BEHOLD YOUR FUTURE: Know Your Lease Provisions, or Else!

What if you could see three to five years into the future on every lease transaction? How much value would you find in that skill? Unless you happen to be one of the clairvoyant few, you will probably learn from past mistakes and not from a crystal ball. Here are five lease clauses and some real life experiences that might save you from a potential nightmare. These stories may give you a greater appreciation for what might otherwise appear to be relatively unimportant lease terms.

1. THE OPTION
“I’ve got a great tenant for you,” an excited agent exclaims. “He wants a three-year lease with a three-year option.” The emphasis placed on the latter part of the sentence makes it clear that the agent sees the option part of the deal as a major coup for the landlord.

You try to explain than an option never favors a landlord, only a tenant. The agent counters with, “You should be excited about a tenant that wants to be in your project for six years.” You ask the agent if you can do a three-year lease giving you an option to force the tenant to stay another three years if you like him. There is silence on the other end of the line. Apparently your sarcasm is not appreciated.

To protect your owner, try to avoid options whenever possible. There is no benefit, and if the lease is not structured correctly, the results can be disastrous.

A client of mine shared the following story with me. My client had given an option with some “standard” option language included in it. If the tenant chose to exercise its option, the new market rent would be determined by the owner. If the tenant did not agree, three appraisers would be chosen to determine the rental rate. The end result in my client’s case was a rental rate on a very large single-tenant building that resulted in a several-hundred-thousand-dollar negative impact on the value. In hindsight, the owner would have rather had the tenant leave than to be stuck with rental rate two of the three appraisers agreed upon. This particular option was for five years, so the result was devastating.

While the best-case scenario for your owner is to avoid options altogether, the worst-case scenario for your owner is to allow a fixed-rate (unless it is unrealistically high) or open-ended option. With a fixed-rate option, you have severely limited the upside for your owner. With an open-ended or arbitrator-driven option, the value of the property can be negatively impacted for years to come.

Between the best and worst cases, you may be able to find a middle ground. One middle ground solution is to allow somewhere in your provision language an option at a market rate “as determined by a landlord at its sole discretion. Tenant may have the right to arbitrate the reasonableness of the determination of the rate, but not the rate itself.” There are many additional provisions and insertions that can be added, but the key is that no third party should ever have the power to set the rate on an owner’s building.

Now whenever I hear a request for an option (and I can’t negotiate out of it), I look into my crystal ball and read those middle-ground words. The fog clears instantly, and I know that I have protected the owner from a murky future.

2. THE USE CLAUSE
Anyone who has been in property management for more than a few years can relate humorous and sometimes frightening stories about a nightmare tenant that they have had or heard about. Since our company has specialized in highly management- intense, multi-tenant properties, we perhaps have seen more than most of these companies. In retrospect, many, if not all, of these problems could have been cured or at least alleviated by having a more specific and more restrictive use clause.

A common ruse by prospective tenants is to give you only partial truths or limited explanations as to what the intended use of the premises will be. We once entered into a lease with an acupressure company that turned out to be a front for a Korean brothel. We learned from this experience to investigate more closely any companies dealing with holistic medicine, acupressure, acupuncture, and massage. This particular tenant would have been hard to spot since they had done a good job at setting up a front. However, most companies are not that deceptive nor imaginative.

Probably the worst experiences I have witnessed relating to a use-clause abuse have had to do with smells. In one case, an acrylic nail salon created fumes that made adjoining tenants begin to call in sick. We now have a very strong understanding of the power of acrylic nails, and we protect ourselves accordingly.

Another bad experience with “smell” uses came as a result of the thriving coffee industry. A prospective tenant with a well-known corporate name approached our company to put in a coffee-roasting facility at our project. He mentioned that several malls were falling over themselves in order to bring him into their mall because the wonderful aroma attracted shoppers and was a tremendous amenity for the mall. We figured that if the mild smalls smells were good enough for an indoor regional mall, they should be good enough for an open-air, multi-tenant business park. Were we ever wrong! Not only was the smell of the coffee roasting one of the most disgusting smells I had ever encountered, but the roasting produced an ash that dispersed into the air and covered everything within a one-block radius. When the roaster kicked on, the complaint calls started coming in.

The problem was that we knew he was going to do coffee roasting when we moved him into the facility. We thought the adjoining tenants would be calling to thank us rather than threatening to break their leases. Not knowing where to turn, we looked to the local governmental agencies to help us in this smelly situation. Interestingly enough, everything that the tenant did met with federal and state guidelines. We were simply left with our nuisance clause to try and save us. Eventually it turned out that the tenant moved. We could have saved ourselves a lot of time and aggravation by putting more protection in the use clause.

The more specific and descriptive you can be in your use clause, the less likely you will encounter problems. In a difficult market, we are often urged by landlords to make any deal that we can make. The experiences of our company tell us that when you are dealing with uses that have smells, sounds, or excess parking needs, you can never be too careful. To protect yourself and your landlord, make sure that your use clause contains the following, at a minimum:

Proposed use may not:
-Annoy or interfere with the rights of lessees;
-Cause, maintain, or permit any outside storage on or about the project;
-Commit or suffer any waste upon the project;
-Do any act that constitutes a nuisance or disturbs the quiet enjoyment of the other lessees;
-Commit acts that will increase the rate of insurance on the project.

Have your project attorney review your use clause and your project rules and regulations for continuity; and you will reduce your risk even further.

3. DAMAGE AND DESTRUCTION
Picture yourself sitting down after a hard day of managing tenants. You turn on the evening news. The view from the news channel’s helicopter shows a blaze from a commercial property. You tense instinctively and pay closer attention. The reporter on the scene has a practiced pensive look on her face, and then you realize she is talking about your building.

During the past 10 years, our firm has overseen two major fires, two major roof collapses, and cars driving into buildings on two separate occasions. Disasters really do happen, and they can happen at any moment’s notice to any building you manage.

The moment any of these catastrophes occur, the first job is to control the situation and make sure everyone is safe. After that, everyone focuses on the lease provisions regarding damage and destruction for guidance. Many leasing agents and managers have never read a damage and destruction paragraph. Occasionally there are requests from a tenant to change the paragraph. If you have a well-written standard paragraph, my advice is that you do not change a thing.

One area that a tenant may wish to change is the amount of time a landlord has to rebuild. In a project we manage that was burned down from a tenant’s negligence, we had six months to rebuild. We succeeded with only two weeks to spare. If this paragraph had been altered, we could have lost up to three major tenants. We were protected by our refusal to alter this paragraph. In more than 1,000 lease transactions, we have never lost a tenant by being inflexible on this part of the lease. Stick to your guns, and you will enjoy watching the news far more!

4. THE FIRST RIGHT OF REFUSAL
How often have you heard the following: “Oh, just one more thing. I want to be notified before you lease any space around my suite. Could we just insert a first right of refusal in the lease?”

This seemingly innocent request is approved hundreds of times each day by landlords all over the country. Many times this request is granted even though to deny it would not kill the deal. Granting this provision is a little bit like hiding a time bomb in one of your filing cabinets at work. It may not go off on the person who placed it there, but it may well explode on some unsuspecting owner or manager in the future.

The number of ways that a landlord can violate a first right of refusal clause are almost too numerous to mention. Even if a landlord does remember to abide by the terms of the first right of refusal, the clause can often cause other irreparable damage. Most first rights of refusal are predicated upon the owner receiving an acceptable offer from a third party. Many times these offers come in from the outside brokerage community. The outside brokers were notified of a suite availability and were operating in good faith in attempting to find a replacement tenant. Unless all brokers who are showing that space are notified before their showing that the space is subject to a change of first refusal by a current tenant (most brokers are never told), the fury of the commercial broker who brings in a ready, willing, and able tenant will be tremendous. Not only is the prospective tenant’s broker upset with the landlord, but the broker loses all credibility with the client. Brokers don’t take kindly to such treatment and have long memories.

So now the challenges with this seemingly innocuous clause begin to mount. For the landlord to escape from harm, the leasing agent must first remember that the first right of refusal exists. This sounds reasonably simple, but in everyday practice, it really is not. Although many sophisticated software systems have quality tickler systems, many property management companies do not use them. Also, many leasing agents never see any of the property management reports that come with the standard software.

Management companies must devise a foolproof way of tracking these first rights of refusal provisions or the legal ramifications could be significant. If the leasing agent forgets this clause exists and leases the space to an interested prospect, the floodgates open for all sorts of legal liability.

To make matters worse, the leasing agent who granted this right of first refusal is often no longer with the firm and his or her predecessor walks unsuspectingly into this clause.

The only way to protect yourself from this landlord-hexing clause is to take the following steps:
-Make sure that all of your leases are audited, looking specifically for this language or expansion-language clauses.
-Place any affected leases into some type of tickler system, and make sure the leasing agent gets a copy of it.
-Make sure that the leasing agent has read the appropriate clauses in any lease documents that contain first rights or options.
-Make sure that mention is made of the right of first refusal in all of your broker promotional material on the space advertised.
-Make sure that the notice provisions are followed to the letter.


Never, never, never grant one of these clauses unless you are absolutely certain that the tenant is ready to walk from the deal. And even then ask yourself the question, “How important is this particular transaction?”

5. THE LATE FEE
The standard lease form you are using provides for a 5-percent late fee if rents are not received on or before the 10th of the month. The tenants usually sign it but occasionally ask, “What if I’m a few days past the grace penalty? Will I really get hit with a late fee?”
If you answer with anything other than a strong “yes,” the future starts to cloud.

In the future, you can count on the fact that this tenant never will pay rent until the 10th, usually will pay on the 15th, and often will wait until the end of the month. After a while, all the tenants know that it is OK to pay in the middle of the month. Everyone is comfortable with the mid-month payments except your lender, who somehow still insists the mortgage payment be paid on the first. The future in this case shows a frustrated owner, angry tenants, and cash flow problems.

Over the years we have adopted a very strict late-fee policy with our tenants. The penalty is 10 percent after the fifth of the month. When taking over the management on new projects, we have been able to reduce the delinquency by as much as 40 percent by actually following through on the late-fee provisions. We always keep the remittance envelopes, which show the postmark date for proof if needed. This diffuses many irate tenants who claim that they sent their checks in on time.

Two years ago, one of our largest clients told us to move the late fee date up to the third of the month. We were concerned that the tenants would not agree to the more stringent deadline, but we have since put this in all leases and are able to get them approved. Tenants are told at a very early stage of the relationship that we take the due date of the rent and the late-fee provision seriously. If the tenants know at the beginning of the lease what your position is, it increases the likelihood of receiving rent on time.

If you want to decrease your collection problems, insist upon a strong late-fee provision and enforce it. The tenants will respect the lease if they know you are enforcing it universally and they have been pre-warned against paying late.

So dust off your crystal ball and turn down the lights. Look inside the globe for all the answers that you will ever need in property management. If no images appear, remember the preceding stories, and be very careful before changing the lease. War stories are often your best warning, so gather your management friends and trade experiences. You will move forward to a more risk-free future.