July 15, 2020

TEN THINGS TENANT BROKERS SHOULD DO IN LETTERS OF INTENT

As leasing attorneys for tenants, we read many letters of intent (“LOI”) as part of our job. Some are excellent, providing a concise description of the parties’ business deal. Others raise more questions than they answer. We applaud brokers who do a thorough job with LOIs because during the LOI negotiations, a tenant’s negotiating leverage is much higher than when we negotiate the lease. To assist tenant brokers, we have put together a list of ten subjects covered by LOIs that can make or break an LOI and suggestions on how to address them in the LOI.

1. Commencement Date
If the landlord is constructing the tenant improvements in the premises, the commencement date of the lease must never be a date certain. The commencement date should be the later of (a) the targeted commencement date and (b) the date the landlord actually reaches substantial completion of the tenant improvements. This protects the tenant in two ways: (1) if the landlord is late in delivery of the tenant improvements, rent or the rent abatement period if there is one will not commence until the landlord actually delivers the premises in the condition required and (2) if the landlord is early in delivery, it prevents the rent clock from commencing before the tenant is ready for occupancy.

If the tenant is constructing the tenant improvements, make sure the commencement date slides if the landlord does not provide timely access to the premises.

2. Late Penalties
If the landlord is late in delivering the premises with the tenant improvements completed whether due to factors within the landlord’s control (such as delays by the landlord’s contractor) or not within the landlord’s control (such as building or occupancy permit delays, weather, other “force majeure” items), the LOI should provide for penalties for the lateness. Common penalties are one or two days of rent abatement for each day of delay in delivery.

We believe the delivery of the premises is purely a landlord risk because the landlord is in the business of providing space and not even force majeure delays should prevent the tenant from getting a penalty. Keep in mind that a penalty may be needed to offset the tenant’s holdover costs that the tenant will incur as a result of the delay in delivery of its new premises when the tenant is moving from another building. Further, the tenant should have a right to terminate the lease if the landlord fails to deliver by a certain outside date. At some point, the tenant may prefer to walk away from this lease rather than continue to wait for the landlord to perform and deliver the premises in the condition required.

3. Tenant Improvements
Make clear which party is constructing the tenant improvements. This sounds simple, but we see plenty of LOIs that provide “The tenant improvements shall be constructed by [DATE].” Entire leases have had to be redrafted due to this omission.

4. Base Year Leases
Let’s be honest. Triple net leases are much more tenant favorable than base year leases.* Base year leases are hard to negotiate and harder to administer. But if your tenant client is stuck with a base year lease, you must make sure the method by which calculations are made are fair for the tenant. You do this by specifying that operating expenses “which vary directly with occupancy of the building” should be “grossed up” to the level that would be incurred if building occupancy was 100% for both the base year and all subsequent years.

This is especially important for buildings with low occupancy in the base year. A common error tenant brokers make is setting the occupancy threshold for the gross up at 95% rather than 100%. By agreeing to 95% gross-up, the tenant can end up paying more than it should if occupancy of the building exceeds the 95% threshold in any given year because the base year expenses were only grossed up to 95% occupancy. Comparing 100% to 100% guarantees a fair “apples to apples” comparison.

5. Operating Expense Exclusions
When a lease (most often an office lease) requires the tenant to pay its share of operating expenses to the landlord, the landlord should not be able to pass through all operating expenses to the tenant. The parties should instead negotiate exclusions from the definition of operating expenses that may be passed through to the tenant. We suggest you include at least two operating expense exclusions in every LOI.

First, you should negotiate a blanket exclusion for all capital expenses except for those that reduce operating expenses or are installed to comply with legal requirements passed after the date of the lease. These permitted capital expenses must also be amortized over the useful life of the applicable improvement. This is very important. A majority of landlord lease forms we review nowadays give the landlord the right to pass through all capital expenses, which can be a big unforeseen cost to the tenant.

Second, we also recommend getting a full handle on how the landlord’s management fees will work. Those items which are unrelated to the actual management of the building should be excluded from operating expenses, and the percentage management fees that may be included in operating expenses should be capped. For example, if the tenant is reimbursing the landlord through operating expenses for (a) the salaries of the landlord’s managerial employees, (b) the salaries of employees of the management company stationed in the building, and (c) a percentage management fee on gross rents for the building, the percentage management fee exceeds the landlord’s actual management costs for the building. As a senior broker we worked with once remarked, the management fee should more accurately be called a “landlord profit fee.”

6. Controllable Cost Cap
Many brokers in LOIs for office space negotiate a cap on the “controllable” operating expenses that may be passed through to the tenant each year. The cap is a percentage that determines how much the controllable operating expenses in any year can increase as compared to the controllable operating expenses in the prior year. The purpose of the cap is to prevent unreasonable and/or unexpected increases in controllable operating expenses from year to year.

For such a cap to be worthwhile to the tenant, the LOI must specify that the cap is applied “year over year” and is not simply a “cumulative” cap in which the cap escalates by the stated percentage each year. A 4% cumulative cap, as an example, would be 12.5% over the first year by the third year. Unless, we have significant inflation not seen since the 1970’s, a cumulative cap will be of no benefit to the tenant. Further, brokers should negotiate a broad definition of “controllable operating expenses” in the LOI. Many landlords provide a very narrow definition of “controllable operating expenses” in their draft leases that effectively removes almost all operating expenses from the cap. Overall, in our many combined years of practice, we cannot remember any cost cap that turned out to be useful.

7. Maintenance Obligations in Industrial Leases
As a corollary to the operating expense exclusion for capital expenses described in #5 above, the allocation of maintenance duties and expenses in industrial leases is also important and often given short shrift in LOIs. Responsibilities are often delineated based on whether an item is on the interior or exterior of the premises. Thus, in many leases, the landlord takes responsibility for the building structure and roof and is responsible for paying all of the capital and regular expenses for those items. The tenant, on the other hand, has full economic responsibility for all building systems and equipment, dock doors, landscape, driveways and parking lots.

First, consider whether parking lot and landscape responsibilities are something the tenant is equipped to do in the first place and whether the tenant would be willing to pay operating expenses to the landlord for those items. Second, consider the capital expense issue: is it fair for the tenant to be paying for capital expenses for items that will benefit the landlord beyond the expiration of the term of the lease?

We recommend that if the tenant is required to make capital replacements to building systems and the like that the landlord be required to pay its share of the cost based on the number of years the useful life of the capital item extends beyond the lease term. In negotiating the formula, the parties could also take into consideration potential lease extensions and require the tenant to reimburse the landlord at the time of the lease extension for any portion of the cost paid by the landlord that would be attributable to the extension term.

8. Space Measurement
At the LOI stage, the tenant will not have had the opportunity to evaluate the landlord’s measurement of the premises. We can tell you this – – when it says “approximately” we get suspicious. The best practice here is for the LOI to set forth the measurement standard by which the parties agree to measure the premises and, for a multi-tenant building, the building as well. We use the ANSI/BOMA Z65.1 standard (2010 or 2017) for office space and an industrial BOMA standard or usable area standard for industrial and warehouse spaces. If you are not familiar with these standards or the terminology, the BOMA website does a great job in explaining them and describing how standards have changed over time.

9. “As Is” Language
We think it is a mistake to agree to “as is” language for space not already occupied by the tenant. To concede in the LOI that the tenant takes the premises in “as is” condition gives the landlord a big win without a fight. In almost all cases, the tenant will not have thoroughly inspected the premises for defects above the ceiling, in floor flatness or even for code violations. We suggest that the landlord deliver the premises to the tenant in good working order, free of defects and if applicable with all telecom and IT cabling removed. The tenant should also have the right to notify the landlord of any defects within a certain number of days of delivery of the premises, and the landlord should be required to correct those defects promptly, at landlord’s cost.

10. Fair Market Rent
For any expansion or extension options where the rent to be ascertained is a fair market rent (the “FMR”), you should make sure that the FMR is defined to include all similar buildings in the area of the premises and not only the building containing the premises. Further, all similar relevant transactions should be considered. For example, do not in an extension option limit the FMR determination to renewals only. Finally, make sure that rents are being compared on a net effective basis by factoring in tenant concessions such as free rent and tenant improvement allowances. Most landlord leases do not distinguish between rents which include tenant concessions and ones which don’t such as renewals. To do otherwise is to risk an inflated FMR for the tenant.

*Base year leases are sometimes referred to as modified gross leases. This type of lease is mainly used for office space. The tenant pays to the landlord base rent and its share of operating expenses in excess of the operating expenses incurred by the landlord in the designated “base year.” Therefore, during the base year, the tenant only pays base rent because the base year operating expenses are incorporated into the base rent. In subsequent years, the tenant pays both base rent and its share of any increase in operating expenses. If operating expenses in a subsequent year are less than operating expenses in the base year, the landlord receives the entire benefit of the decrease in cost because the tenant is still required to pay base rent (with no deduction). This is why base year leases are more favorable to landlords.