By: Craig T. Watrous:
Office leasing presents a unique variety of issues for landlords and tenants to consider. Due to the nature of a business’s operations, a tenant’s use of commercial space can require expensive tenant build-outs, special use considerations, ADA compliance, and technology access. Because of these up-front costs, commercial office leases often last between 3 to 7 years. The result is a game of risk and cost shifting between the landlord and the tenant. For landlords, office leases can be lucrative and relatively stable investments. For tenants, the terms of their lease can affect the profit margins, growth potential and overall operations. For these reasons office leases are often heavily negotiated, complex documents that shouldn’t be taken lightly. This article attempts to summarize some of the key issues that both landlords and tenants should consider when negotiating their office leases. Rather than take sides, we’ve tried to highlight areas in the office lease that both the property owner and the business owner/director should consider. Of course the list isn’t exhaustive, but hopefully it provides food for thought.
Existing Condition of the Premises
The condition of the Premises prior to commencement of the Lease will largely determine the amount of tenant build-out required to get the space ready for the tenant. In addition to the Tenant build-out which is discussed more below, the tenant and landlord will need to determine what representations and warranties are going to be made regarding the space’s condition. Is this an “As-Is” transaction resulting in a triple net lease where the tenant becomes responsible for the maintenance, repair and replacement obligations related to the Premises during the term of their tenancy? Or is the landlord willing to make some reps and warranties concerning the condition of parts of the Premise, for example the condition of the structural components, the compliance with existing laws, the condition of the HVAC equipment, etc.?
Construction of Tenant’s Improvements/Build-out
Assuming the space isn’t perfect and ready to go (which it rarely is), the issues related to the construction of the tenant’s improvements (the build-out or remodeling of the space), the completion of such improvements, the commencement of the term of the lease, and the obligation to start paying rent are among the most important issues to be addressed in the lease negotiation. What is the scope of the landlord’s obligation to finish out the space? How much is the landlord willing to contribute? How will these costs be amortized into the lease? What contractors and architects can the tenant use? How will change orders be handled? What are the time frames for completion, and what happens if completion gets delayed and the tenant can’t open on time? Landlords and tenants often enter into a work letter which should outline most of these issues. The terms of the work letter should then be referenced in the lease to make sure that the parties are on the same page.
Term, Commencement Date, Rent Rate and Renewal Options
When the term of the lease actually starts and when the obligation to start paying rent begins should be tied in with the construction and completion of the tenant’s improvements. Often it depends on whether or not the landlord or the tenant is responsible for finishing the tenant’s improvements, as that party has more direct control over when the Premises are actually available for use. The parties may determine a fixed date, or it may start on the day the tenant commences its business operations in the space. There might be penalties for delays. If the landlord is constructing the tenant improvements and significant delays occur, does the tenant have the right to terminate the lease or to seek damages?
Office leases often have terms between 3 to 7 years. For landlords, because cost is put into the space prior to the lease which is often unique to the tenant, a longer term helps to recapture some of the upfront costs. For tenants, the main concerns are often its location and a space that suits the business in the present and near future. If that location works, the tenant will want a longer term and lease extensions to lock it in. When things are going well both parties will want the lease to continue, but considerations should be put in place regarding not only the initial term but also renewals and extensions. While the tenant may want automatic extensions, the landlord should consider putting in provisions that protect it from getting locked into a long term relationship with a problematic tenant. If the tenant has had defaults in the past, the landlord may want discretion over future renewals. How will rent be determined for the renewal periods? Will the landlord offer additional tenant build-outs during the renewal periods to upgrade and/or modify the Premises? Landlords need to be able to plan well in advance how their spaces are going to be used, so the parties need to also negotiate how far in advance the tenant needs to exercise its renewal options.
Some businesses need signage, particularly if the offices are going to be used to meet with clients. Similarly, landlords want to ensure that the tenant is able to draw clients while protecting the appearance of the property. If the premises are part of a larger building there may be some restrictions on sign placement, size and style dictated by local building codes or ordinance. If the premises are older, the tenant may want to install new signs.
Security Deposit and Personal Guaranty
Businesses sometimes fail. Keep in mind, some office equipment is leased and most used office equipment has very little value, so when a business goes under often a landlord’s best hope of recovery is to go after the tenant’s security deposit. Thought needs to be put into how much deposit is reasonable while still working within the business’s initial operating capital needs. Does the landlord want to require a personal guaranty from one or all of the tenant’s principals? Personal guaranties are particularly common in scenarios where a landlord is leasing to a smaller business and/or a newer business.
The parking is often overlooked in office leases but it can be vital to the tenant’s use of the space. However, it’s not just the parking for the businesses’ clients that needs to be considered but also parking for the tenant’s employees. For property owners, if other tenants use a development’s parking facilities, they need to be careful that one business tenant doesn’t monopolize the lot.
Ambiguities in leases lead to disputes, and disputes can lead to lawsuits. A standard, off-the-shelf form, likely won’t address the particular needs and concerns of the business owner/director and property owner. It’s worthwhile for both parties to spend extra time upfront negotiating lease terms and putting the details in writing. We hope this article has been helpful.
(Mallon Lonnquist Morris & Watrous, PLLC, is a business, employment, real estate, and litigation law firm. Craig T. Watrous is a Colorado real estate attorney and partner at MLMW, based in Denver, Colorado. Craig regularly represents clients both in contracting and disputes. Craig can be reached at firstname.lastname@example.org and (303) 722-2165.)