(The AIR lease form should be carefully reviewed to address missing
provisions and to clarify existing terms to avoid costly disputes.)

THE AMERICAN INDUSTRIAL REAL ESTATE ASSOCIATION provides some of the most widely used commercial real estate lease forms in California. Many landlords and tenants—and more important their brokers—favor using these forms because they help get the deal done fast and cheap—concepts that deal makers may perceive to be anathema to attorneys. Often, the parties simply fill in the blanks on the front cover of the lease form, draft a short addendum to address issues specific to their deal, perhaps scoff at the notion of needing attorneys, and then sign the last page. The parties rarely revise the language in the lease. After all, it is the standard form.

Over the years, however, landlords and tenants faced with lease disputes have discovered that what is one landlord’s standard is not necessarily another’s, and more important, what is one landlord’s standard is not the tenant’s. Moreover, landlords and tenants have discovered that the lease form does not address all the issues that they should be concerned about, and in some cases, even when it does, it does so in ambiguous ways. For these reasons, parties to a lease should specifically discuss certain issues before using the AIR Standard Lease form.[1]  

One issue on this standard form is the commencement date. Parties should look beyond Paragraph 1.3, Term, which provides a blank to be filled in for the commencement date of the term of the lease. Elsewhere in the lease, Paragraph 3.3, Delay in Possession, provides that if the landlord fails to deliver the premises to the tenant by the scheduled commencement date, there is no penalty, unless the landlord delays delivery of the premises by 60 days. If that happens, the only recourse a tenant has is to terminate the lease. This section further provides that if the premises are not delivered within 120 days of the commencement date, the lease will automatically terminate. These two paragraphs can become problems when a dispute arises about construction delays for the tenant improvements to the premises, especially when the landlord is responsible for the work.

In many cases, tenants must move into their new premises by a certain date because they are moving out of existing locations and must do so by a certain date or risk paying holdover rent and other damages. Even if the tenants do not have expiring leases, timing is still critical, since the tenants have already ordered furniture and hired employees. The tenant cannot afford to wait 60 days after the scheduled commencement before looking elsewhere for a new location (which, itself, often takes several months). Tenants therefore have reason to negotiate for the standard 60 days to be reduced. In some cases, the tenant may insist on zero, but most landlords will require some delay time, if not even 60 days.

Discussing the 60-day period does more than diminish the tenant’s timing risk. It motivates the landlord to commit its resources to making sure that the tenant will have access on time. The landlord will not want to risk losing the tenant after spending time and money constructing the premises to suit the tenant’s needs. Since delay will likely cause damages to the tenant, if possible it should also require the landlord to agree to pay the tenant’s damages in the event the landlord delays delivery of the premises. For example, the landlord can agree to pay for the tenant’s holdover damages for its existing location and give the tenant free rent for each day of the landlord’s delay.

In many leases, the commencement date is defined as the date that the landlord achieves “substantial completion” of the tenant improvement work. Substantial completion means that the landlord has completed enough work that the tenant is able to conduct its business from the premises. What remains are “punch-list” correction items (e.g., fixing a doorknob, doing touch-up paint, etc.). When the parties use “substantial completion” to define the commencement date, the language in Paragraph 3.3 must be modified, since it only gives the tenant the right to terminate if the landlord fails to deliver possession of the premises within 60 days of the commencement date, as determined by substantial completion. This circular language is not helpful to a tenant because the landlord will only be in danger of violating Paragraph 3.3 if the landlord substantially completes the work to the premises and then refuses to hand over the keys. This is highly unlikely.

A more common problem arises when the landlord, for a variety of reasons (such as construction delays), fails to substantially complete the work to the premises on the date that the parties intended. In this more likely scenario, the landlord will be permitted to delay completing its work without penalty since the tenant’s 60-day right to terminate is only triggered after the landlord substantially completes the premises, not before. To protect itself, a tenant should demand a fixed date by which the landlord must deliver the premises or give the tenant the right to terminate or collect damages or both.

From the landlord’s perspective, some of these same issues will arise if the tenant is responsible for the work and the commencement date is tied to substantial completion. To avoid the circuitous language, most landlords will want to shift the construction delay risks to the tenant and provide that the commencement date shall occur upon either a fixed date or the date the tenant opens for business, whichever is earlier, regardless of when the tenant completes its construction.

To figure out which party bears responsibility to comply with applicable laws (“requirements” in the most current AIR lease forms), one must first read through a maze of paragraphs in the lease form that contain confounding “subject to,” “except as otherwise provided,” and “notwithstanding” disclaimers. Even if parties or attorneys successfully navigate the lease form, they must consider the two cases decided by the California Supreme Court on the same day in 1994: Brown v.Green [2] and Hadian v. Schwartz,[3] in which the court analyzes two virtually identical provisions in a prior version of the AIR lease form concerning compliance with laws provisions and reaches opposite conclusions.

Paragraphs 2.2, Condition; 2.3, Compliance; 6.3, Lessee’s Compliance with Applicable Requirements; 7.1(a)-(d), Lessee’s Obligations; 7.2, Lessor’s Obligations; and 49, Americans with Disabilities Act; all address the various rights and responsibilities of the landlord and tenant.^4[4]

Read together, these paragraphs provide that the tenant is responsible to comply with all laws affecting the premises resulting from 1) the tenant’s use of the premises, or 2) any cause (even unrelated to the tenant’s use of the premises) if those laws affect the premises following the expiration of a landlord’s six-month warranty, unless compliance is required during the last two years of the lease term, in which case the tenant will only be responsible for the amortized portion of the cost to comply with laws, amortized over 12 years.

In Brown and Hadian, the California Supreme Court held that despite the fact the tenant expressly agreed to comply with applicable laws, that agreement alone did not encompass the repairs at issue if the repairs qualified as substantial. Therefore, despite contrary language in the lease, a landlord may still be responsible for repair costs. In both cases, the court disregarded the clear and unambiguous language in the AIR lease form. Instead, the court applied a six-factor test for the tenant’s obligation to repair: 1) the relationship of the cost of the curative action to the rent reserved, 2) the length of the term and the time for the cost to be amortized, 3) the relationship of the benefit to the tenant to that of the reversioner (i.e., the landlord), 4) whether the curative action is structural or nonstructural, 5) the degree to which the tenant’s enjoyment of the premises will be interfered with while the curative action is being undertaken, and 6) the likelihood that the parties contemplated the application of the particular law or order involved.

In Hadian,[5] the landlord incurred costs in seismic reconstruction of a building ordered by the city as part of an earthquake hazard reduction program. The court held that the landlord alone was responsible for such costs, notwithstanding a provision in the lease requiring the tenant to, in part, comply with all applicable requirements regulating the use by the tenant of the premises. The court held that the term of the lease and the extent to which the incidents of full ownership of the property are transferred to the tenant are among the most important provisions of the lease to consider in determining whether it is truly a “net” lease. This reasoning suggests that if the lease is a net lease, then it may be held that the parties intended for the tenant to share in such costs. In this case, the term of the lease was only three years, which the court determined was a very short term and would have provided the tenant a limited amount of time in which to amortize the costs of repairs over the life of the lease. The cost of the repairs represented a substantial percentage of the aggregate rent over the term and would amount to capital improvements to the property that would primarily benefit the landlord.

In Brown,[6] the landlord incurred costs in connection with removing asbestos-laden material from a building pursuant to a county order. The court held that the tenant was responsible to reimburse the landlord for the costs. The court found that the term of the lease was long enough to permit the tenant to amortize the costs. The amount necessary to remove the asbestos-laden material was less than 5 percent of the total rent reserved over the 15-year term of the lease. In addition, the lease expressly provided that the landlord was to have no obligation and the tenant all obligation to repair and maintain the premises, whether structural or nonstructural.

What this suggests is that neither landlords nor tenants should assume that merely allocating the risk to one party or the other (even unambiguously) in the lease will be determinative of which party will ultimately bear the risk. The final outcome depends on the court’s six-factor test, but the language in the lease will play a relevant factor in determining the outcome, and the parties should make sure the terms meet their expectations.

In addressing the specific language in the relevant paragraphs, a tenant should resist the requirement that it bear the cost to repair or comply with laws if the compliance is triggered after the landlord’s six-month warranty period expires, especially in a short-term lease in which the substantial benefit of the compliance will inure to the landlord. Also, a tenant should object to the language that gives the landlord the right to terminate the lease if the compliance is caused by reasons outside the tenant’s use. The tenant should not lose its lease for something that the landlord will be required to remedy even after the tenant moves out. A tenant should consider revising the amortization period to apply to the “useful life” of the item rather than the form’s 12-year period. Further, tenants should attempt to delete Paragraph 49 or modify it to state that the landlord must warrant that, at least, the premises complies with disability laws or will by the commencement date.

Audit Rights

Another part of the standard lease that bears examination is Paragraph 4.2 of the AIR office lease forms. It provides a nonexclusive list of operating expenses that the landlord may charge the tenant and lays out a few exclusions. Since the list is nonexclusive, it is assumed that unless excluded, additional items may be charged to the tenant. It has become common practice for tenant attorneys to provide a list of exclusions from operating expenses to ensure that the tenant is only paying for its fair share. Most lists contain reasonable exclusions (e.g., charitable donations made by the landlord, lease expenses with other tenant prospects, entertainment or travel expenses, etc.), but in some cases aggressive tenant attorneys try to include a few substantive exclusions that are not part of the negotiated deal (Proposition 13 protection, preclusion of earthquake insurance, or exclusions of all capital expenditures). In the end, the tenant should ensure that the landlord does not treat the collection of operating expenses as a source of profit. The landlord, in turn, often seeks to make sure that it keeps a consistent list of permitted inclusions in its leases to avoid the accounting nightmare of having items excluded under some leases and included in others.

The AIR lease form does not contain a right for the tenant to audit the landlord’s books and records concerning operating expenses. No case law in California gives a tenant an implied audit right, but it is widely believed that a tenant may compel an audit through discovery following commencement of a lawsuit. At least one case in Maryland holds that a tenant had an implied common law right to audit the landlord’s books when the lease was silent.[7] With this in mind, it is best for both parties to address the tenant’s audit rights in the lease. At a minimum, the audit provision should address 1) the time and manner for requesting and conducting the audit, 2) the qualifications of the person performing the audit, 3) who pays for the audit and whether the tenant is entitled to reimbursement of audit costs if an error is discovered, and 4) confidentiality.

Assignments and Subletting

Paragraph 12, Assignment and Subletting, and Paragraph 36, Consent, address the various rights and obligations of the parties with respect to assignment and subletting. In essence, the tenant is afforded the right to assign or sublet the premises to a third party, subject to the landlord’s reasonable consent. These paragraphs are fairly balanced, but landlords and tenants often seek something other than balance. From a tenant’s perspective, the AIR lease form notably does not allow a transfer to an affiliate without the landlord’s consent. From a landlord’s perspective, the form fails to address recapture rights that give the landlord the right to terminate the lease if the tenant seeks to assign or sublet (especially if the tenant stands to profit from the transfer). The AIR lease does contain a separate addendum that covers limited recapture rights that most landlords like to revise to make unlimited. At first glance it would appear that an unlimited recapture provision and Paragraph 36, Consent-Reasonable, are inconsistent provisions. The California Supreme Court in Carma Developers (California), Inc. v. Marathon Development California, Inc.,[8] held, however, that a recapture clause in a commercial lease is enforceable and is not subject to a reasonableness requirement. Assuming that the landlord does not add the recapture addendum, the AIR lease form does not address what happens in the context of a transfer by the tenant for a profit and how the profit will be treated by the parties. Most landlords require at least 50 percent of the profit generated from a transfer. Regardless of how it is split, the profit must be defined. Tenants will want to exclude transfer costs (such as broker commissions, improvement allowances, downtime, legal fees, and so on). Landlords will want to ensure that the tenant is not defining “profit” in a way that avoids having to pay landlords their fair share.

Landlords also prefer to provide in the lease that if the tenant accuses the landlord of improperly withholding consent to a proposed transfer, then the tenant must seek a court injunction to require the landlord to issue its consent rather than sue for damages. Paragraph 12.1(e) provides that a tenant may recover compensatory damages from the landlord in addition to obtaining injunctive relief. Therefore, landlords often want to modify the paragraph to delete that remedy.

Other Issues

The AIR lease form was drafted and paid for by brokers. Therefore, it is no surprise that there are several provisions in the lease form that reward or protect brokers. Some of these provisions include Paragraphs 2.4, Acknowledgments; 15.1-15.2, Broker Fees; and 25, Disclosures Regarding the Nature of a Real Estate Agency Relationship. It is customary for most attorneys, much to the chagrin of brokers, to delete these provisions as superfluous at best and possibly harmful.

For example, Paragraph 15.1 provides that a landlord must pay the broker an additional commission if the tenant exercises its option to extend the term of the lease. If the parties agree to pay the broker this additional commission, then they should say so in a separate commission agreement between the landlord and the broker. This clause has nothing to do with the relationship of the landlord and tenant and should not be part of the lease. Another example is the statute of limitation of one year for either party to bring a claim against the broker arising out of the lease transaction. This has nothing to do with the landlord-tenant relationship and should be deleted.

Security Deposit. Paragraph 5 of the lease provides, in part, the terms upon which the security deposit may be used by the landlord. Landlords must revise this section to avail themselves of the ability to apply security deposits against a defaulting tenant’s future rent obligations. In 250 L.L.C. v. PhotoPoint Corporation,[9] the court ruled that under Civil Code Section 1950.7, upon the termination of a lease, the landlord may not retain the security deposit to cover its damages for future rent owed under the lease (as opposed to past rent). The court explained, however, that a tenant can waive Section 1950.7 in commercial leases, thereby allowing landlords to apply the security deposits toward future rent. Therefore, attorneys for landlords should add a waiver of the protection of Section 1950.7 or any similar, related, or successor provision of law. While the 2006 form has been updated to allow for future rent, the parties should take the extra step of expressly waiving the statute.

Removal and Surrender. Paragraph 7.4(b) of the lease provides, in part, that the landlord can require the tenant to remove its alterations and utility installations provided that the landlord delivers notice not earlier than 90 and not later than 30 days before the end of the lease. Tenants may seek language that the landlord must give tenants notice of the necessity of removal of alterations and utility installations before the tenant makes them. This way, the tenant can determine—before undertaking the anticipated work— whether the improvements make economic sense, after factoring in the cost of removal at the expiration of the lease. In some cases, these costs may be substantial.

Paragraph 9, Damage or Destruction, provides a landlord with the right to terminate the lease if the damage to the premises exceeds six months’ rent. This is an arbitrary figure and not customary in other leases. Depending on the terms of the lease and rent, the parties may review this threshold to suit their deal.

Limitation of Liability. Paragraph 20 of the lease provides, in part, that the tenant will look solely to the project for satisfaction of any liability of the landlord with respect to the lease. When an attorney representing the tenant is faced with a landlord that is not willing to eliminate this provision, the attorney may seek to expressly clarify that the tenant may also look to the rents, issues, profits, proceeds, and other income arising from the project regardless of who the receiver is (e.g., the landlord or its lender), and that the provisions of Paragraph 20 shall have no effect on the tenant’s rights to withhold or offset rents.

Nondisturbance and Attornment. Paragraph 30.3 of the lease provides, in part, that the tenant’s subordination of the lease will be subject to the receipt of a nondisturbance agreement regarding security devices (i.e., ground leases, mortgages, deeds of trust, or other hypothecations or security devices) that the landlord becomes a party to after the execution of the lease. The lease does not address security devices entered into by the landlord before the execution of the lease. The landlord may find it difficult to obtain a nondisturbance agreement from a current lender, but an attorney representing the tenant should request one anyway. Without one, the lease could be terminated upon foreclosure.[10]

Paragraph 30.2 of the lease provides, in part, that if another party succeeds to the interest of the landlord upon a foreclosure, that party will not be liable to the tenant for the prior landlord’s acts or omissions or be subject to any offsets or defenses which the tenant might have against the prior landlord. Although this is a standard provision in most leases, what is the tenant to do if the landlord fails to pay the tenant improvement allowance, if any, or construct the tenant improvements? An attorney who represents the tenant will want the lease to provide that the tenant may deduct from rent the applicable amounts upon such failure by the landlord.

Waiver of Jury Trial. Paragraph 47 of the lease requires the landlord and the tenant to waive their rights to a trial by jury in any action or proceeding involving the property or arising out of the lease. However, in Grafton Partners, L.P. v. Superior Court,[11] the California Supreme Court held that predispute contractual jury trial waivers are not enforceable in California. Consequently, landlords and tenants must resort to alternative methods to handling future disputes. A party (whether a landlord or a tenant) that wishes to avoid a jury trial should add a separate provision in the lease requiring either judicial reference (a process similar to a court trial, which may be appealed) or arbitration (a process that in virtually all cases is nonappealable).

The AIR lease form, while commonly used and favored by brokers, should be carefully reviewed by the parties before they sign the lease to address missing provisions and to clarify existing terms to avoid costly disputes. As much as parties may want to close a lease deal quickly and cheaply, the less costly method may be to involve lawyers at the beginning of a landlord-tenant relationship rather than at the end.

Los Angeles Lawyer January 2007 Los Angeles attorney Nadav Ravid is a partner and the administrative chair of Buchalter Nemer’s real estate practice group.