The Dos and Don’ts of NNN Leasing
Almost every business negotiates a lease at some point. Whether gross, modified or triple net (“NNN”), the pitfalls and landmines are often much larger than initially understood when looking for a space for a business. Many companies rely on their real estate brokers or try to negotiate the lease themselves as opposed to hiring an attorney to negotiate on their behalf. After all, no one is going to pay a partner or an associate at a Century City or downtown law firm $500 to $1,000 an hour to negotiate a lease that likely will take many hours to negotiate. That is one of the reasons that over the last ten years the bulk of the commercial real estate transactional business has gone to smaller and more affordable boutique real estate law firms.
When tenants and landlords really get into trouble is when they skip the engagement of an attorney entirely, a penny wise and a pound foolish. I have had many people over the years come to my office or call me asking why their landlord is charging them for after-hours heating ventilation and air conditioning (“HVAC”) use, won’t release their tenant improvement allowance (“T.I.”) or won’t make repairs. The answer is almost always because that is what they negotiated their lease to say. They think that their big REIT landlord is going to have pity on them because they are a mom and pop business and not charge them the fees and expenses because “it is just not right.” Unfortunately, nine and a half times out of ten they are out of luck and they end up in default or worse yet, end up in litigation with their landlord.
Some people would rather not pay an attorney to negotiate a lease than pay hundreds of thousands of dollars to their landlord for ridiculous costs that should have never been in the lease in the first place. When I am negotiating a lease for a landlord, I can always tell who is going to turn out to be a good tenant and who is going to default and vacate the premises in the middle of the night. The tenants that hire good attorneys to negotiate hard on their behalf turn out to be good tenants because they are shrewd business people with their act together. The tenants that just sign a lease because they emotionally like the space and don’t know what they are doing wind up defaulting and declaring bankruptcy.
Landlords often try to save money and have their broker draft a lease on the landlord’s "standard" form. There is no such thing as standard as every piece of property is unique and different. The most unsavvy landlords have their broker use the broker’s form, the California Association of Realtors (“CAR”) or Association of Industrial Realtors Commercial Real Estate Association (“AIR”) lease forms. The CAR and AIR forms are drafted by brokers with one purpose in mind, to protect brokers from liability. The uses of the lease forms more often than prove to be wholly inadequate for their needs.
NNN leases are the kind of lease most often used by retail landlords. The triple net means that the tenant’s share of real property tax, insurance and common area maintenance expenses (“CAMs”) are additional monthly fees on top of the monthly rent. These extra expenses often fluctuate (in only one direction). A gross lease, the kind of lease most often used in industrial buildings and often used in office buildings, are where all or most of the extra expenses are included in the monthly rent. In a modified gross lease the landlord usually includes some of the extra expenses in the monthly rent and sometimes the tenant is responsible for the maintenance and repairs.
In ten years of negotiating primarily NNN leases, here are a small number of some of the pitfalls that tenants need to be aware of:
• After-hours HVAC: With a use that is for a restaurant, law firm, accounting firm, radio station or have another use that involves being in the office or retail location at night or in the early morning, watch out! Landlords want the lease to say they will turn on the air conditioning when requested, but they will charge for use during those hours for the whole building, not just the premises in question. With a use that involves after hours occupancy, a tenant needs to make sure that they either: (i) negotiate out any after-hours HVAC charges, (ii) after-hours HVAC charges are only for the tenant’s specific unit and the rate is same as during the day or (iii) make sure the tenant has their own electric and gas meters on the unit so that they can pay the associated costs directly.
• Rent Commencement Date: This is always a hotly debated lease point. From the landlord’s perspective, they want the rent to begin as soon as the lease is executed. From the tenant’s perspective, they want the rent to be paid only after the expiration of any free rent period, all of the tenant improvements have been completed and/ or the TIs have been paid and most importantly, after the applicable municipal bodies have approved all permits and the premises are in compliance with all codes and regulations. What happens if a tenant starts paying rent only to find out they can’t open because the building is not to code and the landlord refuses to make it to code?
• T.I. Payment Schedule: Most work letters read that the tenant does not get to keep any unused T.I. If there is left over T.I. and a few months down the road something else breaks, why should the tenant have to come out of pocket? Tenants should also try to negotiate that any extra T.I. can go to fixtures and furniture. The dollar amount is not the only important factor when negotiating for T.I., most leases say that the T.I. is only for construction costs that are performed prior to the rent commencement date.
• Repairs and Maintenance: It is standard for the landlord to make all necessary repairs and complete the ordinary maintenance. Landlord’s do not make repairs to tenant’s fixtures. If the tenant installed a new HVAC unit or if the landlord installed one on behalf of the tenant to prepare the space for that specific tenant, it is standard that the tenant pays for quarterly maintenance of the HVAC unit. If the tenant fails to perform the required maintenance, landlord is not responsible to make repairs to the HVAC unit.
Here is a real life horror story. I had a nonprofit client call me and tell me they signed a “really short (only a few pages) and friendly” lease without consulting me. There were major structural repairs needed on the building. The client was outraged that the landlord refused to perform the needed work. When I looked at the lease, which was unfortunately on the CAR form, the box had been checked saying that the tenant would perform all structural repairs. The tenant had already sunk so much money into improvements that moving was not an option. The tenant ended up performing over one hundred thousand dollars in structural repairs to landlord’s building. Had the tenant paid an attorney to review the lease, this money would never been spent.
• Landlord Default: This is another tricky one that is hard to get the agreement from many landlords, especially when the brokers are doing the negotiating. What happens if the landlord defaults? The answer of most landlords is “sue me”. There are never winners in lawsuits, both sides always lose. It is much more cost effective for both sides when the landlord is in a true default, that the Tenant shall have the right to make the necessary repairs, or to take the necessary action, on behalf of the landlord, and the landlord shall credit the rent for the cost of such repairs or action.
• Written Notice: Every notice in every lease (and any other legal document for that matter) should always be in writing and delivered via overnight delivery or certified mail so that you have proof of delivery. Voicemails, telephone calls and texts should never constitute notice because you have no way of proving you actually gave the notice if the other side says they didn’t receive it.
• Late Fees and Late Penalties: This point has to do with the written notice point above. It is critical that the tenant not be penalized for late rent (or other defaults) if the tenant doesn’t know that the landlord didn’t receive the rent. If the rent check gets lost in the mail, the bank made a mistake on the electronic transfer or the more likely scenario, someone in accounting screwed up, the late fees and penalties should only begin after the tenant has received a written notice of such from the landlord and the tenant has been given an opportunity to cure. The landlord always pushes back with “why should I give the tenant an interest free loan every month”? The compromise is that the landlord only has to give a couple of written notices every year before the late fees start automatically accruing because if the tenant can’t fix the problem after a month or two they have more serious problems than the mailman lost the rent check and that shouldn’t be the landlord’s problem (although it is exactly the landlord’s problem).
• Lost Rent: If you go out of business, you need the landlord to at least start looking for another tenant as soon as you let them know what is going on. In California landlords are not required to do so. The lease should read that the “landlord shall not be entitled to any amount of lost rent which could have been reasonably avoided.” Often times landlords don’t want to do this because if they sign another lease and cut their losses (and the new rent may or may not be at a lower rent than defaulting tenant was paying), the landlord will not be able to accelerate the future rent and get a judgment against the defaulting tenant for all future rent owed under the lease.
• Cap on CAMs: Make sure there is an annual cap on CAMs so that regardless of what the landlord wants to include you have a ceiling so that you can control your costs. Additionally, certain items should be excluded from CAM charges such as insurance deductibles, improvements to make the center or building compliant with the American's with Disabilities Act, California Title 24 (the building energy efficiency program) and any capital expenditures. Do you need a golden water fountain in your shopping center? If you are at a Caruso Affiliated property you are paying for one whether you want it or not. Most of Caruso’s tenants do want fancy amenities but unless if you are Cartier, you probably don’t want to pay for a lot of over the top common areas. You should also seek a cap on real property taxes because you don't want your rent to go through the roof when the landlord may sells the building.
• CAM Audits: Most lease forms do not allow tenants to perform CAM audits. It is imperative that tenants have this right as I have never seen a CAM audit come back without something a little off (usually more than a little off). If the CAM audit comes back with material discrepancies, tenant should not have to pay these costs. Most CAM audits are performed by auditors on contingency so there is no down side in a tenant letting someone come and audit the books and it helps to keep landlord honest.
• Confirm the Square Footage of the Premises: The monthly rent and your share of CAMs is based on the square footage of your space. You must have your architect determine the actual usable space square footage. Additionally the lease needs to indicate that monthly rent and your share of CAMs is based on the actual usable square footage and not the rentable square footage as the landlord would like to use. In retail centers the tenant's space must never include any common areas. However, in office buildings the landlord can include a common area load in the usable square footage for things like bathrooms and hallways. The common area load in an office building should not be more than 10% - 20%.
• Underlying Documents : Many tenants never ask to see the Restrictive Easement Agreement (“REA”), the Covenants Conditions and Restrictions (“CCR”) and the Operation and Easement Agreement (“OEA”) even though their lease says that they are going to strictly abide by them. I could never understand how people agree to something they have no idea what is says. Although usually not an issue, I have personally seen recorded restrictive documents that prohibit the potential tenant’s use. The landlord was ready to sign a lease with a tenant they couldn’t let in the shopping center. I have also seen restrictions on signs that were deal killers for big national tenants that insist on their own specific signage.
• Subordination and Non-Disturbance Agreements (“SNDA”) and Tenant Estoppels: Landlords often insist on being given power of attorney over their tenants if they refuse to sign a SNDA or estoppel in a timely fashion. This should never be granted. You also don't want to be put into default if you don't sign the document within a few days. Real estate is all about leverage. If you have been waiting to ask the landlord for a lease amendment, there is never a better time to ask then when they are about to close a refinance on their loan. Also, if your landlord is in default, letting their bank know about the default is a great way to get the landlord to cure the problem.
• Exclusive Use: Landlord’s must be very careful when granting exclusive uses. If you are a yoga studio, do you want another yoga studio or even a Pilates studio opening up next door? I hate to say it because most of my clients are landlords, but there are some landlords (not my clients) out there who could really care less if they cannibalize their own clients’ businesses.
Many restaurants want exclusive uses that their landlord will not put another restaurant in the same center. I personally believe this is not a good business decision. We live in an age when the economy is based on experiences. We used to have an economy based on services and prior to that our economy was based on the manufacturing and sales of goods (see B. Joseph Pine II and James H. Gilmore, The Experience Economy (1999)). Brick and mortar businesses are facing steeper competition from online discount retailers. If you are a retailer (a store, restaurant, bank, hair salon or any business that has a place where customers walk in), you need to be in a shopping center or a mall that has a lot experiential co-tenants. Why? Because in the 21st Century many people do their shopping from their computers at home. When they get bored sitting in front of a computer all day they leave home to look for an experience. Shopping centers with lots of food choices, bars, movie theatres, gyms, children’s play areas, salons, etc. are where people go for an experience. What experience is the number one draw? Restaurants. Provided there is ample parking, nothing is better for a commercial retail asset then a hot new restaurant. People will flock there and wait around for a table. They will get bored and shop at the other shops while they wait. They will get hungry and tired of waiting and try the other restaurants in the center. Even if there is no wait, the fact that they are there dining makes them aware of the surrounding businesses and thus much more likely to be patrons of the co-tenants as opposed to before the restaurant opened.
Negotiating leases is a risky business. When business owner’s sign personal guarantees, the risk goes through the roof. It does not make business sense to attempt to negotiate such a high dollar item that potentially leaves millions of dollars of liability in the business owner’s lap, without the advice of an attorney. A good broker will advise you to seek legal counsel. Some brokers are wary of advising their clients to engage an attorney because they have the view that lawyers slow down and screw up deals, both leases and purchase and sale agreements. This is unfortunate advice because this means that the broker will be giving their client legal advice which is actually a criminal offense in California. The real estate game should always be viewed as win-win transactions. Although in leasing many negotiated points come down to dollars and cents, both the landlord and tenant should not look at the other as an adversarial opponent but as a partner in business. A knowledgeable broker and a well informed lawyer working in conjunction can almost always find a mutually beneficial compromise to any sticking point. For every hot button item deal point there is a compromise so that both sides can sleep well at night.
The information in this article is intended to be a general description of real estate law and is not advice as to any transactions, nor is this article advice to any person or to any client and should not be relied upon as such. If you or your client desire to receive specific legal or tax advice on a specific transaction, then please call Caldwell Law at (818) 992-2921.