By: Edward Woodall

Many people think that leasing commercial real estate is less complicated than buying or selling it, especially for a tenant. But that just isn’t so. Commercial leases contain any number of terms that can cause all sorts of problems for your business—varying in severity from the merely annoying to the absolutely crippling. In this blog post, the first in a two-part series, we’ll review some of the most common commercial lease pitfalls.

Rent

There are two general kinds of rent that a landlord can charge a tenant: base rent and percentage rent.

Percentage rent requires that the tenant pay the landlord a percentage of their gross sales, typically limited to gross sales in excess of a threshold figure. While this is typically thought to align the interests of landlord and tenant—both want the business to be successful and have high sales—percentage rents can also be a source of conflict. In recent years, the emerging area of e-commerce has proved to be a serious problem for tenants paying percentage rent. Is a sale attributable to the leased premises if it was made online? Does it matter if the leased premises are the tenant’s only location, if the tenant shipped the sold goods from the leased premises or from a warehouse, or if the customer visited the leased premises (such as a showroom) before placing the online order? These are all issues that landlords and tenants should consider. Other common but non-obvious percentage rent sticking points include whether the tenant can deduct any expenses from gross sales, and the reporting period for sales, which is especially important for seasonal businesses.

Base rent, sometimes called fixed rent or minimum rent, is considered less contentious than percentage rent. After all, anyone who has ever rented an apartment understands base rent—it’s a fixed amount, due on a fixed date every month. Easy enough. But there are complications to consider:

• When is base rent due? When is it considered late? Many landlords have to pay a mortgage, so they need rent to come in before mortgage payments are due. This naturally leads to the next question.
• When can landlords sue tenants for late rent? When can landlords charge a late fee? Many leases require landlords to send tenants a written notice before charging a late fee or suing for late rent.
• How will base rent increase over the years? This question is especially important for leases with terms longer than a handful of years. Most leases use one of the following methods:
  • Step up rent, which gradually increases over the years in predetermined amounts on a predetermined schedule.
  • Indexed rent, which adjusts the fixed rent with changes in particular economic indices such as the CPI or other measures of inflation.
  • Market rent, which is determined by either the periodic agreement of the landlord and tenant or a periodic appraisal of the property. We strongly recommend that this method be avoided—it’s practically guaranteed to lead to a dispute when the time to adjust rent comes around.

TICAM

TICAM—Taxes, Insurance, and Common Area Maintenance—is another area where unwary landlords and tenants can find themselves in trouble. Anyone who has ever owned property knows that there are expenses you just can’t avoid. You have to pay local property taxes. If you’re smart, you have to pay for property insurance. And you have to pay to maintain the buildings, landscaping, and so on. Most landlords would like to pass some or all of these costs on to tenants. While TICAM payment can be endlessly complicated, most tenants will pay a proportionate share of TICAM, based on the square footage of their leased premises. What goes into TICAM is often limited or controlled using the following methods:

• Net leases require the tenant to pay monthly installments of the total TICAM each year. These often operate using estimates of expenses given at the beginning of the year and reconciliations with actual expenses at the end.
• The expense stop method requires the tenant to pay monthly installments of the TICAM to the extent it exceeds a set amount.
• Many leases use a base year method, which requires the tenant to pay monthly payments of reasonably estimated increases in TICAM to the extent it exceeds TICAM paid in the base year, usually the first year of the lease. Sometimes the base year figure is subject to adjustment based on inflation.
• Capping increases in TICAM is also a common technique for protecting tenants from unlimited TICAM increases. In addition to actually setting the percentage figure for increases, parties to the lease also need to consider whether the permitted increases will be cumulative, i.e. rolling over from year to year, or non-cumulative, and whether any expenses will be excluded from the cap.
• Not all “common area” expenses should be included in TICAM. In addition to carefully defining the common area (do vacant shops count as common area?), landlords and tenants should also carefully define what counts as maintenance. Landscaping and replacing the light bulbs obviously count as maintenance but hiring a landscape architect and building an expensive garden and fountain arrangement in the middle of the shopping center is a capital expense. Where do you draw the line?

Security Deposits

Landlords often require tenants to give them security deposits when they’re unsure of the tenant’s future ability to pay rent or meet its other obligations. While residential tenants have certain statutory rights with respect to security deposits under North Carolina’s Tenant Security Deposit Act, commercial tenants are not similarly protected. This gives parties to commercial lease much more flexibility. How long after lease expiration can the landlord wait before refunding the deposit? What, if any, conditions must be met before the deposit is refunded? Other common issues include how, if at all, interest accrued on the deposit will be handled (interest can add up quickly on a deposit of several thousand dollars) and whether the deposit will be refunded or credited to the tenant’s rent as the expiration date of the lease approaches and tenant builds up a track record of performance.

Lease Term, Options to Extend, and Holding Over

In order to be valid, all leases must state a particular term. The expiration date of the lease term can be fixed to a certain date, or it can be set at a certain number of days after a certain event, usually delivery of possession of the premises or the first rent payment. But knowing the current expiration date isn’t the end of the story. Many leases contain options for the tenant to extend the term for a set amount of time. These options to extend the term should contain conditions on their exercise, such as a deadline for informing the landlord, and should lay out any differences in the terms of the lease between the original term and the extended term, such as increased rent. To complicate matters, a lease could give the tenant a right of first refusal or a right of first offer instead of an option to extend. And sometimes tenants stay in the leased premises and keep paying rent after expiration of the lease term, even without an option to extend the lease term. This is called “holding over.” North Carolina law provides some default terms for the rent amount holdover tenants have to pay, and how far in advance landlords must give them notice to leave before kicking them out. But the lease can lay out the rules for holding over well in advance of that situation arising, which can be beneficial to both parties.

Maintenance

How the premises will be maintained, and by whom, is another issue that inexperienced commercial tenants or landlords might overlook. Unlike in residential leases, commercial tenants are usually expected to perform most of the maintenance of the premises. But there are limits to this. Depending on the circumstances of the premises and the bargaining power of the parties, landlords often maintain items such as:

• The structural portions of the premises, such as the roof, exterior walls, and foundation
• Plate glass
• Plumbing, electric, or HVAC systems

When the landlord has to make repairs, other issues arise. Sometimes the repairs will necessitate entering the leased premises. May the landlord enter at any time, or are they limited to certain hours? Do they need consent from the tenant to enter, do they have to give advance notice, or can they just enter? And if the repairs disrupt the tenant’s business, who bears the risk of loss for that? A well drafted lease will address all these issues.

Assigning the Lease

Sometimes the lease has to be assigned. Maybe the tenant is getting bought out or selling their business, or maybe they’re just reorganizing their business assets. Without contract language addressing the issue, all leases are freely assignable—the tenant can assign the lease to anyone. But every commercial lease these days addresses assignment in some way. Landlords would typically prefer to have control over who the new tenant (or assignee) will be. Typically, they reserve the right to approve the assignee, with some restrictions on their ability to withhold approval. But sometimes tenants are able to negotiate for better assignment rights. It’s typical for the lease to give a class of pre-approved assignments, which require no landlord consent. The most common types of pre-approved assignments are assignments to subsidiaries and other entities under common ownership or control with the original tenant. Slightly less common are pre-approved assignments to entities buying out the original tenant, or to assignees with a certain net worth. Another issue that often arises with assignments is the landlord’s expenses. In even fairly simple assignments, the landlord can incur appreciable legal costs. Many leases require the tenant to pay the landlord a fee for reviewing assignment requests, whether they’re approved or not.

Conclusion

In this blog post, we’ve reviewed only a few of the most common commercial lease pitfalls. In the next post in this series, we’ll look at some more issues, focusing especially on those that landlords often require for their protection. If you want to learn more about commercial leasing or find out what Venn Law Group’s commercial real estate attorneys can do for you, contact us here.

Edward B. Woodall is an attorney at Venn Law Group who works incorporate law and commercial real estate, including leasing, financing, taxation, business structures, and dispute resolution. He is passionate about helping business owners solve a variety of complex legal problems and has performed more than 100 hours of pro bono work. In addition to his law degree, he also has a background in history and Spanish.