The Landlord’s Perspective on Selected Key Lease Issues

INTRODUCTION

A. Purpose of Presentation: to Explain and Discuss the Purpose and Legal Effect of Selected Clauses Typically Appearing in a Landlord Lease Form.

B. This is a Landlord-Oriented Discussion. Most Leases are drafted by or for Landlords, and therefore, not surprisingly, most Lease provisions are intended to benefit only the Landlord. It is often the least understood, most Landlord-oriented provisions that generate the most debate, but a full understanding of the purpose of a given clause is critical to effectively negotiating a favorable resolution—you can’t make a cogent argument to change a clause you don’t understand.

C. Use of the AIR Lease Form. To assist in our discussion, I will make frequent references to one of the recent American Industrial Real Estate Association Lease forms (the Standard Industrial/Commercial Multi-Tenant Lease – Gross, 04/14 version). I chose this form because it is commonly used in commercial real estate—all over the country—and because it is well organized with descriptive headings so it lends itself to discussion of the types of clauses that you will find in any competent commercial Lease. The AIR form is also useful because it is a reasonably balanced form, as you would expect a broker-sponsored document to be, so the provisions are not as lopsided in favor of the Landlord as a typical manuscript Lease. Finally, the AIR form is useful because it has been the subject of a number of reported judicial decisions, so we have some guidance as to how courts are likely to interpret the document.

D. Ground Rules: Interrupt and ask questions!

KEY LEASE PROVISIONS

A. Basic Provisions (Section 1 of AIR).

1. Landlord’s Objective: Set forth all of the key deal terms in a single location in the Lease, rather than have blanks that need to be filled in interspersed throughout the document.

2. Discussion: Be wary of discrepancies between the Basic Provisions and the body of the Lease (ambiguities are likely to be interpreted against the Lease drafter), and make sure that all the blanks are filled in. For example, one case held that the failure to insert the base year in the standard Lease form resulted in a holding that the parties did not intend the Tenant to pay property tax increases at all.

B. Premises (Sections 1.2(a) and 2 of AIR).

  1. Landlord’s Objective: To clearly (and usually narrowly) define the space as to which the Tenant has the right of exclusive occupancy, and prevent future disagreements about the square footage of the Premises and the parties’ respective obligations with regard to the Premises.
  2. Discussion:
    a. Control and Construction Obligations: A Lease is, by definition, the right to exclusively occupy certain Premises for a term so it’s important to have a clear demarcation between what constitutes the “Premises” and the rest of the building or property (such as the “common area” or “base building”). This has implications as to the parties’ respective construction obligations, too.
    b. Compliance-With-Laws Obligations: The definition of the “Premises” also has significant implications as to the parties’ respective compliance-with-laws obligations (see Sections 2.2 and 2.3 of AIR). The AIR provisions reflect the results of the two cases decided by the California Supreme Court in 1994, Brown v. Green, 8 Cal. 4th 812 (1994), and Hadian v. Schwartz, 8 Cal. 4th 836 (1994), both of which interpreted an earlier version of the AIR Lease. In those cases, the court essentially ignored the plain language of the Leases and invented a six-part test to determine which party, Landlord or Tenant, is liable for compliance-with-laws costs. It’s notable that even though the language in the two Leases was nearly identical, the results in the two cases are completely different. Note that the terms of Section 2.3 of the AIR limits the Tenant’s remedies to causing the Landlord to rectify the noncompliance at Landlord’s expense (as opposed to being able to terminate the Lease, or sue for damages).
    c. Space-Measurement Issues: The AIR Lease (see Sections 2.1 and 2.4(a)) and many other modern Leases use a “stipulated” or “deemed” approach to square footage, which is to say that the rent is fixed, and is not subject to adjustment if it turns out that the actual square footage of the Premises differs from that recited in the Lease. Tenants often ask for the right to measure the space, which raises many issues:
    (i) Which Standard? Tenants often ask to use “the BOMA Standard” to measure the Premises. However, this is an inherently ambiguous reference, as BOMA has published its office buildings standard more than once (the most recent version is the 2010 version), and there are many kinds of ways of measuring buildings in the BOMA publication, including “gross building area,” “usable area,” “store area,” as well as “rentable area.” And to complicate things further, there are now two methods, Method A (the Legacy Method) and Method B (the Single Load Factor Method), for measuring rentable area under the 2010 standard. There are also now separate standards for retail, industrial, and multi-unit residential buildings.
    (ii) Threshold for Adjustment to Rent? It’s not uncommon for a field measurement of space to differ from the measurement made using building plans, nor is it uncommon to have one architect’s field measurement vary from that of another architect. It’s also common for Landlords to “inherit” measurements of the building and individual Premises from prior Landlords. For these reasons, the 2010 BOMA office standard states a 2% threshold—any variance of 2% or less is to be ignored—and it’s reasonable for a Landlord to insist on such a threshold if the Tenant is granted a remeasurement right.
    (iii) Overstatement of RSF Can Constitute Fraud. In the case of McClain v. Octagon Plaza, LLC,159 Cal. App. 4th 784 (2d Dist. 2008), the California Court of Appeal held that a commercial tenant adequately pled a claim for fraud in the inducement in a circumstance in which the Lease (which was an AIR form) overstated the rentable square footage of the Premises by 7.6%, overstated the Tenant’s share of common expenses by 4%, and that the Landlord knew or had reason to know that the statements of rentable square footage were materially inaccurate. This was in spite of the Lease’s disclaimers about square footage. The McClain court held that these disclaimers were subject to Section 1668 of the California Civil Code (which deems contracts that exempt one from responsibility for fraud or willful injury unenforceable as being contrary to public policy) and therefore they did not bar the Tenant’s fraud claim or establish as a matter of law that the Tenant’s reliance on the lease’s statements of size was unjustifiable. In addition, the court noted that the disclaimer providing that rent was not subject to revision regardless of actual size was similar to an “AS IS” clause of the sort that California courts have routinely rejected as ineffective in insulating a contracting party from a fraud claim regarding a nonobvious defect.
    (iv) Outside Date for Measurement?
    (v) Arbitration or Other Methodology for Resolving a Square Footage Dispute?
  3. CASp Inspection (Section 49 of AIR):
    (i) California Civil Code Section 1938 states as follows:
    “A commercial property owner or lessor shall state on every lease form or rental agreement executed on or after July 1, 2013, whether the property being leased or rented has undergone inspection by a Certified Access Specialist (CASp), and if so, whether the property has or has not been determined to meet all applicable construction-related accessibility standards pursuant to Section 55.53.”
    A “CASp” is an accessibility specialist who has been certified by the State of California to inspect properties for compliance with construction-related accessibility standards and authorized to issue a certificate of compliance which may be displayed at the property. Civil Code Section 55.53 is the statute that sets forth the technical requirements for that certificate.
    (ii) Scope of Application. The AIR provision follows the language of the statute fairly closely. However, as with any new legislation, there are ambiguities in its language that have yet to be interpreted and complications in its application that commercial property owners should consider when formulating a compliance strategy. These ambiguities and complications include questions regarding what is considered to be “commercial property,” “property being leased” and a “lease form.” A conservative response would be to assume that the courts will interpret these terms broadly and in favor of the Tenant, and accordingly, a prudent owner should consider including the disclosure requirement not only in Leases, but also in subleases, assignments, and amendments that extend the lease term or expand the Premises for any property being used for commercial purposes.
    (iii) Whose Knowledge? The statute does not address the possibility that there could be an existing CASp inspection of the property that is not known to the property owner (for example, a tenant, lender, or prior property owner might have obtained a CASp inspection that hasn’t been shared with the current owner). In order to protect the property owner, a Landlord should limit the statement to what is actually known to the Landlord at the time the statement is made. The Landlord should also consider adding to the Lease a requirement that the tenant not conduct a CASp inspection without the prior approval of the Landlord and/or that the Tenant is required to deliver to the Landlord a copy of any CASp inspection conducted by the Tnant.
    (iv) Lack of Express Penalty: Although there is no penalty or other consequence specified under the new law for not including the required disclosure information in a commercial Lease, failure to comply could nonetheless result in potentially serious negative legal consequences for a property owner. Noncompliance could result in claims or cross-complaints by a Tenant against its Landlord should the Tenant be sued for failing to comply with disability-access laws, or in extreme case, a Tenant may use the noncompliance as a grounds to seek to terminate the Lease (that would typically be a difficult remedy for a Tenant to obtain, though).
    (v) To CASp Inspect or Not? This new requirement places even greater emphasis on the need to clearly designate in commercial Leases how responsibility for compliance with disability-access laws is allocated between the Landlord and Tenant. It also serves to focus the attention of commercial property owners on the question of whether or not they should undertake a CASp inspection of their property. This is not a simple decision. There is nothing under prior law or SB 1186 that requires a commercial property owner to hire a CASp to inspect its property—in fact, Civil Code Section 55.53 specifically negates any such obligation and states that a Landlord or Tenant’s election not to hire a CASp is not admissible to prove that person’s lack of intent to comply with the law. So, this remains a voluntary program, and there are a lot of considerations that should go into making this decision, particularly with older properties. Prudent commercial property owners should use the imposition of this new disclosure requirement as a opportunity to assess and update how they address disability access in their Leases and property-management practices.

C. Use (Sections 1.8 and 6 of AIR).

  1. Landlord’s Objective: To control how the Landlord’s property is used. The Landlord’s position is that they do not want other people to determine the appropriate use of the Landlord’s real estate.
  2. Discussion: Most standard form Leases contain a provision, such as that set forth in Section 6.1 of the AIR Lease, which states that the use of the Premises is limited to that set forth in the basic Lease provisions, as in Section 1.8 of the AIR Lease. Tenants will frequently ask that the Landlord add words to the end of that clause such as “without the prior written consent of Landlord, not to be unreasonably withheld.” The addition of this consent language can undermine the purposes set forth above, and if possible, Landlord should preserve the right to make a subjective decision as to what use the property is to be put. There are lots uses that may be permitted by applicable zoning but nonetheless are (i) undesirable, or (ii) have a potentially negative impact on the project or other Tenants, or (iii) could result in the Landlord breaching an obligation (such as a exclusive-use or use restriction granted to another Tenant in the project). If the Lease does not restrict the use of the Premises, the Tenant generally has the right to use the Premises for any lawful purpose, and any ambiguity will be construed in favor of unrestricted use.

D. Operating Expense Issues (Sections 4.2, 8.1(a), and 10.1 of AIR).

  1. Landlord’s Objective: To allocate among the users of the project 100% of the cost of maintaining, repairing, replacing, operating and managing the project (or in the case of a base-year Lease, 100% of the increases in those costs), and thereby preserve the return on its investment from the base rent. The “Gross” version of the AIR form is deceptively named—it has a base year only for real property taxes and insurance costs, and all other expenses are passed through on a net basis—so you should never assume that a Lease’s title accurately describes what the document actually says.
  2. Discussion:
    a. Absence of a Developed Body of Law on Operating Expenses There is not a lot of law in this area, and the customs and practices vary greatly by jurisdiction. Through careful drafting and review, this is an area where sophisticated attorneys and brokers can add a lot of value. If what you draft is clear, it is likely to be enforceable.
    b. The Landlord’s and Tenant’s Conflicting Perspectives on Base Year Issues:
    (i) The Balanced Approach: The legitimate purpose of a base-year arrangement is to permit the Landlord to pass through inflationary increases in operating expense, perhaps with some flexibility to add new expenses. There should be mechanisms in place to ensure an “apples to apples” comparison between the base year and comparison year expenses.
    (ii) The Tenant’s Perspective: Pump up the base year, deflate the comparison years. The best mechanisms to achieve these results is to gross up the base year expenses, and to carve out limitations on what can be passed through in the comparison years.
    (iii) The Landlord’s Perspective: Deflate the base year, and pump up the comparison years. The best mechanisms to achieve these results is to gross up the comparison years, and to carve out exclusions from what will be included in the base year.
    c. The Gross Up Concept (No AIR Provision)
    (i) The Rationale: To neutralize the effect of changes in building occupancy levels on expenses that vary with occupancy. In other words, to calculate the operating expenses based on the assumption that the building’s occupancy rate is constant (95% is typically used) throughout the Lease term, to ensure that rent increases associated with variable costs reflect true increases in costs rather than merely increases in occupancy levels.
    (ii) “Variable Expenses” are those that fluctuate with the building’s occupancy rate. Examples include utilities, janitorial service, and property management fees. Some expenses are fixed—such as security and insurance costs, and perhaps real estate taxes. Some expenses have both fixed and variable components, such as elevator costs for which routine maintenance is fixed but heavy use requires more frequent repairs.
    (iii) Who Benefits from the Gross Up? To the uninitiated, the gross up appears patently unfair to the Tenant, like a nefarious Landlord plot to inflate expenses that the Tenant has to pay. In reality, a gross up can benefit both the Landlord and the Tenant, and the concept is fair to both parties, so long as it is appropriately and consistently applied. If the occupancy level is below the agreed-upon percentage (e.g., 95%) in the base year, a gross up of base year expenses benefits the Tenant. If occupancy falls below 95% in comparison years, the gross up of operating expenses benefits the Landlord.
    (iv) Example of a simple gross up provision:
    “For any year (including the Base Year) during which the Building is not 95% occupied during the full calendar year with all occupants paying full rent, Landlord shall adjust the Operating Expenses to what the Operating Expenses would have been had the Building been 95% occupied during the entire calendar year and had all occupants been paying full rent (as opposed to free rent, half rent, etc.).”
    Note that the “all occupants paying full rent” provision is critical, because management fees (generally one of the largest line items) and gross receipt taxes are typically based on rental income.
    (v) The gross up of the base year for a tenant is critical, particularly in a new building. Some crafty Landlord Leases make the gross up optional at the Landlord’s discretion, or only required if the Landlord grosses up a comparison year.
    (vi) Query: should a NNN office lease be grossed up? Such a gross up only benefits the Landlord, as there is no base year to gross up.
    (vii) Buy the BOMA publication: The Escalation Handbook for Office Buildings: A Guide to Understanding, Preparing & Grossing Up Expense Escalations (BOMA International, 1998) by William H. Brownfield, CCIM, CPM. This is the leading publication on the gross up process, and it includes a good explanation as to how grossing up can benefit both Landlords and Tenants.
    d. Adjustments to Base Year to Protect the Landlord:
    (i) The sophisticated Landlord will want the right to exclude from the base year certain expenses that it believes would artificially inflate the base year but are not likely to occur in subsequent comparison years. Examples include: (1) increases caused by market-wide labor-rate increases resulting from extraordinary circumstances (such as boycotts and strikes), and (2) utility rate increases arising from extraordinary circumstances (such as conservation surcharges, embargoes, surcharges, or other shortages).
    (ii) Some aggressive Landlords try to establish a “floor” on certain categories of expenses, such that the Tenant does not get any benefit from a subsequent decrease in that particular expense. Common examples are electricity and real estate taxes, with the result that any decrease in those expenses in a comparison year cannot be netted against increases in other expenses.
    (iii) Some Landlords use separate “pools” of expenses, one for “operating expenses”, and one for “real estate taxes”, and perhaps a third for “utilities,” such that a decrease in one pool cannot be netted against an increase in the others.
    e. Reasonable Exclusions from Operating Expenses for Comparison Years to Protect the Tenant. The Tenant’s critical list of exclusions:
    (i) No increase in management fees (expressed as a percentage of the building’s gross rent) over the management fees charged in the base year.
    (ii) Self-insurance, large deductibles and other costs to restore the building following casualty.
    (iii) Capital expenditures, with perhaps an exception for those expenditures that (a) are intended as a labor-saving device or to effect other economies in services to the building, or (b) are required under any government law or regulation not in effect as of the Commencement Date. A common compromise is to permit the pass through of those, and perhaps other capital expenditures, subject to an overall per annum cap (say, of $.10 per rsf, per year). (Note: Landlords should always request the right to replace existing building systems and components (as opposed to new improvements). Tenant should in all events insist on amortization over useful life of the improvement.)
    (iv) No discrimination against the Tenant, or “free riding” by other Tenants (i.e., charging the Tenant for services that other Tenants get for free, e.g. overtime HVAC).
    (v) New types or categories of expenses not included in base year.
    f. Tenant’s Audit Rights:
    (i) Not only is a contractual audit right of obvious benefit to the Tenant, but it should also be welcomed by the Landlord, in order to contractually limit a right that probably is implied (but ill-defined) under California law. I am not aware of a reported California decision addressing a Tenant’s right to audit operating expenses, but one almost certainly exists, given the covenant of good faith and fair dealing that is implied in all California leases (see Kendall v. Ernest Pestana, Inc. 40 Cal.3d 488, 506 (1985)), coupled with the right to an action for accounting where a fiduciary relationship exists between the parties and the facts are peculiarly within the knowledge of one of them (see Keeble v. Brown, 123 Cal.App.2d 126, 133 (1954)). P.V. Properties, Inc. v. Rock Creek Village Assoc. Ltd., Partnership, 549 A.2d 403 (Md. Ct. Spec. App. 1988) held that a Landlord of a shopping mall was required to provide Tenant an itemization of costs to enable tenant to verify charges assessed against it under a Lease provision requiring Tenant to reimburse Landlord for its pro rata share of total actual cost of maintenance. The Maryland court based its decision on an implied covenant of good faith and fair dealing, and the fact that a fiduciary relationship existed between the parties where the facts and records upon which the obligation is based are known and kept exclusively by the party to whom the obligation is owed. P.V. Properties has been cited repeatedly by Maryland courts, and once each by the Federal District Court in Maryland, and the Federal District Court for the District of Columbia.
    (ii) Reasonable Landlord contractual limitations on Tenant’s audit rights include:
    (a) time period—how far back can the Tenant go? (Smart Tenants always bargain for the right to audit the base year.)
    (b) what qualifications does the auditor have to have? (CPA may not be the best choice for Tenant).
    (c) scope of audit? Discourage “fishing expeditions”.
    (d) confidentiality?
    (e) Tenant’s remedy if a discrepancy is found?
    (f) must Tenant pay the disputed amount pending final resolution of the dispute?
    (g) limit Landlord’s “hassle factor”?
    (iii) Stipulated-Sum Operating Expense Increases? Some regional mall Landlords are avoiding the inherent complexity and potential controversy of calculating common area maintenance charges (“CAM”) by charging fixed CAM amounts, subject to periodic increases.
    (iv) Addressing Operating Expense Exclusions in the Letter of Intent. It is becoming common for savvy Tenants to insist that the Landlord agree to a list of operating expense exclusions (particularly Proposition 13 increases) at the letter of intent stage, in order to avoid protracted negotiation later.

E. Tenant’s Liability Insurance (Section 8.2 of AIR).

  • Landlord’s Objective: To ensure that the Tenant has sufficient financial resources to respond to any lawsuits arising from the Tenant’s use of the Premises, and to support the Tenant’s obligation to indemnify the Landlord against losses.
  • Discussion: Operation of any business is risky, and the cost of litigation can be staggering. Requiring the Tenant to carry a level of insurance commensurate with those risks is a good way of assuring that a lawsuit against the Tenant won’t put them out of business and deprive the Landlord of a rent-paying Tenant. Also, an indemnification obligation is only as good as the Tenant’s ability to pay: in the absence of insurance, most Tenants cannot satisfy the costs of indemnification.

F. Tenant’s Property Insurance (Section 8.4 of AIR).

  1. Landlord’s Objective: To ensure that the Tenant has the financial ability to restore its business in the event of a casualty and to require the Tenant to look to its insurer, rather than to the Landlord, for compensation for any losses or damage to its property in the Premises.
  2. Discussion: The typical insurance provision is intended to require the Tenant to turn to its insurance company, to whom it has paid premiums; handling claims is what insurance companies get paid to do. There is no reason to look to the Landlord for recovery, even if the Landlord was negligent. (This is consistent with the rationale of the “waiver of subrogation” and “exemption of Landlord from liability” provisions, which are discussed below.)

G. Waiver of Subrogation (Section 8.6 of AIR).

  1. Landlord’s Objective: To prevent the Tenant’s insurer from suing the Landlord following the insurer’s payment on claims to the Tenant.
  2. Discussion: The waiver of subrogation clause is one of the few provisions in a typical Landlord-oriented Lease that is of significant potential benefit to the Tenant. The provision is invariably drafted to be reciprocal, with the result that if either party causes damage to the property of the other, the injured party’s insurance company will not have the right to sue the party at fault. In the parlance of insurance, the insurer is said to be “subrogated” to the rights its insured has against a party causing a loss to the insured; in the absence of the insurer’s waiver of its subrogation rights, for example, a Tenant who negligently burns down the Landlord’s building could be sued by the Landlord’s insurer.

H. Indemnity (Section 8.7 of AIR):

  1. Landlord’s Objective: To immunize the Landlord from costs (including attorneys’ fees) and liabilities arising from the acts or omissions of Tenant, or Tenant’s use of the Premises.
  2. Discussion: The AIR Lease indemnity provision is one-sided, running only in favor of the Landlord. By far the most common Tenant request with regard to an indemnity clause is that it be made reciprocal, often based on the argument that the Tenant is participating in the cost (through operating expense payments) for Landlord’s liability insurance to fund that indemnity obligation. It is preferable to limit the Landlord’s indemnity obligations to the common areas, since the Landlord presumably has more control over those areas than the Tenant-occupied spaces. Landlords typically limit their indemnity obligations to “the extent of insurance proceeds”.

I. Exemption of Landlord from Liability (Section 8.8 of AIR):

  1. Landlord’s Objective: That the Landlord have no liability for any claims for damage to the Tenant’s property.
  2. Discussion: This principle follows from the justification for the waiver of subrogation discussed above. The Tenant is obligated to insure its personal property, and if suffers a loss, it should therefore look to its insurance company, not to the Landlord, for recovery, even if the Landlord was negligent. In other words, it’s a “no-fault” arrangement, whereby the risk of loss is assigned to the party that agreed to carry insurance against that loss.

J. Waiver of California Statutes (Section 24 of AIR):

  1. Landlord’s Objective: To ensure that the provisions of the Lease (i.e., the parties’ contractual, negotiated agreement), rather than statutes, govern their rights and obligations.
  2. Discussion: Typically, the waiver of the statute avoids an inconsistency between the Lease and what the result that the law would otherwise imply. For example, the only circumstance under which the Tenant is permitted to cancel the AIR Lease is pursuant to Section 9.6(b) (when the Landlord fails to commence restoration within 90 days), whereas Civil Code sections 1932(1) and 1933(4) would otherwise permit the Tenant to terminate the Lease in the event of a casualty. Note that the AIR form, being a national form, does not waive specific California statutes (see Section 24 of AIR).

K. Notices (Section 23 of AIR).

  1. Landlord’s Objective: Avoid allegations by the Tenant that they failed to receive a given notice, or that the Tenant provided a notice that the Landlord never received.
  2. Discussion: Beware “Deemed Delivery”. The AIR Lease, like many forms, states that notices are “deemed given” if they are “addressed as required herein and mailed with postage prepaid.” The result is that if the Tenant can establish that they mailed the letter, there is no requirement under California law that they prove that the Landlord actually received it. The leading case for this proposition is Jenkins v. Tuneup Masters, 190 Cal.App.3d 1 (1987). For this reason, I advocate adding the following to the “Notices” provision:
    “Notwithstanding any provision of this Lease to the contrary, if this Lease (or any rider, addendum or subsequent amendment hereto) grants Tenant any option to extend or renew the Term, or to expand the Premises, the exercise of such option shall be valid only if Landlord actually receives written notice thereof from Tenant by the date that such option expires.”

DISCLAIMER

The seminar presented today, as well as any written materials distributed to the participants, is being conducted to promote an open discussion of general legal issues of interest to the attendees. This seminar is not intended to create an attorney-client relationship.

Neither the presentation nor any answers to specific questions nor any written materials shall be construed, in whole or in part, as legal advice to be relied upon by any person.

For legal advice, please contact the attorney of your choice.