Commercial leases with terms those three years or longer in duration require careful attention by the parties.  Such long-term commercial leases may involve retail, office, or manufacturing premises, or a combination of these uses.  Long term leases of retail space are very common.  These long-term leases often cause problems because of the intrinsically close relationship between landlord and tenant.  Buyers and sellers of real estate expect that the real estate closing represents the end of their legal relationship.  A business failure by either the landlord or the tenant in a long-term lease will require careful by the other party to avoid unexpected injury to its business or investment.

On the other hand, landlords and tenants with long term leases will probably be required to deal with each other for 10 or more years.  However, bankruptcy proceedings often terminate the relationship earlier.  Accordingly, the lease is a critical document.  A well written lease should anticipate a spectrum of situations and future issues.  This newsletter will address certain important issues that sometimes are overlooked as well as some which create continual problems for the parties who are each seeking a mutually profitable relationship.

Bankruptcy Issues
At the time leases are negotiated, many landlords focus exclusively upon the immediate business issues and not issues which could become nightmares for the landlord in the future, should the prospective tenant suffer a business failure or other serious losses.  Such problems can cause expensive and lengthy legal and business problems for the landlord.

Commercial landlords and tenants need to appreciate the impact of the Bankruptcy Code on leases.  A typical example is the provision of the Bankruptcy Code that that an individual or other entity in bankruptcy may reject, assume, or assume and assign any unexpired lease in existence on the date of the bankruptcy filing.  In the case of a bankrupt tenant, the lease must be assumed, assigned or rejected within 60 days of the filing of the bankruptcy petition or the lease is deemed rejected. This period often is extended by the Bankruptcy Court at the request of the bankrupt party.

It is important to understand therefore that the lease may be nullified if either party initiates or is forced into bankruptcy.  In recent years, many retail businesses have requested bankruptcy protection and left large vacant stores in shopping centers. Retail chain stores in financial straits often relinquish their unprofitable stores by offering attractive sublease opportunities for healthy, smaller tenants.

There may be a chain of subleases with several entities interposed between the owner of a shopping center and the real occupant.  Such arrangements increase the prospect of a bankruptcy filing and lease rejection by any entity in the lease chain which thereby disrupts the landlord-tenant relationship.  This often occurs when the intermediate entities suffered financial difficulties in the early stages.  It may be possible to negotiate a new lease between the landowner and the real occupant; however, neither party may be pleased with the result.  Bankruptcy situations may impact the financing of tenant improvements.

Landlords are naturally concerned with the prospect of a bankrupt tenant assuming and assigning a lease to a party that the landlord is not satisfied with.  The alternative prospect of the tenant rejecting the lease and relinquishing the premises is equally alarming.  Under the Bankruptcy Code, lease provisions prohibiting assignment are legally ineffective so that the landlord may be forced to deal with a tenant it would never have selected.  If the lease rental rate is below market rent, the bankruptcy trustee may assume it and then try to transfer the lease through the bankruptcy proceedings.

The highest bidder pays cash to the bankruptcy court for the opportunity to take over the lease. The landlord has the option to bid to terminate the lease and obtain the right to lease to a new tenant. The party desiring to step into the shoes of the bankrupt tenant is required to provide adequate assurance of future performance under the lease and any defaults under the lease must be cured. The landlord also may require a deposit or other form of security from the new tenant equivalent to what the landlord would require upon initial leasing to a similar tenant.

There are additional protections for shopping center landlords.  The Bankruptcy Code states that the landlord is not required to accept a new tenant unless:  (a) the financial condition and operating performance of the new tenant is similar to that of the bankrupt tenant at the time the lease was entered into, (b) any percentage rent will not decline substantially; (c) the new tenant will comply with the location, use and exclusivity lease requirement; and (d) the tenant mix in the shopping center will not be altered.  Although those provisions offer protection for a landlord, the bankruptcy of its tenant will likely harm the landlord in a material way.

Leasehold improvements

Bankruptcy nullification is problematical for lease parties that have invested substantially in leasehold improvements.  Lenders often require insist that developers arrange long-term leases to cover their cash flow requirements.  Developers and their lenders should carefully evaluate the financial and business prospects of their tenants, particularly their anchor tenants.  A tenant that pays for its own improvements suffers substantial risks, particularly if it invested in unique fixtures or other improvements that other tenants may find unusable or if they are situated at the end of a lease chain in which one of the intermediaries is in a difficult financial situation.

One device that may protect both parties is a free rent arrangement. Under this approach, the tenant pays for improvements the landlord would normally pay for in order to make the premises suitable for occupancy.  In exchange, the tenant will be entitled to a free rental period at the beginning of the lease.

The tenant should be able to recover its expenditures within a relatively short time frame, thereby reducing its risk of the landlord's bankruptcy. At the same time, the landlord is not required to spend large sums for improvements.  In the event that the tenant subsequently voids the lease through bankruptcy, at minimum the landlord regains an improved property which hopefully will attract other prospective tenants.  For example, this approach benefits landlords owning older properties that were vacant and in need of significant upgrading.

Initial and renewal terms

Long-term commercial leases typically provide for an initial term of between 2 and 10 years, and then one or more renewal or option terms. A rule of thumb is 5 years.  Tenants prefer shorter initial terms and a series of short renewal terms preferably with no rental increases to give them the right to remain if they desire, but to move if business necessities require.  Naturally, landlords typically prefer longer terms with frequent rent increases.
Renewal provisions generally require the decision by the tenant to renew between 60 days and one year prior to the expiration of the current term.  Tenants desire a short notice period for maximum flexibility. If the landlord and tenant cannot reach an agreement on the length of the initial term, a compromise may be a provision granting the longer term, but allowing the tenant to terminate the lease early if a stated financial target such as annual gross sales is not achieved.

The tenant needs to be vigilant about meeting renewal deadlines because the consequences of missing a deadline can be disastrous.  Certain leases provide for automatic renewal if a tenant takes no action, but the tenant should still track the deadlines.

  • Landlord waivers
  • Percentage Rent
  • Tax Escalation Clauses
  • Pro-Rata Share & Additions
  • Renovations
  • Tax Reassessments Upon Sale
  • Lease Options to Renew, Options to Purchase and Other Options
  • Option to Renew Lease
  • Renewal Rental Price or Purchase Price Based on Market value
  • Options to Purchase, Early Termination, Right of First Refusal
  • Nondisturbance Subordination and Attornment Agreements
  • Maintenance issues
  • Summary

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