Key Lease Provisions can Result in Unforeseen Consequences

NAI Affinity
September 26, 2022

CREJ - March 2, 2022

Landlords beware. In negotiating a lease agreement, it’s important that you give due consideration to the long-term impacts of all lease provisions, but there are a few provisions that commonly are overlooked by landlords, which can result in unforeseen consequences. Landlords should pay particular attention to renewal options, the structure of rent increases and right of first refusal provisions.

Many lease agreements contain renewal options, or the right for the tenant to elect to continue the lease at the end of the original term for additional terms. These provisions can reduce a landlord’s cash flow and the value of its property if rent increases during the renewal term(s) are not structured property. At first blush, a renewal option provision in a lease does not appear to be one-sided in favor of the tenant because, if the option is exercised, the landlord avoids a period of vacancy for the property and the costs to secure a new tenant. However, it turns control over what happens at the end of a lease term to the tenant because it is the tenant’s decision to exercise the option. If a renewal option is exercised, the provisions of the original lease typically remain in effect for the additional term(s). If at the end of the lease term the tenant determines that the lease provisions aren’t favorable, the tenant won’t exercise its renewal option. However, if at the end of the lease term the provisions are not beneficial to the landlord, the landlord is stuck if the tenant exercises the renewal option. To avoid situations like an unwanted tenant extending the term of its lease or an under market lease rate, the landlord may consider the following: refusing to grant renewal option periods at a predetermined rent; and providing in the renewal option clause that if the tenant defaults during the initial term the renewal option provision is void. A renewal option provision should specify how many days prior to the end of the lease term the option must be exercised, if it must be exercised by written notice or otherwise, and how rent during the additional term(s) will be determined (including a methodology for how “market rent” may be determined).

The structure of rent increases is important to consider when creating a lease agreement because, if done poorly, it can decrease the property’s value and prohibit cash flow from keeping pace with inflation. Typically, rent increases annually or after a set number of years and at the beginning of a renewal term. Fixed increases provide that rent escalates by a set dollar amount per square foot. Percentage increases stipulate rent escalation by a percentage of the last rent amount. Both fixed and percentage increases are common in triple net leases because they allow for easy underwriting. However, it’s common to find a lease with 1% to 2% rent increase annually, or even rent increases that don’t begin for a few years, which can cause a landlord to fall behind inflation rates. Using a fixed or percentage increase for the optional renewal terms makes it difficult for a landlord to keep up with the market rate. To do so, a landlord would need to be able to predict at the time the original lease is entered into what escalators are needed to keep up with the future market. One solution to consider is escalating rent using inflation-based increases (e.g., Consumer Price Index or Producer Price Index), where the rent will increase by a pre-defined measure of inflation. Though it takes more effort and the landlord may incur fees paying a professional to calculate the increase, this type of escalation clause often is favorable to the landlord. I expect this type of escalation will become more prevalent given the current inflationary environment.

A right of first refusal clause in a lease agreement gives the tenant the first right to purchase the leased premises or purchase/lease contiguous space. A right of first refusal is in the sole discretion of the tenant to exercise or decline. It gives the tenant all the power in determining whether a third-party offer to purchase made to the landlord will be accepted. The tenant will have the right to purchase the leased premises on the same terms as the offer from the third party. However, it’s not as simple as the tenant being able to match the purchase price. There inevitably will be other factors that go into the landlord wanting to favor a third party over the current tenant. The right of first refusal may reduce a landlord’s profitability because it constrains the landlord’s ability to negotiate with multiple buyers, which typically would drive up the price. As with the other provisions, the right of first refusal is confusing if not drafted with detail. It’s important to specifically address possible scenarios that could arise, such as whether the right of first refusal terminates if the sale is not completed and i it’s exercisable when any offer arises or just the first one. This advice would apply to similar clauses such as right of first offer, first rights and purchase options.

As you are reviewing your next lease agreement, be sure to keep the long-term impacts of provisions relating to renewal options, rent increases and a right of first refusal in mind.

"Key Lease Provisions can Result in Unforeseen Consequences", written by: Lauren Larsen, Licensed Real Estate Assistant, NAI Affinity

Source: CREJ - March 2, 2022

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