Top Commercial Lease Issues for Small Business Tenants
by Jeana Morrissey, Arizona Real Estate Lawyer
As one might imagine, the needs and concerns of small businesses with respect to commercial real estate leases are often quite different than those of big business. Addressing these concerns and balancing the rights of both the landlord and tenant is essential.
The main issues for the smaller tenant involve the performance of its business and protection of its assets. The tenant wants to protect its bottom line, to know in advance what the lease is going to cost, to be able to budget this expense, and to avoid surprise costs and liabilities that can be fatal to a small business. The tenant wants to ensure that the landlord’s operation of the property will not impair the tenant’s business. Finally, the tenant wants an exit strategy, either to sell its business or, in the unfortunate circumstance of business failure, to reduce its liability to the landlord.
Protection of Business and “Use” of the Leased Premises
A small tenant must consider the nature of its business and the potential impact on its revenue stream if a nearby tenant is allowed to operate a competing business. Small tenants should expect the landlord to provide a certain amount of protection, because the landlord ultimately controls the type of tenants on the property and the mix of uses that the tenants, collectively, provide to the public or other tenants of the property.
This protection of the tenant’s business must be measured against the tenant’s desire to negotiate with the landlord for some amount of flexibility with respect to its use of the leased space.
Smaller tenants may want to change the use during the lease term to maximize profitability. For example, one business idea may prove to be less profitable than expected or may become less profitable over time as consumer product demands change, technology changes, etc. As a result, tenants need the flexibility to change with the market.
Smaller tenants often do not have large budgets for maintenance, but maintenance is always an ongoing necessity. For this reason, the small tenant will desire to shift that burden to the landlord as much as possible. The landlord, however, will be reluctant to deviate from its regular building maintenance allocation at a smaller tenant’s request. At a minimum, the small tenant will want to ensure that the lease is not overreaching. The small tenant should at least ensure that the landlord has a duty to maintain the building structure, exterior, common areas, and any shared building systems, such as HVAC and plumbing.
Disruption of Services and Casualty Insurance
Smaller tenants need the right to terminate in the event of a disruption in services or casualty damage. The smaller tenant’s business will suffer and ultimately fail unless the problem is remedied quickly. From the landlord’s perspective, all tenant termination rights are undesirable, and in fact may be directly contrary to provisions in the landlord’s financing documents. In addition, the landlord may have an administrative reason for having all leases contain the same terms and conditions in the event of casualty or disruption of services. The small tenant should carefully review the lease provisions related to casualty or disruption of services and do what it can to plan ahead for such a disruption. To protect against the failure of the tenant’s business during a disruption of service or casualty, many landlords correctly insist on the tenant’s carrying business interruption insurance.
Landlords often require a guaranty of the lease by the principals of the smaller tenant. If so, tenants should try to include various limitations in the guaranty. For example, the guaranty might only cover the unamortized tenant improvements and commissions, or, so long as the tenant is not in default, it might be capped at a certain number of months of rent, with the number of months declining over the lease term. Each landlord will have to evaluate this type of request based on the perceived financial stability of the tenant. A guarantor may also negotiate for a release of liability upon the sale of the business to a successor with a specified minimum net worth.
Breach and Default Provisions
The tenant should require written notice followed by a grace period before the landlord may exercise default rights; the grace period allows a cure period for the tenant to make a late rent or comply with another requirement of the lease. In addition, the tenant should try to negotiate a maximum amount of damages in the event of tenant default, such as three months of base rent. The tenant should attempt to include a provision that the landlord has a duty to mitigate damages in the event of the tenant’s default (e.g., take reasonable steps to re-rent). In addition, the lease should contain a total limit on tenant damages in the event of default that also applies to all guarantees overall as a single limit.
Transfer of Lease. Every tenant needs to have some right to assign the lease or sublet the premises as part of an overall exit strategy for the lease. The right to assign the lease or sublet the premises can be critical for the smaller tenant, because it will allow for the natural evolution of the tenant’s business (such as the sale of the business or merger, expansion, or consolidation of multiple locations).
Typically, the landlord’s lease form prohibits assignments of the lease without the landlord’s prior written consent. Moreover, the lease usually characterizes a sale of the business, a merger, or a transfer of more than 50% of the stock as an assignment requiring the landlord’s consent.
Expect the lease to also provide that the transfer of the lease does not release the original tenant or any guarantors from their responsibilities under the lease or any guaranty thereof. Among other important considerations, if the tenant sells its business to a creditworthy successor, the principals of the business will want a release from liability under the lease. The landlord has absolutely no incentive to grant this release if the business is sold after the lease is signed, so the tenant must ask for this on the front end.
Termination of Lease. Although the tenant will want to negotiate for the right to terminate the lease in the event certain circumstances occur, the landlord is typically unwilling to consider such a provision because it wants a secure income stream over the long term. In addition, the landlord’s lender may not allow the landlord to consent to an early termination clause without the lender’s prior approval. A small tenant should note that even though there may be valid business reasons for an early termination clause, landlords grant termination rights sparingly.
Additional Issues to Consider
Utilities – The fluctuating costs of electricity and other utilities can be especially burdensome on smaller tenants. Landlords often ask tenants with excess consumption to bear the cost of separately metering their premises, so this cost burden must be carefully reviewed by the smaller tenant given its typical budget constraints.
CAM – The tenant will desire a cap on additional common area maintenance (CAM) charges.
Build-Out – Smaller tenants in particular often have very limited budgets for the construction of tenant improvements to the premises. To avoid difficulties, the lease should clearly distinguish between those elements of the build-out that are the landlord’s responsibility and those that are the tenant’s responsibility.
Compliance with Law – Depending on the tenant’s use, the tenant may need to comply with the Americans with Disabilities Act (ADA) or other codes and regulations. Leases vary in allocation of responsibility for compliance with laws, and the tenant needs to make sure that the lease is clear on who is responsible for compliance with applicable laws.
Expansion – If the tenant believes its business may grow faster than anticipated, the space may prove to be too small and the tenant will need to expand quickly (preferably into an adjacent space). These types of scenarios are best negotiated before signing the lease.
Parking – Smaller tenants may request special parking commitments, especially if the tenant’s business depends on accessible parking for clientele near the tenant’s premises
Signage – Smaller tenants may need specialty signage to meet the requirements of their franchise agreement. The tenant should be prepared to pay for any extra costs caused by a deviation from the building’s standard signage.
The most important thing to remember is this: Anything that the landlord promises the tenant must be put into the lease or lease addendum. The tenant must not rely on verbal promises of the landlord.
Hire Arizona Real Estate Lawyer Jeana Morrissey to Review Your Lease
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