Commercial tenant lease issues
Jeffrey W. Erdman
Julie S. Pearson
You own the business but not the building where it all happens. Consider your commercial lease options as a critical component of your business. In California, there is no standard lease agreement—every commercial lease is unique, and nearly every substantive paragraph, clause, provision and term can impact your business.
As a commercial tenant, despite the proliferation of ‘standard’ form contracts, no particular terminology is necessary to create a lease. It is enough that the words in the writing show (1) your intention to lease the property, (2) the names of the parties to the agreement, (3) a specific description of the premises, and (4) the rent to be paid for a particular duration. However, commercial tenants are urged to create a comprehensive written agreement that details the specific intent of both parties. Whether a qualified real estate attorney prepares the lease document, or modifications are made to a ‘standard’ form lease, some key terms to consider including in a commercial lease are:
Identify the type of commercial lease
There are 3 main types of commercial leases, which principally vary by how allocation of owner/landlord property expenses is determined. Property expenses include real estate taxes, property insurance, and common area maintenance costs. In a Gross Lease the Landlord pays all property expenses. A Triple Net Lease/NNN lease allocates the property expenses to the Tenant. A Modified Gross Lease provides for the division of property expenses between the Landlord and Tenant.
Define the space
The lease should state the exact rentable square feet, the exact usable square feet, and describe the specific common areas such as hallways, rest rooms and elevators, parking and storage areas which are part of the leased space.
The lease duration
The lease provisions should also contain the following specific dates: The date the tenant can gain possession of/occupy the property; The date the obligations of the tenant and landlord will begin; The last date the tenant may exercise a right to renew or the date of automatic renewal of the lease for an additional specified period; and the date of the termination of the lease term.
Specify the rent
A commercial lease may state a specific monthly or annual rent amount, or a formula to calculate the rent amount, or a combination of rents. Commercial tenants often negotiate to pay a monthly fixed base rental amount, and an additional variable amount related to the landlord’s property expenses discussed above. Commercial tenants can also agree to pay the landlord a portion of the tenant’s sales as additional rent. However, rent is specified, a lease should also state the allowable increases/escalations to rent, how they will be computed, and the frequency they may be imposed and how notice of the change in rent is provided. This avoids a commercial landlord legally increasing rent without warning, or excessively with notice.
Understand your security deposit
Virtually all commercial leases require a substantial security deposit. A security deposit is intended to allow the landlord a reserve of funds to pay for any repairs after the tenant departs or to pay rent if the tenant fails to do so. California law has no restrictions on the amount of funds a landlord can request be deposited for the space. However, the amount should be reasonably related to the amount necessary to cure any default in rent, or repair any damage beyond usual wear and tear. The tenant should seek to negotiate a lease provision to require security deposit amounts be reasonably related to the monthly rental, and require any amounts paid in excess of funds used for repair or to cure default be refunded after the landlord regains possession of the premises. Depending on the amount of funds the deposit restricts, you may consider negotiating a “paydown” of the deposit, to require the landlord refund a portion of the security deposit after a particular portion of the tenancy has passed (i.e., refund 33% after 1 year). Likewise, for large sums, you may consider requesting interest to be paid on the deposit and regularly paid or credited against future rent.
Your personal guarantee
Commercial leases often require the principal members of a proposed corporate or partnership tenant execute personal rent guarantees for the life of the lease or at least some minimum term. A limited guaranty operates only for a specifically-defined period, after which the guarantor’s obligations automatically terminate. A continuing guaranty operates with respect to the principal obligor’s [the corporation or partnership] present liability and future liabilities under successive transactions continuing the original liability or renewing it. Whichever form of guarantee fits your needs, unless the lease expressly provides the guarantor’s personal liability is contingent upon notice of the principal’s default in rent, the guarantor is liable for unpaid rent without any prior demand or notice by the landlord. Also keep in mind, if you sign a guarantee as a representative of a corporate or partnership or other business entity, you are personally liable for the guaranty unless the lease clearly provides the guaranty is made only in a representative capacity.
Do you need a force majeure
More recently, even smaller commercial tenants might consider a clause that excuses performance in the event of a ‘force majeure’ which is one considered to be beyond the party’s reasonable control: acts of God, accident, riots, war, terrorist act, epidemic, pandemic (including the Covid-19 pandemic), quarantine, civil commotion, breakdown of communication facilities, breakdown of web host, breakdown of internet service provider, natural catastrophes, governmental acts or omissions, changes in laws or regulations, national strikes, fire, explosion, or generalized lack of availability of raw materials or energy. Such a clause could be mutual, allowing the landlord to be excused from performing its obligations under the lease.
Plan for improvements and repairs
A commercial lease does not usually require a warranty of habitability - the landlord’s promise the space meets basic requirements (safety, power, water, temperature) for ordinary tenancy. A commercial lease generally only requires the landlord to provide walls, water supply stubs and an electrical connection. As a result, construction/modification of the space necessary for tenancy will usually be the responsibility of the tenant, and terms of such build out or tenant improvements should be part of the lease. Keep in mind, a tenant is not obligated to make improvements or repairs which are primarily for the benefit of the commercial landlord, except as specified in the lease. However, even necessary but unmade repairs to a commercial tenancy are not a legal reason to withhold rent. A commercial tenant’s obligation to pay rent supersedes all other requirements, and generally even habitability issues will be unsuccessful as a defense.
Tenant improvement options
Many landlords offer the opportunity to make physical improvements to the premises at the landlord’s expense as an incentive to prospective tenants with strong credit and business stability. In most cases, a pre-negotiated price per square foot tenant improvement allowance “TIA” is negotiated, which requires the landlord to reimburse the tenant for all or a portion of construction costs incurred by the tenant to customize the leased premises. TIA can be provided as a discount on future rent, reimbursement of tenant incurred costs, negotiated tenant turnkey improvement options, or estimated cost landlord offerings. Build-to-Suit: When commercial space is under construction the tenant works directly with the landlord’s contractor to finish the space according to the tenant’s needs and TIA. Build-Out: When commercial property is already fully constructed and often previously occupied by a commercial tenant, the TIA terms provide for an amount of construction costs incurred by the tenant to customize the leased premises.
Late rent payments
A commercial tenant’s promise to pay rent is independent of other agreements in the lease. This makes the tenant’s promise to timely pay rent the fundamental obligation as a tenant. If rent is late or not paid in full, regardless of other issues with the tenancy, the landlord may take action to obtain payment, including eviction. A commercial lease should clearly state the consequences of late rent payments. Often late payments incur automatic late charges and/or interest on the late rent payment. The landlord may also initiate the termination of the lease for nonpayment of rent. Unless your lease terms specifically provide, partial payments of owed rent may not prevent eviction. The law provides for a three-day notice from the landlord of the intention to terminate a commercial lease. However, parties to a commercial lease may validly modify or even waive the tenant’s right to statutory notice. Consider including terms to require at least statutory notice of the landlord’s intention to terminate the tenancy, in a manner that is most likely to give you timely notice (email, text, in person), and an opportunity to cure the default by paying all or a scheduled portion of the rent owed in a specific timeframe.
Know your use clauses
A Use Clause is intended to clearly specify the permitted and prohibited uses of the commercial space. Having detailed definitions of terms in a Use Clause is highly beneficial. A restrictive use clause prohibits the tenant from using the space for the particular, stated capacities. The list identifies the prohibited uses, such as food preparation, retail sales, residential occupancy, and chemical manufacturing. The tenant is free to do anything not on the list. Unless no sublease is possible, a tenant should generally seek the broadest rights to use the space, with a Use Clause which bars only a few, narrow pursuits. On the other hand, a permissive use clause states what the tenant must do in the space. It puts the burden on the tenant to identify each of the conceivable, desired uses of the space at the time the lease is executed. Whether restrictive or permissive, a Use Clause may take into consideration an exclusive clause provided to another tenant, which prohibits the landlord from renting nearby space to any tenant whose operations would compete with the major tenant.
Assignment and subletting
Unless the lease states otherwise (through the Use Clause or other provision), a commercial tenant is allowed to assign or some or all sublet the space pursuant to the terms of the lease. This allows the tenant to transfer the rent and related obligation for the space to another commercial user for a set period of time or for the remainder of the lease term.
Mutual non-waiver provisions
A non-waiver provision permits the landlord to enforce lease terms that it may have failed to enforce in the past. One common example is failure of the landlord to enforce a late payment provision for the first breach. The non-waiver provision permits the landlord to enforce the late payment provision for any subsequent breach. A tenant should try to ensure that a non-waiver provision is mutual, in the event the tenant is not penalized for failing to enforce a breach by the landlord.
Repairs and maintenance
A commercial landlord’s obligation to repair or maintain the commercial property for the tenant is generally limited to the requirements stated in the lease. Typically in a commercial lease, landlords are only responsible to maintain the property roof, exterior walls, and utilities. The tenant bears responsibility for maintaining and repairing everything else in the leased space. Tenants should consider including a repair and maintain clause in their commercial lease. Such a clause may permit the tenant to obtain and deduct the cost of the reasonable repair from rent, obligate the landlord to promptly start and conclude reasonable repairs to the leased premises at the landlords’ expense after notice from the tenant, permit reduced rent for the period after notice of the necessary repair until the repair is completed, or impose landlord liability for business losses due to the condition requiring repair.
Alterations/improvements/fixtures to leased property
Unless specified otherwise in the lease, a tenant may not modify the property without the landlord’s consent. This can include permanent structural alterations, mechanical improvements and added fixtures such as lighting and signage. The commercial lease should contain a specific term setting forth the rights and obligations of the landlord and tenant to make alterations/improvements/fixtures to the commercial property, the costs and issues of removal, and ownership at the end of the tenancy.
Your insurance/your landlord’s insurance
Insurance clauses in a commercial lease dictate whether the landlord, tenant, or both parties must obtain insurance for the space, what type of insurance is required, and what minimum amount of insurance must be obtained. Commercial insurance can be costly, and prospective tenants should confirm they can satisfy the insurance requirements before committing to the lease. Tenants should also not only secure their own business liability coverage to protect their business, but ensure the lease includes a term which requires the landlord maintain adequate insurance coverage in the event of personal injury on the property or damage to your property due to the landlord’s actions.
Late rent, partial rent and violation of lease terms can be grounds for eviction. Commercial landlords need to give just 3 days notice of eviction. Once proper notice is given, the tenant has only three days to resolve the issue giving rise to the notice. Negotiated lease terms may reduce the harsh consequences if eviction occurs. Consider if the lease should specifically allow partial payment evictions or waiver of the tenant’s right to a jury in litigation.
When negotiating your tenancy, consider including an option to extend the tenancy or terms to permit you to renew the lease. Negotiating lease terms can be time consuming and costly. Well drafted terms which provide an option to extend the existing lease terms can postpone that process usually for a period of less than the full lease term. Renewal options often can specify a reset/adjustment of rent and/or how to calculate the rent for the renewal term (i.e. tied to inflation or occupancy or other relevant conditions). You may not have to simply accept "at market" at the time of renewal. Your renewal option can also resolve a common landlord request for additional security deposit for the renewal period. If you don’t need to modify the terms, but want to keep the space for another full lease term, consider a renewal which allows you to enter a new contract, with the same obligations for both parties, subject to changes in the law and encumbrances since the original lease was executed. If you don’t plan for automatic renewal or an option to renew, your tenancy terminates on the last date of the term. Generally, when you remain in possession past the last date stated in your lease as a “holdover” tenant, a new, automatically imposed tenancy arises on a month to month basis without a new express rental agreement with your landlord.
An option to purchase
Commercial tenants often contemplate ownership of the real property they currently lease. This can be accomplished through an “option” agreement. An option to purchase real estate is a legally-binding contract between the tenant and the real property owner, that allows the tenant, as a prospective buyer, to receive the exclusive right to purchase the property for a specific period of time and for a certain price. To be effective, an option must state the essential term of the time frame of the option and the deadlines within which it must be exercised. An option must also specify the parties, identify the property, and specify the purchase price or a method to calculate a definite price. Failure to include all of these as complete and unambiguous terms, can make your option unenforceable. Once in place, the option agreement prevents the owner from entering into any purchase transactions concerning the property with any other parties, and obligates the owner to sell the property to you, conditioned on your proper exercise of the option. Be aware that unless clearly defined, the specific conditions and timing deadlines required to effectively exercise an option can create pitfalls to enforcing the right to purchase.
Or a right of first refusal
Another method a commercial tenant can use to pursue ownership of the real property they currently lease is through a “right of first refusal”. Distinct from an option, a right of first refusal contemplates that the purchase price and terms are not yet definite and ascertainable but will be determined upon the occurrence of future events, such as a bona fide offer to purchase the property by a third person. But, like an option, a right of first refusal can also provide you with exclusive negotiating power for a period of time. A properly drafted right of first refusal is a legally-binding contract between the tenant and owner. When included in your lease terms, it can give you first priority to buy the property for a certain price in the event the owner decides to sell. Keep in mind, a right of first refusal can only be exercised when the owner actually decides to sell, which may or may not happen during your lease term.
It is fundamental that any commercial lease should also contain terms which clearly dictate how to handle disputes whether between the landlord and tenant, among commercial tenants if multiple tenants lease in the same building, and among multiple tenants and landlord or owner. Terms to consider should include notice provisions, whether disputes must be mediated or arbitrated as an alternative to court, allocation of attorney fees and costs, and remedies.
Once you’ve negotiated all the terms and signed off, consider recording your commercial lease. It’s not essential to validate the agreement, but may be recommended for long-term commercial leases and options and rights of first refusal. Recordation of the commercial lease and related documents is permitted by statute and may be advisable for long-term commercial leases, particularly where substantial sums and long-term plans are made in reliance on the lease terms and the integrity of the landlord. If the nature of the relationship is ever disputed, the absence of a recorded agreement may provide some indication a lease was not intended. By recording your commercial lease agreement with the county recorder you give constructive notice of your leasehold interest “to the world”. This can prevent a third-party who acquires an interest in the property after you recorded your lease from claiming ignorance of your earlier leasehold.
In addition to considering the general lease provisions discussed above, the commercial tenant should consider making some evaluation of the building owner, landlord, zoning laws, environmental expectations and nuisance laws, all of which may affect your commercial lease.
Whether it’s your first or your fifth commercial lease, negotiating and structuring your lease transaction effectively can have a significant impact on your business. Consult a qualified and experienced attorney to consider the options that best align with your business goals before you sign a commercial lease.