A well-drafted lease agreement will go a long way toward protecting a commercial landlord and ensuring that its expectations are achieved. However, sometimes what may seem like a minor lease term can have very large financial consequences down the road. Here is a discussion of a few pitfalls that can be avoided.

Leeway for late delivery of possession

It is common for delivery of the premises to be delayed due to an inability to secure labor or materials to build out the tenant improvements, or the failure of the current tenant to vacate at the end of its term. No matter what the cause of delay, the landlord is exposed to a claim by the tenant for damages that it suffers. These could be exorbitant holdover rent that it must pay to its current landlord or loss of profits if it is evicted from its current premises and, therefore, cannot conduct business. A well-drafted lease will give the landlord leeway on when it must deliver the premises and limit the damages.

Increase the rent on renewal to market

Options to renew the term of a lease should, and typically do, call for increased rent. This rent increase can be based on a stated percentage, an increase in the applicable Consumer Price Index (CPI), or fair market value as determined by arbitration. Because property values and corresponding rental rates in any given area may not increase at the same rate as the CPI, relying on the CPI can result in unreasonably low rent. Even a rent increase based on a stated percentage should be brought up to fair market value at least every five years.

Rent recovery: discount rate vs. interest rate

Many leases include a clause that allows the landlord, upon a tenant default, to immediately recover the discounted present value of all future rent. A common landlord mistake is to specify a discount rate that is the same as the rate of interest that applies to delinquent monthly rent – often as high as 18 percent per annum – believing that a higher discount rate will produce a larger amount owed by the tenant. The exact opposite is true: the lower the discount rate, the greater the amount the tenant will owe; and the higher the discount rate, the lesser the amount the tenant will owe.

Consider possible redevelopment

Over time, leased property may become much more valuable if redeveloped for a different use. A strip mall may become a prime location for an office tower, or an undeveloped parcel leased for a cell tower may gain value if developed. Even a lease to a small tenant cannot be terminated by a landlord (absent a tenant default), because a leasehold is a vested property right. Thus, even a small tenant has leverage to demand whatever payment it sees fit for termination of its lease – it does not have to be reasonable. For a property that is likely to be redeveloped, either a short term, or a right for the landlord to relocate the tenant or terminate its lease, should be included in the lease.

Repair and maintenance: Don’t leave a gap

We’ve seen leases that simply do not address which party has responsibility to repair and maintain certain components in good condition, such as HVAC, water, sewer, electrical, and parking. Without an express agreement to repair and maintain the improvements, a tenant’s only obligation is to not permit “waste” at the property. Therefore, a clause should be included that provides that the tenant has responsibility for any item of repair and maintenance that is not expressly placed upon the landlord by the terms of the lease.

Tenant improvements: Who insures and rebuilds?

Because tenant improvements are often owned and maintained by the tenant, the landlord may believe that the tenant is responsible to insure and rebuild them after a loss. But leases often simply provide that the landlord will rebuild the building after a loss, without expressly addressing the tenant improvements. The lease should specifically call out which party has responsibility to insure and rebuild the tenant improvements. No landlord (nor a tenant) wants to discover after a loss that it has responsibility to rebuild the tenant improvements and that it was not covered under its policy.

Avoid an insurer’s claim: waiver of subrogation

A waiver of subrogation clause is likely to confuse nonlawyers; however, it can be of critical importance. Without a waiver of subrogation, a landlord can be liable to pay for the loss that its tenant suffers that is attributable to the landlord, even if the loss is covered by the tenant’s insurance. For example, if the landlord’s faulty wiring causes a fire that destroys all the tenant’s personal property (e.g., inventory, computers, and equipment), the tenant’s insurance company will pay the tenant for the loss and then be subrogated to the tenant’s rights against the landlord. That means the tenant’s insurance company will be able to recover from the landlord the amount it paid the tenant.

Don’t rely solely on additional insured endorsements

Many leases require a tenant to add the landlord as an “additional insured” on its liability policy. However, landlords should always obtain their own liability policy or require “an additional named insured” endorsement. The “additional insured” endorsement only insures the landlord against claims that arise through the tenant. For example, a claim by someone who is injured or dies in a fire caused by the landlord’s faulty wiring would not be covered under the additional insured endorsement (assuming the tenant did not have responsibility for maintaining the wiring).

When you’re done, be sure you’re done

A well-drafted lease agreement will provide that, upon a sale, the original landlord is released of all liability. Many landlords believe that once they no longer own a property, they necessarily are relieved of the landlord’s obligations under the lease agreement (e.g., to repair), but that is not the case. The new landlord has primary responsibility, but the former landlord remains liable unless the lease agreement provides for release upon a sale. If the new landlord is in bankruptcy, the tenant will find it much easier to collect from the former landlord.

Jonathon L. Goodling is a partner at Miller Nash LLP, where he handles commercial real estate and finance transactions. Contact him at 503-205-2522 or jonathon.goodling@millernash.com.

The opinions, beliefs and viewpoints expressed in the preceding commentary are those of the author and do not necessarily reflect the opinions, beliefs and viewpoints of the Daily Journal of Commerce or its editors. Neither the author nor the 91��Ƶ guarantees the accuracy or completeness of any information published herein.

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It’s a dangerous world out there. We cannot eliminate all risks. But a well-drafted lease can minimize risk, and a poorly drafted lease can unnecessarily create serious problems for either a landlord or a tenant. Following are instances in which a serious problem would not exist but for a poorly drafted lease.

Unexpected operating expenses

Leases often require a tenant to pay its pro rata share of “operating expenses.” Such clauses are often drafted broadly to include all costs of owning and operating the property and may obligate a tenant to pay a share of significant cost items, such as environmental cleanup costs, insurance deductibles upon damage to the property, and the cost of capital expenditures to improve the property.  Regardless of whether the tenant’s pro rata share is a few percentage points or 50 percent or more, a tenant will not want to share in these costs.

Compliance with law

Most leases require the tenant to comply with applicable law.  Some are phrased in such a manner that they obligate the tenant to make improvements to the premises required by applicable law. More than one tenant has been shocked to discover that it is obligated to make expensive capital improvements, such as seismic upgrades or compliance with the Americans with Disabilities Act.

Release of landlord upon sale

Many landlords assume that upon sale of the property they are relieved of all obligations under the lease. This is not the case unless the lease expressly provides to that effect. If the provision is not included, the property is sold, and the buyer fails to perform an obligation required by the lease, such as to construct tenant improvements, the tenant will have recourse against the original landlord.

Condition of premises upon surrender

Leases generally provide that the tenant must surrender the premises in good condition at the end of the lease term. Some leases provide that the premises must be restored to original condition.  Such a clause requires the tenant to remove all improvements that were made by or for the tenant and return the premises to its original condition. This could be an extremely expensive endeavor.

Waiver of subrogation

Every lease should include a mutual waiver of subrogation rights with respect to the insurers. If an appropriate waiver is not included, the insurer of the building, upon paying the landlord for the value of the damage suffered in a fire, is “subrogated” to the landlord’s rights and may assert any claim that the landlord may have arising from the fire. If the fire was caused by the tenant’s negligence, the insurer can sue the tenant to recover all that it paid to the landlord. Conversely, if an insurer of the tenant’s personal property pays for a loss when the loss was caused by the landlord’s negligence, the insurer may recover from the landlord the amounts that it paid to the tenant.

Outside the premises

A tenant should think beyond the four walls of the premises and consider whether it needs to use any amenities, such as parking and common-area conference rooms. Unless the lease directly grants the tenant the right to use such facilities, the tenant may find that they are unavailable when the landlord decides to convert the facilities to a different use.

Discount rate

Many leases provide that upon a tenant default, the landlord may recover all the rent for the entire lease term, discounted to its present value at a specified rate. Many tenants and even some landlords confuse this discount rate with an interest rate. In fact, the lower the discount rate, the more the tenant will owe. A tenant should always negotiate for the highest discount rate possible, and a landlord should always negotiate for the lowest discount rate possible.

Tax-exempt tenant

A 501(c)(3) tax-exempt organization may sign a lease that requires the tenant to pay the taxes ,believing it will be exempt from paying the taxes. However, under Oregon law, the county tax assessor will reject the application for exemption unless the lease expressly states that the rent has been set at a level to take into account that the tenant is a tax-exempt entity and that all the benefits of the property being exempt from taxation will inure solely to the tenant.

Casualty damage to tenant improvements

Tenant improvements can often be very expensive, particularly in high-rise offices. Yet leases commonly fail to adequately address which party has the responsibility to insure the tenant improvements and to rebuild them upon casualty loss. A lease may provide that the landlord is responsible to rebuild the premises following casualty loss, which by its terms includes the tenant improvements. But the insurance the landlord carries may not cover the tenant improvements. Conversely, a tenant may assume that the lease requires the landlord to rebuild the tenant improvements and upon that assumption not obtain its own insurance, when in fact the lease does not so require.

Subordination and non-disturbance

Many leases provide that the lease is subordinate to any existing or future mortgage against the premises. From the tenant’s perspective, this clause should always be coupled with a “non-disturbance” clause, which provides that so long as the tenant performs under the lease, the tenant’s possession will not be disturbed. Without a non-disturbance clause, if the landlord defaults on its loan and the lender becomes the owner of the premises, the lender will have the ability to terminate the lease and evict the tenant. It will be able to use this right to extract a substantial increase in rental.

Both landlords and tenants can avoid danger by using an appropriately drafted lease. Money and time spent with an experienced real estate lawyer before signing a lease is money and time well spent.

Jonathon Goodling is a partner in Miller Nash Graham & Dunn LLP. He handles real property transactions and represents borrowers, lenders, developers, owners, tenants, landlords, purchasers and sellers. Contact him at 503-205-2522 or jon.goodling@millernash.com.

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