark” clause may have on other tenants in a multi-tenanted retail center should a tenant exercise that right in the lease. That tenant may be the anchor in the center and the other tenants may rely heavily on the continuing generation of this tenant so as to generate traffic and business. In all commercial mortgage loans that have significant retail leases, the lender should visualize itself as the potential landlord should it need to step into the shoes of the landlord upon default. The lender as landlord will want sufficient time to cure landlord defaults to preserve leases. Because a lease may not give the lender sufficient comfort to cure its borrower’s lease defaults, SNDAs (Subordination, Non-Disturbance and Attornment Agreements) will frequently contain provisions extending cure periods to accommodate the lender.
Set-Off and Rent Abatement. Commercial leases will often contain a provision allowing a tenant to stop paying a portion or all of the rent, for a certain period of time that the landlord is not meeting its obligations under the lease. If some sort of setoff or rent abatement is unavoidable in a lease under negotiation because of the negotiating leverage of the tenant, the lenders should insist that the amount of the “set-off” or “rent abatement” never exceeds what is necessary to fully service the debt, and to pay real estate taxes and insurance. This can be addressed by setting caps on the amount of rent that can be set-off or abated in any given payment period.
Landlord Obligation to Rebuild or Restore. The obligation to rebuild or restore improvements after a casualty frequently falls on the shoulders of the landlord. This can be a very costly undertaking for landlords, particularly if insurance coverage is inadequate. Lenders should include in the SNDA that it does not assume the landlord’s obligation to restore should it take possession after a loan default. But if the lender does not rebuild, the tenant will insist on a termination right. In all cases, the lender needs to monitor the restoration process closely to help maintain the economic viability of the property so that it continues to have the capacity to service the lender’s debt service.
Subordination, Non-disturbance and Attornment Agreements (SNDAs). The role of the SNDA in a loan transaction is to subordinate a lease to the lender’s security interest in a property. This subordination is usually given by tenants in exchange for a promise by the lender not to disturb the leasehold rights of the tenant in the event of foreclosure provided the tenant is not in default of its lease. However, a key provision for lenders in the SNDA is “attornment”. The attornment provision provides that in the case of a foreclosure, the tenant will attorn to (or recognize) the lender (or the buyer at a foreclosure sale) as the new landlord under the lease with all the same rights of the prior landlord. A new lender will want to be sure that any tenant that has an interest in the property that is prior to the mortgage is obligated in its lease to provide an SNDA in connection with a new mortgage.
Rights of First Refusal, First Offer or First Negotiation. These tenant rights can limit a landlord’s ability to lease vacant space when a tenant possesses these rights. In multi-tenant buildings, tenants who hold these rights may be entitled to notice when other spaces in the building become available, and landlords may not be able to offer vacant spaces to desirable tenants without first offering it to existing tenants who hold these rights. These rights can significantly burden a landlord’s ability to market its building and as a result, negatively impact the long term economic viability of the lender’s collateral.
Single Tenant vs. Multi-Tenant Many issues described in this post (and others) will have far less adverse impact if they arise in only one lease in a large multi-tenanted building. In the case of a single tenant property, however, these issues magnify the impact to the lender since the source of repayment is concentrated in one lease.
Estoppel Certificates Many leases provide that either party will execute an estoppel certificate upon request of the other. The estoppel gives a lender notice of existing issues in the landlord/tenant relationship and any defaults by either party that might need to be cured. A lender should confirm whether the leases require tenants to provide estoppel certificates. The lender should review the estoppel certificate to be sure there are no unexpected issues with the property or the relationship between landlord and tenant that would prove costly to resolve by the landlord, or later by the lender if a foreclosure becomes necessary.
The list above is meant to highlight just a few of the commercial lease provisions that lenders should look for when reviewing leases that will collateralize a mortgage loan.
Written by: Gary D. Buchman
Landlords of commercial properties are often asked to sign a collateral assignment of lease and a waiver of the landlord’s lien on a tenant’s trade fixtures and equipment in favor of the tenant’s equipment lender or franchisor. The usual form presented permits the lender/franchisor to enter the leased premises in the event of a tenant default under its equipment loan or franchise agreement, in order to repossess equipment and trade fixtures. This may occur notwithstanding that such a default of tenant’s loan arrangements is not a default under the lease. When coupled with a collateral assignment of lease, the lender/franchisor will have a right to occupy the premises and to subsequently assign tenant’s leasehold to a new tenant/franchisee. From a landlord’s perspective, there are several key elements to incorporate into these documents:
- The obligation of the lender/franchisor to remove the equipment and trade fixtures at, or promptly after, expiration of the lease;
- The obligation of the lender/franchisor to pay rent and other charges during its possession of the premises;
- The obligation of the lender/franchisor to restore any damage to the premises resulting from removal of equipment and trade fixtures;
- The right of the landlord to approve any future tenant that lender/franchisor may wish to take the place of the existing tenant; and
- The continuing obligation of the existing tenant, notwithstanding the collateral assignment of the lease and any subsequent repossession or assignment of the lease by the lender/franchisor.
An example of a Collateral Assignment of Lease and Landlord Waiver of Lien incorporating the above key elements can be found by clicking here.
Written by: Joshua M. Alper
Two recent decisions by the Massachusetts Appeals Court highlight the importance of carefully drafting commercial leases. In Panagakos v. Collins, 80 Mass. App. Ct. 697, (2011), the Court held that a commercial landlord’s purported failure to mitigate was not relevant in determining damages payable by tenant and its guarantor after termination of the lease for tenant’s default. The case involved a long term lease for a restaurant. The restaurant failed. Tenant attempted to market its leasehold interest and obtain a new restaurant user, but the purchaser sought substantial repairs by Landlord to the parking lot, roof and HVAC system. Landlord, not surprisingly, declined. Upon termination of the lease for nonpayment of rent landlord demanded damages from tenant and its guarantor under an acceleration clause which rendered the rent for the balance of the term immediately due and payable. The trial court found that landlord was under an affirmative duty to make reasonable efforts to mitigate future damages. Finding that landlord had failed to act reasonably to mitigate, the trial court awarded only partial damages to the landlord.
The Appeals Court reversed the trial court, finding, significantly, that “the presence of a default/acceleration clause, such as the one contained in the lease, makes irrelevant the issues of mitigation of damages, because an acceleration clause is an enforceable liquidated damages provision. In essence, inclusion of a liquidated damages/acceleration clause obviates the issue of mitigation of damages. The Court noted that the parties “exchange[d] the opportunity to determine actual damages after a breach, including possible mitigation, for the peace of mind and certainty of result afforded by a liquidated damages clause.”
Another recent decision of the Appeals Court, 275 Washington Street Corp. v. Hudson River International, 81 Mass. App. Ct. 418 (2012), held that a landlord could not recover damages from a breaching tenant for the difference between rent payable by a new tenant and rent that would have been payable by the breaching tenant until the original expiration date of the lease. The Court based its ruling on a simple indemnification clause contained in the lease which, upon tenant’s default, indemnified landlord “against all loss of rents and other payments which Landlord may incur by reason of such termination during the remainder of the term.” The problem for landlord was that the lease lacked a rent acceleration clause and other specific remedies customary and typical in commercial lease arrangements. Relying on long dormant case law from 1906, 1931, and 1934, the Court denied recovery under the indemnity clause reasoning that liability is ultimately “contingent upon events thereafter occurring, because the full amount of which the lessee eventually must pay for the remainder of the term cannot be wholly ascertained until the period ends.” The clear take-away from this case is that simple or abbreviated lease forms contain a wealth of dangers for the unwary.
Written by: Deborah Howitt Easton
While there are commonalities in concerns on the landlord and tenant side in all leases regardless of the use, biotech leases differ from general office leases. When negotiating a lease for a biotech user, the landlord and the tenant need to consider a variety of issues that are unique, or more critical, as a result of such use.
- Build-out. Tenant improvements for biotech users are typically extensive, often specialized and always expensive. These lease deals usually involve large tenant improvement allowances. Where tenant is completing the work, landlords will want clarity on the scope of the improvements as changes can impact and require changes to building systems. Laboratory users generally have a higher demand for fresh air and supplemental HVAC needs. Tenants need to be sure that the building systems can meet their demands or insure that supplemental needs can be met (such as by securing roof rights to accommodate additional HVAC requirements). If landlord is completing the build-out, tenant will want to be sure that landlord has experience with lab construction and tenant will want to retain involvement in the development of final plans and the construction due to the specificity of these projects.
- Security Deposits. Biotech companies can be high risk tenants for a landlord. Biotechnology is a volatile business with many failures. Many smaller biotechnology companies are start-ups with no track record, no financials, no tangible assets and unclear future success. Given the foregoing, coupled with the expensive build-outs and potential environmental risks, landlords should seek substantial security deposits. Letters of credit may be preferable to landlords as they are less vulnerable in a bankruptcy situation and may be desirable to a cash strapped start-up (provided they have sufficient credit to secure a letter of credit). Landlord can provide for the security deposit to burn down after the tenant proves financial health. If possible, Landlords should seek a parent guaranty.
- Hazardous Materials. Given the nature of the chemicals often used by biotech tenants it is critical, for both landlord and tenant, to establish a baseline at the beginning and the end of the term. For landlords it is critical to obtain a decommissioning report from its departing tenants wherein industrial hygienists confirm that testing established that no hazardous material remain in the premises. Landlords will also want to insure that radioactive users have obtained any necessary Department of Public Health sign-offs. Landlords should insist on having the decommissioning reports prior to surrender of the space. The decommissioning process can take some time, however, and tenants may not want to shut down operations early to allow for decommissioning so they should consider this decommissioning period when negotiating the term and the move to a new location. Both parties are concerned with assuming responsibility for environmental damage they did not cause, so establishing the baseline at term commencement is critical. The biotech lease should provide that tenant must comply with all environmental laws and regulations and that all chemicals must be used in accordance with good medical or laboratory practice. In addition to these standard provisions, landlord must require tenant to provide chemical lists so they know what is being used in their building. Landlord should maintain these lists after term expiration in the event there is a question down the road about the source of later discovered contamination. With tenants using more volatile hazardous materials, landlords may consider adding “just in time” purchasing requirements in the lease which provide that certain chemicals are only brought into the building when needed and are not stored there indefinitely.
- Confidentiality. For a biotech tenant whose main asset is often its proprietary research or product development, security and risk-management concerns are paramount. While landlords want to retain access rights to the premises for various reasons, biotech tenants often insist that such access must be on prior notice, subject to tenant security requirements (and possibly a nondisclosure agreement), and will only be permitted in the presence of a tenant representative. Tenants may seek to limit landlord’s access to certain areas if entry could impact a costly clinical trial. Landlords will want to insure that entry by landlord is always permitted if there is a reasonable basis to believe tenant has caused contamination or in the event of a default. Tenants may seek to keep the decommissioning reports confidential as others may glean information from these reports based on the combination of chemicals being used. Landlords should avoid such confidentiality requirements as the decommissioning report is a useful tool for the landlord to provide to future tenants as evidence of delivery of a clean space.
- Animal Use. Allowing for a general laboratory use in a lease may permit a vivarium. Landlords should determine during lease negotiation if animal testing is anticipated and what types of animals will be used. Animal testing can bring on noise and odor issues, unwanted public attention to landlord’s building and, potentially, security issues. Landlords will want to limit the movement of animals in and out to after-hours. Public companies may want to explore side letters to document vivarium uses to avoid public filing of leases regarding animal testing.
Written by: Jane Thomassen
Retail tenants entering into long term leases should be aware that tenants’ rights to assign or sublet may prove illusory if other lease provisions effectively prevent transferring the lease to a third party. Here are several lease provisions that should be analyzed to ensure that a prospective transferee has the flexibility to operate its business and be willing to assume the lease:
- Use. The use clause must be broad enough to allow transfers for a different retail use. If the use clause states that the premises may only be used for the original tenant’s particular use “and for no other use or purpose,” the original tenant be precluded from assigning or subletting to a different type of business. Most favorable for the tenant would be for the lease to provide that the premises may be used for the initial use and “ any other lawful use” or “any other lawful retail or commercial use” that does not conflict with any exclusive use then in effect granted to another tenant in the Shopping Center. A compromise would require landlord’s reasonable consent to a change in use.
- Trade Name. Tenants should be wary of agreeing to operate under a specific trade name. If tenant agrees to conduct business under a specific trade name, it should negotiate the right to change the trade name without landlord’s consent. Alternatively, the lease may provide that changes to the name may be approved by landlord, such approval not to be unreasonably withheld, conditioned, or delayed.
- Alterations. If the lease requires landlord’s consent in its sole discretion for all alterations, a transferee may not be able to redesign/refixture the store. Interior, non-structural alterations after the initial build-out should be allowed without the necessity of landlord’s consent. Material alterations (such as exterior alterations, or those that affect the structure, or materially affect building systems) will usually require the landlord’s consent, but such consent should not be unreasonably withheld, conditioned, or delayed.
- Signage. Transferees will need the right to change exterior signage. If the lease requires landlord’s consent in its sole and absolute discretion for changes in exterior signage, a new tenant may be prohibited from erecting its signage. The lease should provide that landlord’s consent to changes in exterior signage shall not be unreasonably withheld, conditioned, or delayed. Furthermore, tenants should seek to limit landlord’s approval rights to proposed changes to tenant’s exterior signs which are consistent with tenant’s current or future prototypical building signs, or those of a successor regional or national retailer’s prototypical building signs.
- Operating Covenant. If the lease requires continuous operation (i.e., no right to go dark), an exception should be carved out for reasonable time periods for transfers and the build outs required before a successor tenant opens for business.
- Certain Tenant Rights only applying to the Original Tenant. The lease may provide that certain rights granted under the lease are only applicable to the original tenant. Therefore, any transferee will not be entitled to such rights. For example, the lease may provide that the tenant’s right to offset rent in the event of self-help is limited to the original tenant. Try to limit these types of restrictions or carve out an exception for subtenants of a certain minimum net worth.
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