Conducting Leasing Due Diligence? Watch For These Nine Lease Provisions

Originally published in Blakes Bulletin on Real Estate Leasing, November 2007

A purchaser of income-earning commercial real property must take steps to confirm the integrity and enforceability of the rental income stream. Below is a brief explanation of nine aspects of leases that should be reviewed by the purchaser or its legal advisors during the due diligence period.

1. Completeness Of Lease Documentation. A review of the lease documentation received from the vendor often reveals that there are missing pages and unsigned or missing amendments and extension agreements. Since the purchaser needs an accurate snapshot of the documents forming the entire lease, the vendor should be asked to explain any gaps in the documents and provide any missing items. The information contained in estoppel certificates, which tenants will be asked to sign to confirm financial and other terms of their leases, should match the information contained in the leases. If the purchaser waits until after the due diligence date or the closing date to investigate gaps or discrepancies in lease documentation, it will likely be too late to do anything about it.
2. Outstanding Tenant Inducements. Unexpired free rent and rent abatement periods, payment of leasehold improvement allowances and completion of outstanding landlord’s work, if not performed by the closing date, can all affect the purchaser’s return from the transaction. If not adjusted for on closing, the purchaser may be responsible for discharging any such outstanding obligations out of its own pocket.

   Accordingly, outstanding tenant inducements should be identified, confirmed in estoppel certificates and, if appropriate, adjusted for on closing so that the purchaser is not left with unexpected post-closing financial obligations to tenants for which it has not been compensated.

3. Operating Costs. Since a landlord’s ability to recover operating costs from tenants in a timely manner is critical, of utmost importance is a careful review of the definition of operating costs to confirm there are no unusual deductions or exclusions. Particularly important is the ability of the landlord to recover costs of capital repairs and replacements. Also, if an administration or management fee is chargeable to tenants, it is often calculated as a percentage of some measure of operating costs so if the definition of operating costs is restrictive, so too will be the landlord’s entitlement to collect a management fee on the costs of any carve-outs.
4. Exclusive Use Provisions. Most prevalent in the retail context, anchor and other tenants with a large degree of bargaining power are sometimes able to negotiate restrictive covenants from the landlord that premises in the project will not be leased to tenants engaging in competitive businesses. These restrictions frequently list prohibited business activities generally and sometimes the business names of prohibited competitors. With many retailers looking to broaden their lines of business beyond traditional areas to gain competitive advantage, purchasers disregarding exclusive use restrictive covenants in leases take unnecessary risk. All restrictive covenants in each lease should be identified and a canvass of each tenant’s business activities at the property undertaken to ensure there are no conflicts. The identification of restrictive covenants will also shed light on what future leasing opportunities are possible and which will not be permitted, having regard to existing restrictive covenants.
5. Signage And Parking Rights. Tenants may be granted the right to use a specified number of parking spaces (sometimes reserved), often on the basis of a ratio of a number of parking spaces per square feet of rented space. Similarly, the landlord may provide one or more tenants with the right to install signage on the face of the building or on podium signage. Important in both the multi-tenant retail and office context, the purchaser should verify that there are no inconsistencies in any of the existing rights that have been granted and confirm that there is sufficient space to accommodate all of the parking and signage entitlements. This confirmation process will also serve the purchaser well in identifying limits on its ability to grant other signage and parking rights to tenants in the future.
6. Tenant Options To Purchase. A tenant is sometimes provided with a right in its lease to purchase the property in which its leased space is located. For example, if the landlord has entered into an agreement to sell the property to a third party purchaser, the tenant may have been granted a right of first refusal to purchase the property on the same terms as those upon which the property has been offered to the third party. Sometimes the landlord even has to offer to sell the property to the tenant before offering it to a third party. These rights must be identified during the due diligence period and evidence of waiver by the tenant delivered to the purchaser. Even if waived by the tenant for the transaction at hand, the purchaser will want to take a hard look at the terms of the tenant rights to determine the extent to which the ongoing rights will affect the future marketability of the property and any impact on the purchase price that might be offered by a future purchaser.
7. "Go-Dark" Provisions. The leases should be reviewed to see whether or not they allow tenants to cease operating from the premises (even if they continue to pay rent and abide by all other terms of the lease). In a retail setting, "dark" premises reflect poorly on the project as a vibrant operating location.
8. "Make Good" Provisions. A purchaser will also want to determine what the leases require each tenant to do at the end of the term of the lease with respect to returning the premises to base building condition. Removal of a tenant’s leasehold improvements can be a costly proposition for a landlord, especially where complex cabling or interior walls and staircases have been installed. On the other hand, if a tenant (with or without the landlord’s financial assistance) has expended significant resources in rendering premises operational, the landlord might wish to limit the tenant’s ability to remove leasehold improvements without the landlord’s consent, as the premises could be in a more "ready" form for a succeeding tenancy. Ideally, the landlord will exert some measure of control through the lease over the tenant in this area.
9. Early Termination Rights. Some tenants are able to negotiate early termination rights. If exercised, the purchaser’s income stream may be adversely affected. Accordingly, early termination rights should be identified and a purchaser should satisfy itself that it remains comfortable proceeding with the transaction in light of the termination right.

Though the foregoing is not by any means an exhaustive list of the matters that a prospective purchaser should review when conducting leasing due diligence, it is a useful reminder of some of the typical "hot button" issues which every purchaser should consider.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.