Lease Provisions Demystified, Part 1, May 20, 2010

© Goulston & Storrs 2010. All rights reserved.

GBREB / Commercial Brokers Association

Continuing Education Unit – Commercial Leasing

Lease Provisions Demystified

and LOI Language Lawyers Long For

Construction and Option Provisions in Leases

A Truly Understandable Explanation of the Gross-Up

Clause

LOI Pitfalls to Avoid

May 20, 2010


Raymond Kwasnick, Esq.

Goulston & Storrs, P.C.

617-574-4197

[email protected]

and

Karen O’Malley, Esq.


617-574-3503

[email protected]

Materials Prepared by:

Barbara Schmitt, Esq.


617-574-4071

[email protected]

Presented by:

mailto:[email protected]




I. CONSTRUCTION PROVISIONS

Construction provisions in a lease ultimately boil down to a few key questions:

Who prepares the plans?

Who performs the work?

Who pays for the work?

When does rent start?

Key Practice Point: The answers to these questions have a major impact on the way the entire lease is

structured. This is why lawyers cannot draft leases with two alternate construction provisions (for example,

Landlord does work and Tenant does work) with the choice to be made later. Having a clearly drafted LOI

on these points facilitates getting a lease done quickly.

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Simple Scope of Work: If the work to be done is so simple, sometimes no real plans are drawn. The lease may just

have a list of items of work to be done (such as repainting, carpeting and the like), or a simple space plan sketch

attached.

Architectural Plans: If the work is more involved, in most cases, an architect draws the plans.

→ It is critical to determine who is hiring the architect, Landlord or Tenant. This is important because whoever

signs the contract with the architect is taking on certain risks.

Delay Risks: For example, what if the architect doesn’t deliver plans when she is supposed to? If the Tenant

hires the architect, this delay is charged to the Tenant, not the Landlord; if the Landlord hires the architect,

the opposite is true.

Error Risks: What if the plans are drawn wrong, and the building inspector won’t give a certificate of

occupancy? If Tenant hires the architect, Tenant has a fight with the architect, but the Landlord is left out of

it. If the Landlord hires the architect, then the Tenant has a fight with the Landlord, and the Landlord's only

recourse is to turn around and have a fight with the architect.

→ Since hiring the architect involves taking risk, Landlord wants to push this off onto Tenant as much as possible.

Tenant may decide to use the same architect that Landlord has used in the past, but Landlord still wants the deal

structured so that Tenant, not Landlord, is hiring the architect and responsible for preparing the plans. This is a

reasonable outcome because it is the architect, not the Landlord, who is an expert in what the building code

requires, and it is the Tenant, not the Landlord, who will be making almost all of the choices about what the plans

will show. Thus, Landlord says, the responsibility for the plans should be between the Tenant and the architect.

Given that Tenant wants as much control as possible with respect to its build out, most often Tenant is willing to

take on this responsibility.

1. Who prepares the plans?

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This is probably the question that has the most potential to lead to confusion in LOI and lease drafting. In answering this

question, the parties are essentially addressing the same set of issues as with who is hiring the architect -- who bears the risk

of delay or mistake, and if there is a problem, whom does the Tenant go after?

2. Who does the work?

A. Landlord does the work.

In this scenario, Landlord hires the GC, who builds the space out in accordance with the plans.

→ Typically, rent does not start until the construction is substantially complete. This means that if the carpenters go on

strike, it is the Landlord's problem -- the work isn’t getting done, and rent doesn’t start until the work is done (unless

the Tenant has done something to cause a delay).

→ Similarly, if the GC makes a mistake or walks off the job, it is the Landlord's problem and not the Tenant's; rent still

doesn’t start until the work is done.

→ If there are problems with the work, Tenant is going to have a fight with Landlord, not with the GC. In fact, Landlord

often gives the Tenant a warranty on the work for a period of up to a year, so if there is a problem, Landlord has to fix

it. Of course, this usually is the same coverage as Landlord's warranty from the GC, so if Tenant comes to Landlord

with a problem, Landlord turns around and presents the problem to the GC to fix -- assuming, of course, that the GC is

still around, and is returning phone calls.

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B. Tenant does the work.

In this scenario, Tenant hires the GC, who builds the space out in accordance with the plans.

→ Typically, rent starts a certain number of days after the space is delivered to Tenant for the start of

construction, whether or not the work is done. This means that if the carpenters go out on strike, it is the

Tenant's problem -- the work isn’t getting done, but rent starts anyway whether or not the work is done (unless

the Landlord has done something to cause a delay).

→ Similarly, if the GC makes a mistake or walks off the job, it is the Tenant's problem and not the Landlord's;

rent still starts whether or not the work is done.

→ If there are problems with the work, Tenant has to fight with the GC, and Landlord is left out of it. The only

warranty on the work comes from the GC -- assuming, of course, that the GC is still around and is returning

phone calls.

Why would a Tenant agree to do its own work, if there is so much risk? Three (3) basic reasons:

(1) This may be what is market for the location, so Tenant may not have much choice.

(2) Tenant may try to negotiate for a benefit if it completes the build-out early (rent doesn’t start until 90 days

after delivery, regardless of whether the work is finished and Tenant occupies the space before that, or a

reduced oversight/construction management fee payable to Landlord).

(3) Tenant wants to control its own construction process.

2. Who does the work?

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3. Who pays for the work?

There are three basic answers to this question:

→ Landlord Pays: If Landlord pays for all the work, it is also called a “turnkey” deal (which comes from the idea

that Landlord has done everything, so all Tenant has to do is turn the key in the door and move in).

→ Both Landlord and Tenant Pay: If the parties share the costs, typically Landlord will agree to pay a certain

amount (the TI Allowance or Landlord's Contribution are common names for this) and Tenant pays the rest.

→ Tenant Pays: The situation where Tenant pays for everything is relatively rare.

Key Practice Point: If Landlord is providing an allowance, the LOI should specify (i) whether a portion can be used

for soft costs (if this is given, it is often limited to about 20% of the allowance), (ii) the timing and criteria for paying out the

TI (for example, will some portion be paid at start of construction? At 50% substantial completion? At full completion? Will

lien waivers be required), (iii) what happens to the unused portion if Tenant doesn’t spend it all on TI (Tenant gets a rent

credit for some or all of the unused amount, or Tenant has no rights to any unused portion), and (iv) if the work costs more

than the allowance, whose money (Landlord or Tenant) gets spent first.

Key Practice Point: In today’s economic climate where Tenants may have questions about Landlord viability,

Tenants should be determining if Landlord is capable of funding the TI Allowance. Consider utilizing the following

options to get comfort for Tenants: Letter of Credit, Parent Guaranty, Escrow (make sure this is a “true” escrow), and/or

if the Tenant is capable of covering costs itself, offset rights.

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4. When does rent start?

This depends on who is doing the work.

A. Landlord does the work.

→ Typically, the space becomes vacant, and Landlord begins construction.

→ The term (and rent, unless there is free rent involved) begins on the Commencement Date, which is typically

defined as the earlier of (i) substantial completion of construction, or (ii) the date that construction would have

been substantially complete, except for Tenant delays. (For example, if Tenant is responsible for the plans, and

the architect is late with the plans, this would be a Tenant delay.)

→ Where Landlord is doing the work, construction delays, unless caused by Tenant, do act to delay the

Commencement Date, even if they are not Landlord's fault.

→ Typically, the term (say, five years) runs from the Commencement Date, and the rent bumps occur on the

anniversary of the Commencement Date.

Key Practice Point: What remedies does Tenant have if Landlord is late? Consider:

Liquidated damages (e.g., day for day rent credit)

Termination rights (with reimbursement of costs)

Self-help and offset rights

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B. Tenant does the work.

→ Typically, the space becomes vacant, and Landlord delivers it to Tenant for the beginning of construction (the

“Delivery Date”). Tenant starts construction.

→ The stated term (say, 5 years) (and rent, unless there is free rent involved) begins on the Commencement Date,

which is typically defined as XX (typically, 90 or 120) days after the Delivery Date, but XX is often extended for

each day of Landlord delay to Tenant's construction. (For example, if Landlord is supposed to approve change

orders in 5 days but takes 7 days to approve one, that would be two days of Landlord delay.)

→ Where Tenant is doing the work, construction delays, unless caused by Landlord, do not act to delay the

Commencement Date, even if they are not Tenant's fault.

→ Technically, the term starts on the Delivery Date (because the term needs to be in effect before Tenant gets the keys

so that the insurance and indemnity provisions are effective), but the term stated in the LOI (say, five years) runs

from the Commencement Date (not the Delivery Date), and the rent bumps occur on the anniversary of the

Commencement Date (not the Delivery Date).

→ In order to avoid confusion, the period between the Delivery Date and the Commencement Date is often referred to

as the “build-out period” to distinguish it from a “true” free rent period – one where Tenant is occupying the space

but has the rent abated for X months.

Key Practice Point: Landlord needs hard Commencement Date, subject only to Landlord delay.


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C. No work is being done.

→ In this situation, sometimes called a “true as-is” deal, Tenant is going to move into the space without any work

being done.

→ The space becomes vacant, Landlord gives Tenant the keys, and the term (and rent, unless there is free rent

involved) starts immediately.

→ Typically, the term (say, five years) runs from the Commencement Date, and the rent bumps occur on the

anniversary of the Commencement Date.


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II. RFR, ROFO, RFN AND EXPANSION OPTIONS

A Tenant's ability to take on more space in a lease generally falls into one of four

categories:

1. Right of first refusal (RFR)

2. Right of first offer (ROFO)

3. Right of first negotiation (RFN)

4. Expansion option.

These all give the Tenant certain unilateral rights to expand, but they differ in

what triggers that right and when it can be exercised.

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1. Right of First Refusal (RFR)

In a true RFR, nothing happens until Landlord has gone out and completely negotiated a deal with a

third party to lease the space that is subject to the RFR.

Once that deal has been finalized, Landlord then must give Tenant the right to take the space on all of

the terms and conditions that Landlord has negotiated with the third party.

Naturally, this is a great impediment to Landlord in leasing the space, since it doesn’t know if the space

is truly available until after the negotiations are complete, and few prospective tenants want to play that

game.

Accordingly, true RFR’s are rare, and most times that this term is used, it is actually referring to a

ROFO.

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2. Right of First Offer (ROFO)

In a typical ROFO, Landlord decides that it wants to lease the space that is subject to the ROFO, and (often) how that

space will be configured. Whether or when to lease the space is up to Landlord; there is no obligation to offer it to

Tenant at any particular time, and often no obligation to lease it in any particular size or shape (for example, if the

ROFO applies to contiguous space on the third floor, Landlord can choose to offer that space in 2,500 sf chunks or

10,000 sf chunks).

When Landlord does decide to lease it, Landlord goes to Tenant first and asks if Tenant wants the space. Tenant has a

short period of time in which to say yes or no; if it does not say yes within the specified time frame, it loses the right to

the space, and Landlord is free to lease it to others.

Typically, Tenant must take the ROFO space in the size and configuration specified by Landlord.

ROFO space is usually leased at market rates (or 95% of market rates). Often, Tenant can go to an arbitration or broker

determination of market rent if it disagrees with Landlord's quote; however, Landlords want to be sure that Tenant is

bound to take the space before the arbitration happens.

If there is no arbitration right, then Tenant will often ask for some protection in the lease to be sure that Landlord is not

quoting an inflated rental to discourage Tenant from taking the space. The most common way to provide this protection

is that if Tenant does not exercise the right, Landlord must re-offer the space to Tenant if it wants to lease it to someone

else on materially better terms.

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Key Practice Points: A great LOI will address the following issues relating to a ROFO:

Identify the ROFO space with as much specificity as possible. For example, with plans.

→ Avoid contiguous creep. Avoid identifying ROFO space as “contiguous” because space that is not presently

contiguous might become contiguous.

Spell out what the rent for the ROFO space will be (e.g., market rate).

→ If Landlord is willing to give arbitration, this can be stated as well.

What will the term be for the ROFO space?

→ Will Tenant take the space for the same remaining term as the rest of its premises, or must Tenant agree to

whatever term (e.g., 5 years) Landlord is offering to the world at large.

→ In the coterminous instance, the ROFO right will often expire a period of time (e.g., 2 or 3 years) prior to the

expiration of the lease term, to avoid Landlord having to lease the ROFO space for a short period of time.

Is the ROFO a one-time right or a rolling right?

→ A one-time right means that once Tenant is offered a particular space and does not take it, it loses all rights in

that space for all time. (A variation on this is that once Tenant does not take a particular space, it loses all rights in

all of the ROFO space for all time.)

→ A rolling right means that once Tenant is offered a particular space and does not take it, it continues to have

ROFO rights in that space the next time it becomes available for lease. One-time rights are much cleaner, and

therefore are preferable to Landlords.

2. Right of First Offer (ROFO) (cont’d)

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3. Right of First Negotiation

A right of first negotiation is essentially a ROFO without the price protection for the Tenant.

Landlord agrees that it will offer the space first to the Tenant, and that it will negotiate in good faith with the Tenant for

XX days.

However, if Landlord and Tenant are unable to reach agreement on the rent in that period, Tenant has no further rights

in the space and Landlord can lease it to anyone else at any rent, whether or not lower than what it offered Tenant.

Obviously, Tenants do not like this because it gives them little protection against Landlord quoting an unreasonably

high rent in order to discourage Tenant from taking the space.

As a result, a true RFN is rare, especially in today’s market.

Landlords should be willing, as an alternative, to enter into a ROFO with an arbitrated market rent, provided that Tenant

is committed to take the space before it can go to arbitration. Like a ROFO, an RFN can be one-time or rolling, and the

LOI should give the same information as for a ROFO (except the rent).

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4. Expansion Option

While RFR/ROFO/RFNs may apply to a loosely-defined class of space (any contiguous space on the third floor, for

instance), expansion rights are typically more tightly defined (the 5,284 sf on 3 currently occupied by XYZ

Corporation, for instance, or a space designated by Landlord containing between 5,000 and 7,500 sf on the sixth floor).

What really separates an expansion option from a RFR/ROFO/RFN is timing.

In an expansion option, Landlord must offer the space to Tenant within a certain window of time, and Tenant must

notify Landlord that it wants the space by a certain number of months ahead of that time period.

Tenant knows that it absolutely has the right to add that space within that time frame, and Landlord knows that it

absolutely must offer that space to Tenant within that time frame. Both Landlord and Tenant know that if Tenant does

not exercise by a certain date, then the expansion option is void.

The window of time for delivery of the space can be tied to the dates in the lease (e.g., space must be offered in the fifth

lease year) or may be specific calendar dates (e.g., space must be offered to Tenant between 1/1/11 and 3/31/12).

Typically, the rent is market, but in some cases it may be the rental rates then in effect (on a psf basis) under the lease.

Key Practice Point: A great LOI will identify the following with respect to the expansion space: (1) when it will be

available, (3) how much notice Tenant must give, and (3) what the rent will be. It may also be useful to state any

conditions to exercise: no (continuing) default, minimum occupancy, etc.

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Lease Provisions Demystified, Part 1, May 20, 2010

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