Wednesday, August 13, 2014

Best Practices in Commercial Lease Transactions

By Sara Engle von Bernthal

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!