Commonly Misunderstood Tenant Issues in Office Lease Negotiations
Debra L. Bruce, JD, PCC.
If you aren’t a real estate lawyer, you may feel a little boggled by the terms of the office lease proposed by your prospective landlord. Which provisions are fairly standard? Where are the minefields that could blow up later? Our Guest Blogger, Scot Dixon, is a real estate lawyer at Vinson & Elkins LLP in Houston, TX. He points out common misconceptions and traps for the unwary relating to commercial office leases in Texas.
Guest Blogger – E. Scot Dixon:
I. WHAT EXACTLY CONSTITUTES THE “PREMISES”
The base rent in an office lease is usually a “per square foot” figure rather than a fixed number. Base rent is determined upon something called the “leaseable area” of the premises. It is important to keep in mind that “leaseable area” is a specialized term of art and does NOT mean the actual area of the premises that Tenant occupies. The “leaseable area” is the actual area of the premises itself (often called “usable space”) plus what is commonly referred to as a “common area factor,” which is the Landlord’s estimate of the percentage of total building area taken up by common areas.
“Common areas” are usually defined as all areas in the building that are used by or for all tenants of the building, such as: building lobby, corridors, janitorial and electrical closets, elevator rooms, and rest rooms (common areas typically do not include vertical penetrations such as elevator shafts and stairwells). The Landlord determines the percentage of the building these areas represent and adds that percentage to the amount of space the Tenant occupies to come up with the “leaseable area.”
So, for example, let’s say that the usable area of the Premises is 2,000 square feet and the rental rate is $15.00 per square foot per year. Now assume that the building has a “common area” factor of 15% (meaning Landlord estimates that the common areas of the building comprise 15% of the total building area). This means that the number of leaseable square feet (which, recall, is the number of square feet upon which Tenant pays rent) is 2,000 square feet plus 15%, for a total of $2,300 square feet. The bottom line to all this in our example is that the common area add-on factor results in an effective 15% increase in the nominal rental rate, if the total rent payable per year (using leaseable square feet) is divided by the usable area of the premises. In our example, the total annual rent is $15.00 X 2,300 or $34,500. Dividing this total by the usable area (2,000 sf) gives an “effective” rental rate, if you will, of $17.25 psf, compared to a nominal rental rate of $15.00 psf.
II. WHAT SHOULD THE “PERMITTED USE” BE?
Often the “permitted use” of the premises in an office lease is simply stated in the Landlord’s form as “general office use.” Landlords always want to define the use of the premises as narrowly as possible to prevent misuse or abuse of the premises, or to simply have greater control over how the project as a whole is used. However, a well-represented Tenant can often obtain some flexibility in this area by carving out additional “niche” uses that are not offensive to the Landlord (e.g., light manufacturing/assembly and some limited retail-type uses such as product demonstration and on-premises sales to customers/clients). The lesson here is that if there is some use ancillary to “general office use” for which Tenant wants or needs to use the premises, or if Tenant’s business in the premises will be some type of “hybrid” use that does not quite fit “general office use,” make sure to explain this to the Landlord (Landlords are often very receptive to the “real” needs of the Tenant in this regard), and also make sure that these additional desired uses get spelled out in the Lease. Addressing this topic early in the negotiation process will clear up any misunderstandings and will avoid later conflict in this area.
III. NAVIGATING OPERATING COSTS
A. What is “Gross Up” of Operating Costs
In a retail lease, the Tenant’s proportionate share of common area expenses and real estate taxes for the shopping center is typically a separate charge in addition to the base rent. In an office lease, by contrast, the initial “base rent” contains, in addition to a “true” rent component, another component for the Tenant’s share of the initial calendar year’s common area expenses and real estate taxes, so that the initial rent is an “all-in” figure (at least during the first year, often called the “base year”). Thereafter, the Tenant pays its pro rata share (defined to be Tenant’s leaseable area by the total leaseable area of the building) of what are called “escalations,” or increases in the common area expenses and real estate taxes (usually lumped together under the terms “operating expenses” or “operating costs”) for the building or project. This means that the rent goes up as operating expenses go up over the course of the lease term.
In fact, the “operating expense” escalation is the most commonly encountered rent escalation clause in an office lease. Its ostensible intent is to reflect and pass through to Tenants the increases in the Landlord’s operating costs for the building or project. It is often quite complex in practice, however, and too often, it can result in abuse by Landlords who do not keep costs down or who use the escalation as a “profit center” rather than as a cost reimbursement mechanism. Because, under the mechanism, Tenant will typically pay increases over a base year’s operating expenses, the Tenant has two important issues with which to contend. The first is making sure the base year’s operating expenses are as high as possible, and the second is determining what is or is not included within operating expenses.
To make certain the Tenant does not bear the risk of a sudden increase in occupancy of the project, it is important to “gross up” the operating expenses in the base year. Grossing up basically means taking actual operating expenses during a given period (e.g., the base year), and increasing those expenses to an amount that “would have been” incurred if the building or project had been fully occupied (usually defined to be 90-95% occupancy). Many Tenants balk at a gross up provision, thinking that it must be a way for the Landlord to turn operating expenses into some sort of profit center (that is, why on earth should Tenant pay for operating expenses as if the building were 95% occupied if it is only 60% occupied?). The reason is that, while many building costs do not vary significantly with occupancy levels (e.g., insurance premiums, real estate taxes, equipment maintenance), there are a number of costs that do in fact decrease when there are building vacancies. For example, only occupied space needs to be cleaned (so called “char” service) and only occupied space incurs significant costs for utilities. Similarly, management fees based upon a percentage of gross rental income only apply to occupied space. Since no part of these “variable” expenses is attributable to vacant space, a Tenant’s share of these charges can be equitably increased either by grossing these charges up to assume full building occupancy (which is more common) or by adjusting Tenant’s pro rata share by dividing Tenant’s leaseable area by only the total leaseable area of the building that is actually occupied at the time.
The two keys to making sure that grossing up is equitable to both Landlord and Tenant, are (i) to clearly spell out that expenses in the base year as well as subsequent years are grossed up, and (ii) to make sure the lease provides that only variable operating expenses are grossed up. If operating expenses were not grossed up in the base year, and let’s say vacancy is high during the base year, then if occupancy increases in later years, along with a corresponding increase in variable operating expenses, the Tenant would pay a disproportionate amount of the increase in these expenses. Also, since, as discussed previously, only those expenses that vary with occupancy should be grossed up, the Landlord will bears the risk of building vacancy as to fixed costs.
B. What should be included or excluded from “Operating Costs”?
1. General Exclusions
This is the place where the Tenant really needs to take pains to assure that it is not being overcharged by a Landlord who is trying to turn operating expenses into a profit center. Common methods of abuse by Landlords are: (i) passing along the cost of expenses and improvements of a capital nature in the year incurred; (ii) “double dipping” by including electricity and other charges specifically paid by an individual tenant in the general utilities charge; and (iii) charging management fees for a property manager that is an affiliate of Landlord that are higher than third party management fees would be.
To help protect against the potential for abuse by Landlords, here are some common exclusions from the “typical” Landlord definition of operating expenses to which Landlords will often accede:
(i) Principal and interest on mortgages and similar indebtedness
(ii) Ground rents
(iii) leasing commissions, legal fees, promotional costs, and the like paid in connection with lease of space in the project
(iv) “tap fees” and similar charges relating to sewer or water connections
(v) entertainment or travel expenses
(vi) cost of repairs, replacements, and the like paid for by insurance proceeds.
(vii) the cost of any alterations or improvements to the project to correct any construction defects or to bring the project into compliance with existing laws (e.g., the Americans with Disabilities Act)
(viii) repairs necessitated by condemnation or casualty
(ix) any costs incurred by Landlord in connection with lease negotiations or disputes
(x) costs incurred by Landlord in connection with any violation of law by Landlord or any other tenant (e.g., environmental laws) or in connection with a violation of by landlord or any other tenant of any lease
(xi) costs that are reimbursed directly by another tenant or for services provided to some tenants specifically but not to tenants as a whole
(xii) depreciation of the project and related improvements
(xiii) costs of renovating, redecorating or improving a specific tenant’s space or vacant space.
(xiv) amounts paid to subsidiaries, affiliates or other landlord-related parties for services rendered to Landlord in connection with the project to the extent such charges exceed the amounts that would be paid by Landlord to an unaffiliated third party
(xv) salaries of any employees of Landlord above the level of building manager
(xvi) Landlord’s general overhead and administrative expenses which are not properly chargeable to operating expenses for the project.
(xvii) cost of new or additional buildings or other additional structures.
(xviii) the cost of capital improvements, capital repairs, capital equipment, capital tools, or depreciation, as determined under generally accepted accounting principles consistently applied (except as expressly permitted by the lease)
(xix) income, excess profits, franchise, transfer, estate or inheritance taxes of Landlord
(xx) any other item of expense that, but for this exclusion, would be included twice, so that no duplication will occur
2. Capital Expenditures
The next problematic area is how to account for large, so-called capital expenditures, such as a new roof or a new air conditioner. These items are not really repair or maintenance items, but are rather improvements to the project that will often have a useful life far in excess of a Tenant’s lease term. On the one hand, Tenants often argue that the cost of these items should not be charged to them in the year they are incurred, since these capital items will often be in place for many years past the expiration of the lease. On the other hand, Landlords will claim that these expenditures, while large, are often necessary and will result in a net decrease in operating expenses going forward. The classic example is the new HVAC unit that replaces the old, worn out one. Although the purchase and installation of the new unit results in a one-time “hit,” or large out-of-pocket cost, the unit will “pay for itself” over time by reducing the monthly electric bill. The typical compromise is to allow capital expenditures that are calculated to reduce overall operating expenses, but to amortize those costs over the useful life of the improvement. Here is a sample provision:
“Operating Costs shall include the annual cost of all capital improvements made subsequent to the final completion of the Building (including the Premises) which, although capital in nature, are made to reduce the normal operating costs of the Building, but such costs shall be amortized over the useful life of such improvements, in accordance with generally accepted accounting principles, consistently applied.”
3. Management Fees
Another area of concern is the issue of the management fee for the project. Landlords will often employ an affiliated party as the property manager, and Tenants often rightfully worry that the Landlord is padding operating expenses by overcharging for the management fee. One solution is to provide that, for any management company that is affiliated with Landlord, the management fee will be “capped” at a rate that will not exceed what Landlord “would have paid” to an arms-length, unaffiliated third party charging competitive rates. Another solution is to cap the fee at a percentage of gross rents. Also, please be wary of any provision in a lease that attempts to charge BOTH a management fee (however calculated) AND some sort of administrative fee or “surcharge” calculated as either a percentage of gross rents or operating expenses. This surcharge is often a “double dip” and a well- represented Tenant can usually get it deleted.
4. Controllable Operating Expenses
A third and (for this discussion) final way to limit Landlord’s overcharging of operating expenses is to “cap” the rate of annual increases for what is called “controllable” operating expenses (the specific definition will vary, but “controllable” operating expenses are typically those operating expenses other than insurance, real estate taxes, and certain other items that are not considered to be within Landlord’s control).
IV. WHAT SHOULD THE LANDLORD MAINTENANCE OBLIGATION/SERVICES BE?
The Lease should clearly define out the repairs or maintenance items Tenant will be responsible for under the terms of the Lease. The Lease should usually provide that the Landlord is responsible for repairs to the structural and exterior portions of the building, the roof, the building’s mechanical systems (e.g, plumbing, electrical and HVAC). The Tenant should only be responsible for interior, nonstructural repairs and should also not be responsible for the direct costs of repairs to the items in the preceding sentence, unless caused by the negligence of the Tenant (the Tenant’s argument is that the repairs to such areas are not within Tenant’s “sphere” of control, and that the costs for these repairs are getting passed through to all tenants in the form of operating expense escalations in any case).
B. Occupancy Related Services
The Landlord should generally be responsible to provide such basic services as lighting (including changing light bulbs, etc.), electrical, janitorial service, elevators, hot and cold running water, and HVAC (during “normal building hours”) at no additional cost (other than as a pass-through to all tenants as part of operating expense escalations). It is important that the hours of operation for the building (particularly for HVAC) be clearly addressed, especially if Tenant’s office is operational outside of normal business hours and on weekends. It is not unusual for some buildings to operate the HVAC until only 7:00 p.m. during the weekdays, and not at all on weekends. The lease should also clearly spell out Tenant’s responsibility for paying for “after-hours” HVAC, and what the charge will be (it may be possible to have the building HVAC separately zoned for a Tenant who conducts significant business “after hours”). Another issue that has arisen frequently over the past several years is the issue of extra charges for the provision by the Landlord of so-called “non-standard services,” particularly in the area of electrical service. Many Landlord-form office leases contain frankly “antiquated” language stating that the Landlord will provide electrical services at no additional charge for “standard” office equipment such as typewriters and adding machines, but not for equipment that consumes “excessive” amounts of electricity or in excess of “building standard” electrical loads. Since nowadays there is hardly an office that is not filled with personal computers, photocopiers, and similar items that certainly use large amounts of electricity, but by any modern standard would nevertheless be considered “standard,” the issue as to what actually constitutes “standard” equipment for the purposes of the lease may be a source of controversy. Also, if the Tenant does actually possess unique equipment needs, either as to electrical or weight loads, this issue should be addressed as early as possible in the negotiation/drafting process.
V. ASSIGNMENT AND SUBLETTING ISSUES
Every sophisticated lease contains a prohibition against assigning the lease or subleasing the premises without Landlord’s prior written consent. The reason for this is understandable: after the Landlord has made a leasing decision based upon the identity and creditworthiness of a particular Tenant, the Landlord does not want to then have the Tenant turn the premises over to a different tenant, with whom the Landlord is not familiar and who may not meet the Landlord’s leasing criteria. On the other hand, every Lease needs an “exit” strategy, and each Tenant requires a bit of flexibility in case it no longer can use all or part of the space.
A. Landlord’s Consent Standard
The first area to address is the so-called “consent standard” of the Landlord. Many Landlord-form leases say that Landlord can withhold consent to a proposed assignment or subletting in Landlord’s “sole discretion,” meaning that the Landlord can withhold its consent for any or no reason at all, even if the Landlord is acting unreasonably. In this case, many Tenants request that this standard be changed to a “reasonableness” standard where the Landlord will not unreasonably withhold its consent to a proposed assignment or sublease. The difficulty comes in deciding whether, in a particular circumstance, a Landlord’s consent is being given or withheld “unreasonably.” One possible fix for this problem is to establish a list of criteria for a prospective assignee/subtenant which, if met, will mean that a Landlord’s withholding of consent to the proposed assignment or subletting will be defined to be “unreasonable.” A typical list would include: (i) creditworthiness equal to or better than Tenant; (ii) being a regionally or nationally recognized company; (iii) having a balance sheet at least as sound as that of Tenant; and (iv) the absence of a prior negative leasing history (either with this Landlord or other landlords).
B. Internal Restructuring
Another area of flexibility in assignment/subletting is in an internal restructuring, where, for example, a Tenant may desire to assign a lease to a new or different subsidiary, or consolidate all of its leases into one entity, for whatever reason. In such a case, the prohibition against assigning or subletting may be technically implicated but the “true” Tenant has not really changed. In this case, Tenants can often ask for and receive a “carveout” to the general prohibition against assignment and subletting that permits assignment without Landlord’s prior consent to an affiliate of Tenant, such as to a sister company, a subsidiary or parent, or to a new entity created through corporate restructuring, consolidation, or merger, so long as (i) the original named Tenant remains liable under the lease, and (ii) the assignments are not part of a larger scheme to “spin-off” the Lease to an unrelated third party.
C. Sale of Tenant’s Business
Another assignment and subletting issue arises when a Tenant is attempting to sell its entire business. For example, let’s say that a Tenant is selling its entire company and all its assets and properties, and will assign all of its leases to the purchaser of the business as a part of the larger transaction. Tenants often feel that an individual Landlord should not be able to “hold them hostage” by essentially delaying or holding up the sale of the entire company by refusing to give consent to a lease assignment, particularly since oftentimes the Tenant’s business is being acquired by a larger and more creditworthy party. Many Landlords are amenable to a carveout to the requirement of prior consent when the assignment or subletting in question is part of such a larger “lock, stock, and barrel” transaction.
This article originally appeared October 2004 in The Practice Manager published by the State Bar of Texas, and is republished with permission of the author.