When a purchaser sets out to purchase commercial real
estate, it typically conducts due diligence in order to gain a full
understanding of the physical, environmental and title condition of the property
to be purchased. Unfortunately, the same due diligence is not always employed
by a prospective tenant in a commercial lease transaction – although many of the
risks inherent in a purchase transaction often apply to a commercial lease
transaction. While a tenant can (and should) request that the landlord
represent and warrant that (a) the landlord has the right, title and authority
(without the consent of any other parties) to lease the premises, (b) the
premises are in good condition and repair, and (c) the premises and tenant’s
intended use of such premises are not in violation of any laws (including
environmental laws) or any covenants, conditions or restrictions of record, a
prudent tenant should also consider the following due diligence and practices
in order to protect against unanticipated liability in connection with a
commercial lease.
Good Standing
Certificate. In order to ensure that the entity constituting landlord
validly exists and is in good standing, for a relatively small fee, the tenant
can obtain (or require the landlord to provide) a good standing certificate for
the landlord entity. In addition, the tenant can require the landlord to
provide a copy of its organizational documents and resolutions confirming the authority
of the individual signing on behalf of the landlord to execute the lease. At a
minimum, the tenant should consider checking any available state website to
confirm that the landlord entity exists.
Title Commitment;
Survey. The prospective tenant should obtain a title commitment with
respect to the property of which the premises is a part. For only about
$350-$500 (except in attorney-controlled states, where the costs may be
higher), a title commitment, (inclusive of copies of the title exceptions
referenced in such commitment) can be a valuable tool to identify any title
issues affecting the premises. A title commitment will (1) confirm that the landlord
entity with whom the prospective tenant is dealing with actually owns the property,
(2) identify any significant title exceptions, including cross-access easements
and use restrictions affecting the property or tenant’s intended use, (3)
disclose any delinquent taxes and mechanic’s or other liens, (4) ensure that the
correct legal description is attached to the lease and (5) identify any ground
lease and/or mortgage interests affecting the property (with respect to which
an “SNDA”, as defined below, should be obtained). For a commercial lease
involving substantial leased premises, a relatively long lease term and/or a
significant investment by the prospective tenant in improvements, the tenant
should consider obtaining a leasehold title insurance policy (which, if zoning is
an issue, should include a zoning endorsement). While more expensive than a
title commitment, a title policy will provide insurance against losses arising
from certain title claims affecting the premises. Finally, a prospective tenant
should consider obtaining a survey of the property (especially if land, as well
as improvements, will be leased) to fully understand the boundaries of the
land, the location of any easements, and any encroachments affecting the land.
SNDA. A
subordination, non-disturbance and attornment agreement (“SNDA”) should be
obtained from the holder of any ground lease and/or mortgage lien on the
property in a form which is reasonably acceptable to the tenant. An SNDA
ensures that the lease will continue in effect in the event of any foreclosure
arising out of landlord’s default under a ground lease or mortgage instrument,
as applicable. If tenant has sufficient bargaining power, it should (a) require
the landlord to obtain an SNDA from any existing ground lessor or mortgage
lender at the time of lease execution and (b) expressly condition any future
subordination of the lease upon the delivery of an SNDA. By requiring an SNDA
at the time of lease execution (or as a condition to the lease), the landlord
and the lender have an incentive to negotiate and finalize the SNDA. Please
note, however, that if the tenant is only a small tenant in a relatively large
office building or retail complex, the landlord may be unwilling to pursue (and
the ground lessor or lender may be unwilling to provide) an SNDA. In this case,
the tenant should be wary of making any significant tenant improvements to the
premises at its cost since such investment could be lost in the event of a
foreclosure.
Memorandum of
Lease. While neither party is typically willing to record the lease
(since it contains confidential terms), if a tenant has sufficient leverage, it
should require that a memorandum of the lease be recorded with the register of
deeds in the county in which the property is located. The memorandum of lease
(which must comply with all recording requirements, including minimum margin
sizes and notary acknowledgements) will provide record notice of the tenant’s
lease so as to ensure the priority of such lease over subsequent liens and
encumbrances. Given the likelihood of a landlord selling or refinancing at some
time during the lease term, any subsequent lender will be placed on notice of the
lease, and will be incentivized to enter into an SNDA with the tenant. Please
note, however, that, unless the tenant is leasing a significant portion of a
building, many landlords (particularly in connection with the leasing of a
small space in an office or retail complex) may object to the recording of a
memorandum of lease.
Physical
Inspection. Under a “triple net” lease, the responsibility for (or cost
of) the maintenance, repairs and replacements to the premises and common areas,
and compliance with applicable laws is typically imposed upon the tenant. As a
result, the prospective tenant must be sure that it understands and accepts the
risks associated with the then current physical condition of the premises.
Accordingly, a tenant should consider hiring a qualified inspector to provide a
thorough inspection of the property, including any building systems (e.g.,
heating, ventilating and air conditioning systems) for which the tenant is
responsible in order to avoid the cost of unexpected repairs or expenses. The
tenant should also try to include a provision in the lease which expressly
relieves tenant of responsibility for (a) any repairs or replacements of a
capital nature (except to the extent that the cost of certain capital items is
amortized over the useful life and tenant is only responsible to reimburse
landlord on an annual or monthly basis for that portion of the amortized cost
which is attributable to the lease term) and (b) any violations of laws
existing on the commencement date. The landlord should also be required to
deliver a current certificate of occupancy for the premises, which will provide
some evidence that the premises are in compliance with laws and are deemed fit
for occupancy by the local authorities.
Environmental
Audit.
Many tenants are not aware that under federal law and most
state laws, a tenant can be held strictly liable for any environmental
conditions affecting the property of which the leased premises are a part (even
if it did not cause such conditions). An exception to this rule exists in some
states as to a lease of office space within a building. A tenant can avoid
liability for environmental conditions (which are of particular concern with
respect to a lease of industrial property) if it makes “all appropriate inquiry”
as to the environmental condition of the property by conducting a Phase I Environmental
Site Assessment of the property in accordance with the requirements of federal
law and, to the extent necessary to meet the “all appropriate inquiry standard,”
it conducts a Phase II Environmental Site Assessment (which may include soil
borings and groundwater testing). In some states, this is enough to establish
liability protection for pre-existing environmental conditions; in other states
such as Michigan, if an environmental condition is identified, a tenant should
submit a Baseline Environmental Assessment with the appropriate state agency in
order to protect against liability for any pre-existing environmental conditions.
Of course, a tenant can gain further protection by requiring the Landlord to
not only represent and warrant that there are no hazardous materials on or
about the property of which the premises are a part, but also to indemnify the
tenant against any losses arising out of environmental conditions existing
conditions existing on the commencement date of the lease or thereafter caused
by the landlord.
Since a tenant of commercial property may be subject to many
of the same liabilities and risks as a purchaser of commercial property, it
needs to take similar precautions in evaluating a commercial lease transaction.
Although the practices and due diligence recommended above will require time
and money, they may protect a prospective tenant from liability well in excess
of the costs incurred – and, as a result, may be worth the delays and expense!
