In Due Diligence, the Lease is the Most… Important

The buyer in a commercial real estate transaction is always at a disadvantage. The seller possesses the property, and usually, all of the requisite information concerning same. More often than not, the buyer has little or no knowledge concerning the property, but must diligently investigate and inspect it or risk understanding, all too well, the still surviving doctrine of “caveat emptor” (let the buyer beware).

Confirming what property is being received, what condition it is in, what can or cannot be done with the property, and what risks are inherent in its ownership are of critical importance and warrant due diligence inspection rights (and corresponding rights to terminate) in every contract to buy real estate.

Title commitments, surveys, environmental audits, and building inspection reports are the most often utilized tools found in a “diligence tool box”. With leased property, however, a careful analysis of the lease(s) is arguably the most important, but often overlooked diligence activity. Many lose sight of the fact that in addition to “buying bricks and dirt”, with leased property, they are “buying” an expected income stream, and it is the lease that can “dam up the works”. While it is obviously crucial to examine a landlord’s financial statements, the lease review should begin, not end there. For example, you may not find a tenant’s early termination right footnoted in its financials. Additionally, a lease clause mandating landlord rebuild after a casualty will be problematic if a prospective buyer’s mortgage contains a clause requiring pay off of the loan upon such casualty.

 Among the more important lease terms to pay special attention to are:

 1.          Term

 While seemingly obvious, it is important to check the term of each of the leases.  A lease or leases with just a couple of years left in the term may not justify the purchase price.  Since, in today’s economy, there are still more spaces than tenants to fill them, it should not be assumed that a soon to be vacated space can be easily re-leased. 

 It is also important to check whether the terms of any leases have expired, even though the corresponding tenant(s) remain in possession.  Additionally, make sure the seller provides a copy of all tenant “exercise of option notices”.  In many cases, a tenant in possession of premises after its original term expired, (who had failed to send a notice to renew), will be characterized as a month-to-month tenant.

 2.         Rights of Refusal to Purchase

 If a tenant has a right of first refusal to purchase the property, prospective buyers, (before they spend any diligence money) should direct their sellers to issue any required notices to such tenant. Otherwise, litigation is bound to ensue and buyer, seller and tenant could be spending a lot more legal fees than any of them budgeted.

 3.         Rent Caps

 Check to see if there are any caps on operating expense escalations.  Annual caps of 4%-5% on “controllable” expense increases are considered reasonable; however, some leases do not make this distinction, and the landlord is not able to pass on to the tenant “uncontrollable” insurance, real estate tax or utilities expense increases beyond the cap.  Some leases will even preclude the landlord from passing on real estate tax increases resulting from a sale of the property to the tenant.

4.         Early Rights of Termination

 The prospective buyer should check the leases carefully to see whether or not the tenant has a right to terminate the lease prior to its scheduled expiration.  Often these provisions are buried within the body of the lease.  A ten year lease with the right of a tenant to terminate it at the end of three years should be considered a three year lease, not a ten year lease.  Additionally, some tenant form leases may give the tenant the right to terminate the lease upon a landlord default.

5.         Maintenance and Repair Obligations

 Some buyers of income producing property may be unpleasantly surprised to learn that what was billed as a “triple net lease” was instead an expensive variation on a theme.  In a “true triple net lease” tenants will typically pay landlord for their share of taxes, insurance and utilities, and landlord’s operating costs (including reimbursements for repairs, replacements and maintenance).  However, many leases will allow the landlord to recoup common area maintenance expenses like landscaping, but exclude landlord’s right to reimbursements for capital expenditures (e.g.., a new roof) or even for repairs such as patches to driveways, for example.  Commercial leases can also obligate landlord to replace the HVAC or any major mechanical systems.

 6.         Exclusives

 Many shopping center leases grant tenants the exclusive right, for example, to sell wireless products, or operate a restaurant with particular menu items.  At times, these exclusive provisions are overly broad, and can seriously hamper a landlord’s efforts to lease unoccupied tenant spaces.  A prospective buyer should also carefully review the actual uses of each tenant and any exclusive use provisions in the leases to make sure that the landlord has not breached any of the same by leasing space to a tenant whose use is in violation of another tenant’s exclusive use rights.

7.         Insurance – Casualty

 As briefly described above, many tenant-oriented lease provisions require a landlord to rebuild upon certain casualty events.  Often, but not always, landlords are given the right to terminate the lease if their insurance proceeds will not be sufficient for them to rebuild or if their mortgage requires a payoff in case of such casualties.  While buildings don’t burn down every day, if they do, the result can be extremely expensive with a one-sided tenant lease provision in this regard.

8.         Assignment and Subletting

It is also important to review the Assignment-Subletting provisions of a commercial lease. Ideally, the landlord should have consent rights, and the original tenant should remain liable after the sublease or assignment. Otherwise, it may be too easy for a credit tenant to walk away and substitute a financially undesirable tenant in its place.

  

Obviously, the prospective buyer has little bargaining strength vis-à-vis the tenant to insist upon lease modifications. However, a careful lease review and analysis by a legal professional, prior to the end of a purchase agreement due diligence period can give buyers all the bargaining strength needed vis-à-vis their sellers and let them know when to renegotiate, when to hold ‘em, when to fold ‘em, when to walk away and when to run.