Avoiding Lease Pitfalls – Negotiating the Letter of Intent, Los Angeles Business Journal and Orange County Business Journal, December 10, 2007

December 2007

When negotiating the letter of intent or business term sheet, most people focus on financial aspects such as the rent, tenant improvement allowances, CAM expenses, and security deposits. The rest of the “legal” issues are left to the attorneys to negotiate with the understanding (or hope) that one way or another the attorneys will find a way to get the deal done. The problem is that oftentimes, these legal issues overlap with “business” issues. Moreover, there are several key variables that dictate whether or not an attorney should concede some of these legal issues. These variables include the market (is it a landlord’s or tenant’s market), the net worth of the tenant (is the tenant McDonald’s or a mom-and-pop restaurant), the rent, the lease term, the amount of construction investment by each party, the location of the premises, and the demand for similar space. Clients tend to leave it to their attorneys to evaluate these variables and figure out what matters in a particular deal. But not all attorneys are familiar with the current real estate market or what is considered the “standard” way of resolving the legal issues given the variables.  To ensure a smooth negotiation process and avoid delays, frustration, and increased costs, the parties should resolve the legal issues at the letter of intent stage. Here is a list of some of the important legal issues to consider:

1. Possession/Delivery Date

Most leases provide that a landlord will deliver the space to the tenant by a certain date, or upon substantial completion of the tenant improvements. But there is no penalty if the landlord delays delivering the premises. When the possession date is critical to a tenant, the letter of intent should provide that if the landlord delays delivery, the tenant will be entitled to a rent credit. If the delay continues for an extended time (30-180 days), the tenant may have the right to terminate the lease. In some cases, depending on the variables above, the parties should consider adding that the tenant recover its out-of-pocket expenses including its architect’s fees, attorneys’ fees and related costs, up to a certain amount.

2. Options/Fair Market Value

Most letters of intent provide that the tenant will have one or more options to extend the lease term at the fair market value. Some leases state that the fair market value will be determined by the landlord and if the tenant disagrees, the tenant can only revoke its option. Other leases provide that the fair market value will be the highest and best rent the landlord can obtain for the premises. And most provide that the rent will never be lower than the last month’s rent. Tenants should reject these types of provisions or at least modify them to be more balanced. As can be expected, it is fairly common for tenants and landlords to disagree over what the fair market rent is. When this occurs, each side’s “expert” has a very persuasive argument why his or her client’s number is the right one. To avoid these types of (expensive) disputes, the parties should include in the letter of intent a definition of fair market rent and a mechanism (three party neutral arbitration is a common option) to determine the rent should the parties disagree.

3. CAM Expenses

Oftentimes, the letter of intent will state the landlord’s estimate for CAMs (retail) or operating expenses (office) for a given year. But the lease will usually provide that, regardless of the landlord’s initial estimate, the landlord may charge the tenant whatever the actual expenses are without any limit. To avoid the potential of skyrocketing increases, some landlords have agreed to put limits on “controllable” CAMs. For example, landlords may increase the CAM expenses annually by a fixed percentage or the increase in CPI. The certainty of a verifiable fixed increase is appealing in that it provides a cap and the tenant does not need to worry about being overcharged or auditing the landlord’s accounting books. But before agreeing to an automatic increase, tenants should consider whether or not simply increasing the CAMs or operating expenses by their actual increases would result in paying a lower amount. Oftentimes, it will.  Therefore, the parties should figure out what is best for them under the circumstances and include in the letter of intent whether or not the CAM increases will be based on actual increases, CPI, or a fixed percentage.

4. Construction Bonds/TI Allowance

Leases typically provide that a landlord may require the tenant to obtain a lien and completion bond before it starts construction so that, among other things, the landlord is protected from mechanic’s liens on its property if a tenant fails to pay its contractor. Bonds typically cost 2-3% of the total construction costs. Some tenants should have a sufficient net worth to give comfort to the landlord that the risk of nonpayment is minimal. In these cases, a bond may be a waste of the tenant’s money. Instead, the letter of intent should provide that the tenant will not be required to obtain construction bonds.

Leases typically provide that a landlord will not pay the tenant improvement allowance until the tenant satisfies a litany of construction requirements. Where the allowance is substantial, the letter of intent should provide that the landlord will pay a percentage once the tenant starts construction or at least completes a certain portion of construction, so that the tenant is not completely out-of-pocket.

5. Assignment/Subletting

Leases typically provide that a tenant may transfer its lease with the landlord’s reasonable consent. The letter of intent should provide that a tenant may transfer its lease to an affiliated company, such as to a subsidiary, without the landlord’s consent thereby avoiding, among other concerns, delays, and the need to pay the landlord’s associated costs and attorneys fees.

6. Other issues

There are several other important issues including kick-out clauses, co-tenancies, relocation rights, exclusive uses, condition of premises, rights to make repairs, and no-build zones. The more issues the parties deal with up-front the less risk there will be for unnecessary delays and increased costs.