The Lucifers Lurking in your Lease

Posted on July 18, 2018 in Business Transactions

Moving from home office to commercial space is a big leap in the life of a small business. The obligations you take on in a commercial lease can become your largest single monthly expense…and your largest single exposure to risk.

Patricia found this out the hard way. Her fragrance and cosmetics business was growing. As demand increased, so did her need for more space to accommodate inventory and employees. The ten-year lease for the new space demanded a personal guaranty. Then, four years into the lease, the economy softened and Patricia’s sales contracted. Patricia tried to get out of the lease, but the landlord feared leaving the space empty and held her to its terms. When she defaulted, the landlord sued the company and Patricia – and won. The judgment was enough to push the now-fragile company out of business and Patricia into bankruptcy.

What might Patricia have done differently? Had she focused more on the potential for risk in the lease, Patricia might have identified terms to negotiate more favorably. While leases should always be reviewed with legal counsel, know that there are five major areas in most leases to be wary of:

1. Additional Rent. Rent is rent, right? Wrong. Landlords will pass along extra charges to you, the tenant, because you are occupying the space. Lumped under the category of “additional rent” (and defined as such in the lease), your failure to pay them becomes just as serious an infraction as failing to pay your rent for the space you occupy. “Additional rent” usually includes everything other than your fixed (that is, basic monthly) rent, such as real estate taxes and charges for water (hot or otherwise), sewer, gas, steam, electricity, light, heat, power, and services supplied to your premises.

They may also charge you for a proportion of maintenance costs for common areas. Some unscrupulous types may try to take advantage by apportioning more than your fair share of these charges to you. For example, Patricia’s lease specified that she would pay 10% of all additional rent charges incurred by the landlord. However, her premises occupied only 5% of the building. Had she inquired, she might have been able to reduce her percentage to conform to the proportion of space she actually occupied. As the economy softened, and local real estate taxes skyrocketed, these costs were also passed along, disproportionately, to Patricia. In addition, with utilities, are there dedicated meters or does the landlord charge you a percentage of the total expense incurred by the building? If the latter, try to get estimates on utility costs.

2. Maintenance and repairs: Especially when leasing storefront property, maintenance and repairs can add significantly to your monthly nut. Many leases specify that the tenant who occupies the street level must remove snow and ice, other obstructions or debris, and clean dirt (even graffiti!) in front of or on the premises. If you don’t do so, the landlord may, and will bill you. Not surprisingly, these charges tend to be higher than the ones you might pay if you hired someone yourself. Tenants are also generally responsible for maintaining sprinkler systems, repairing air-conditioning and heating units, handling repairs (that do not affect the structure of the building), and removing garbage from the premises.

Other costly, and unplanned, situations can arise. For example, leases can also include a tenant’s responsibility for repairing pipes, plumbing lines, electrical lines, appliances, and other systems located in and around the premises. Robert, a restaurant owner, had a flood caused by a blockage in the pipes under his kitchen floor. Because the flood occurred in his portion of the building, Robert – and not the landlord – had to pay for the repairs, even though another tenant had created the underlying problem.

3. Destruction, fire, and other casualty. Leases always favor the landlords who prepare them. If the premises are damaged by fire or other casualty, leases often give the landlord (not you) the option to repair and restore the premises or to terminate the lease. Should the landlord opt to repair, leases can grant landlords a significant period of time to fix the space.
Although you, as the tenant, are usually not responsible for paying rent during that time, a practical question emerges: what happens to your business? Do you have a contingency plan, bearing in mind that, once repaired, you will have to return to the premises and resume paying rent? It may be difficult to find space, reestablish yourself in new surroundings, only to have to uproot yourself again once the old premises become available. This is an area where it pays to investigate business interruption insurance. In addition, landlords often do not have to restore the space to perfection; only to being “substantially ready.” What “substantially” means can be the stuff of lawsuits. Nonetheless, once the premises are “substantially ready,” your obligation to resume rent payments kicks in, usually within a week.

4. Termination of Lease and Default. Commercial landlords have a powerful arsenal. Leases contain all sorts of reasons for which a landlord can terminate a lease or extract penalties from a tenant. If you are late with the rent, you can get slapped with a notice that you are in default, tacking on interest and attorneys’ fees (yes, just for sending the notice) – even where the situation was not your fault, such as a check lost in the mail. Should you fail to correct the problem by the deadline in the notice (usually two weeks or less), that alone can be grounds for eviction. Don’t expect too much sympathy from the courts; they are none too lenient in excusing the defaults of commercial tenants.

Furthermore, for as many remedies landlords have against tenants, tenants have virtually none against landlords. Let’s say that, for whatever your reasons (good or bad), you need to terminate the lease early in order to move to larger or smaller space. Nonetheless, a landlord could still hold your business responsible for paying the rent through the balance of the lease term, unless there is another tenant to take the space at the same or higher rent. In states like New York, a landlord has no obligation to try to find a new tenant. So you may get stuck having to wait until the end of the lease to leave the space, regardless of whether you want or can afford to stay there.

5. Personal Guaranties and Good Guy Clauses. Landlords often ask for a personal guaranty from a business owner – and may refuse to rent the space without one. A personal guaranty provides that the “guarantor” (usually, the business owner) will make good on any lease payments that the business itself fails to meet. Effectively, a personal guaranty adds the business owner as an obligated party to the lease. If you provide a personal guaranty, it enables the landlord to collect the rent (and additional rent) from either you or your company. This is a risk for small business owners like Patricia, where the company provides her sole source of income: if the business cannot make enough money to meet its expenses, it is unlikely that business owner herself will be able to make the payments in its place. As a result, like Patricia, the only escape may be to file for personal bankruptcy protection.

However, some landlords will include a “good guy clause” in the lease. This provides that, in the event that a business needs to terminate a lease early, the landlord will not enforce the personal guaranty as long as the business has vacated the premises and has paid all rent up to the date of termination. This can allow business owners a “way out,” and might have saved Patricia from having to declare personal bankruptcy. Bear in mind, though, that the landlord may still look to the business – even if not the owner — to continue to make all rent payments through the end of the lease. Be sure to read the good guy clauses carefully, as some will only allow you to get out of the personal guaranty in the event that your company is going out of business – not just for any general desire to leave the space.

Conclusion

Negotiating the terms of a lease involves more than just knowing what space you want and how much the rent will cost your business. There are a number of hidden costs and factors that can escalate the rent over and above what you originally budgeted to pay each month. If the landlord presents you with a “take it or leave it” proposition, be sure you can financially absorb the risks that lurk within the lease. If not, you may be better served by avoiding those Lucifers altogether and looking for other space.

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