By Imran Naeemullah, Amy Lawrenson, and Karen Nashiwa
During the due diligence process, whether an attorney represents the lessor or the lessee, the attorney will want to consider numerous lease provisions when advising the client. Although every situation is different, the following are some key lease provisions that often arise during due diligence. Please note that in this article “due diligence” is being used somewhat loosely to encompass everything from considering a particular property to the terms to include in a letter of intent, in the initial lease draft, provisions to include (if representing the lessor, the typical drafting party) and provisions to pay close attention to during the initial review (if representing the lessee, the typical reviewing party). The intent of this article is not to offer a comprehensive guide to reviewing leases or negotiating leases, but instead to provide an overview of some key provisions to consider during the due diligence process. At the end, a checklist is included to aid attorneys in their due diligence efforts.
First, who is the lessor and who is the lessee? It sounds simple and basic, but perhaps because this is simple and basic, sometimes people gloss right over this. Ensure that you have all parties’ complete names. For example, if a party is an entity, the lease must include the entity’s full name and jurisdiction of formation. If a trust, the name of the trustee and the full name of the trust must be included in the lease. If there are multiple parties, all owners must be included. One of the authors conducted due diligence for a lease in which the lessee was a defunct entity. Because the entity did not exist at the time the leases were entered into, corrective documents ratifying the leases and changing the lessee’s name were necessary before the deal could move forward.
The lease must describe the premises with particularity, to the exclusion of all other real property. This benefits the lessor and lessee alike. Consider whether there are any obstacles to doing so. For example, is the square footage of the premises readily available? Is there a valid legal description of the premises? Is there a clear map of the premises (and does it include any extraneous information that may potentially lead to confusion or conflict with the written description of the premises)? Identifying missing information or potential problems can help to avoid issues in closing the transaction. Including a proper legal description and depiction of the leased premises in the lease helps to ensure that the parties agree on the described premises.
Use of the Premises
Use is a perennial issue in leases. What is the intended use of the premises? Many leases require that the lessee use the premises only for purposes allowed by applicable law and zoning regulations. Such a provision requires a two-step review. First, is the intended use permitted under applicable zoning regulations, and second, is the intended use allowed by other applicable law? For example, applicable zoning regulations may allow a medical marijuana dispensary on the leased premises, but state law might prohibit the sale of medical marijuana.
When considering use, the attorney should also contemplate what the lessor wants (if representing the lessor) and what the lessor will allow (if representing the lessee). For example, if the prospective lessee wants to open a music studio the lessor will be concerned about a potential nuisance to its other lessees. The lessee will want to ensure that the lease allows for it to operate its business without having to worry about lease violations.
Use also extends to other issues. For instance, the lessor should consider what type of businesses it will allow in the premises; and the lessee should consider whether the lessor’s allowed use will be compatible with its intended use. Exclusive use provisions should also be considered. For example, a lessor must consider whether an exclusive use provision is necessary to protect an existing lessee’s business (whether contractually or as a practical matter to preserve revenues from percentage rent), and a lessee must consider whether an exclusive use provision is acceptable. Both sides should give careful consideration to exclusive use provisions, particularly as the exclusive use provision may not be tested until well into the lease term. For example: Is a hamburger (e.g., at a fast-food burger restaurant) a sandwich for purposes of an exclusive use provision in favor of a deli?
Will the permitted use of a new tenant cause issues with existing tenants or at the end of the lease term? In the event a lessee abandons the premises, the personal property left behind is usually deemed abandoned, and lessors often have the right to remove or dispose of such personal property without liability to the lessee. But what if the personal property is a type of property with which a lessor does not want to be involved? One of the authors represented a lessor who leased space to a gun store. The lessee stopped paying rent and abandoned the premises, so the lessor evicted the tenant. Although the matter was straightforward, what to do with the guns and ammunition left behind was not. Thankfully, the Bureau of Alcohol, Tobacco, Firearms, and Explosives was in charge of handling what was left behind.
Insurance falls into two general categories: the insurance required by the lease (e.g., commercial general liability insurance, property insurance, etc.) and insurance that the lessee should consider obtaining. A lessor must consider the types of insurance it wants the lessee to obtain as a condition of entering into the lease. The landlord must consider what insurance coverage is reasonable for the market and what a lessee is likely to be able to obtain for an affordable price. A lessee must consider what the lessor is likely to require and whether the mandated coverage can be obtained for an affordable price.
For example, consider a lessee entering into a ground lease for a hotel located near the ocean. It is not located in an area of likely flooding, according to the Federal Emergency Management Agency (FEMA), but the lessor insists on flood insurance because it does not want to rely on the FEMA risk map. Can the insurance be obtained at all, and if so, is the premium reasonable? Is it likely to be renewable for the entire lease term at an affordable price?
Again, in this hotel example, the lessor may be concerned about the potential for earthquakes and wants the lessee to obtain earthquake coverage. The property might be in an area where an earthquake is extremely unlikely, yet coverage may be difficult to obtain and will be expensive. Consider whether this may be off-putting to the lessee and, if the lessee objects, whether the lessor will be willing to waive this requirement.
A further consideration may be the type of lessor. If an entity routinely deals in real estate transactions, this may not be an issue, but if the lessor is a group of trusts, then negotiating the lease terms may be more difficult. Additionally, depending on the type of lease, the lessee may want to consider title insurance. This is particularly true for long-term ground leases. The lessee should consider whether the premises will be insurable, what policy coverage will be available, what endorsements will be necessary (and available), and the cost of coverage. It is generally advisable to begin looking into title insurance considerations early in the process, particularly if underwriting may present some issues, therefore requiring time and attention in connection with the delivery of the items that the title insurer will require in order to commit to issuing the policy.
A lessor’s counsel will want to evaluate the lessee’s business for potential nuisance to other lessees or neighboring properties. Lessee’s counsel will want to determine whether its client’s intended use may create potential nuisance issues. Each side will have this in mind when negotiating language related to nuisance, so learning about the potential issues in advance will help.
For example, a hot sauce manufacturer is looking for a new location for its production facility. There are two prospective sites, one that is more appealing to the manufacturer but is in an industrial complex where the other lessees likely would be exposed to hot sauce “fumes” in the air and could complain to the lessor, and another location that is less convenient but is in a sparsely populated area. Given the potential for nuisance claims, and the lessor’s likely unwillingness to allow use of the premises that may constitute a nuisance, it may be better to advise the client of the potential issues before lease negotiations so it can focus on the alternative site.
Often, negotiated provisions address termination, relocation, and expansion rights. For example, a lessor may want to negotiate for the right to relocate the lessee to another space, whereas a lessee may want to negotiate for the right to relocate if a larger space is needed. The potential for these negotiations should be considered during due diligence and the likely alternative spaces evaluated for feasibility.
Particularly in a long-term ground lease, but sometimes in other leases such as restaurant leases or office leases, the issue of who keeps the improvements at the end of the lease term is an essential topic. During the due diligence review, the lessor will need to determine how important keeping the tenant improvements is and what concessions the lessor may be willing to make.
Audit rights are often closely negotiated. For example, the lessee may want to negotiate for the right to audit common area maintenance expenses. During due diligence, the lessee should consider the frequency, mechanism, and costs associated with periodic inspections of the premises during the lease term. Having clear expectations on the transparency of how reconciliations are prepared can help prevent friction and disputes between the parties.
Renewal options may be of interest to either party. For example, are conveyance or transfer taxes imposed on leases of a given duration, and do those taxes apply to options of a certain duration? Flagging and researching potential issues upfront can save time later in the process.
Other Issues to Consider
Assignments. The assignment clause is important and often heavily negotiated, in which many issues need to be thought through. Should the assignment release the original lessee from all obligations under the lease (rarely agreed to by landlords)? Can either party freely assign their interests or is prior written consent required? What about affiliates—can assignments to affiliates be freely effected without prior written consent? If a lessee will be taking an assignment of a lease, it is critical to review in advance what the assignee’s obligations will be, such as with respect to rent, CAM payments, maintenance obligations, and surrender obligations. This tends to be more pronounced when representing a lessee, but sometimes lessors can have obligations that a potential assignee should be mindful of.
Subleases. Subleases present a unique issue and should be discussed thoroughly prior to lease execution. The sublessee is subject to all of the terms of the master lease, so it is important for the sublessee to review the master lease during the due diligence process to ensure that complying with those terms is acceptable. Likewise, lessors must vet potential sublessees to ensure they meet any lease requirements, such as those imposed by consent to sublease provisions.
Due authority. Many leases require the parties to represent and warrant that they are duly authorized to enter into the lease. Parties should make sure they have that authority or, if specific authorization is required, that the appropriate documentation is completed and signed in a timely manner. If a new entity will be formed that will enter into the lease, consider the lead time required for the state of formation to process the filing. Do not let a potential filing issue delay or kill the transaction.
As Benjamin Franklin’s adage goes, “An ounce of prevention is worth a pound of cure.” The checklist and topics covered should aid a practitioner in lease due diligence. Being aware of and discussing key provisions with your client in advance is a best practice that decreases problems down the road, which should lessen the need for expensive cures.
This article was originally published in the July/August 2022 issue of the American Bar Association Real Property, Trust, and Estate Law Section’s bi-monthly magazine, Probate and Property.
Amy Lawrenson is a partner at Baird Holm LLP in Omaha, Nebraska. Imran Naeemullah is an associate at Cades Schutte LLP in Honolulu, Hawai‘i. Karen Nashiwa is deputy general counsel at Triple Oak Power in Portland, Oregon.