Demystifying the Commercial Lease: Letter of Intent Fundamentals
Children frequently try out an instrument before committing to lessons. Music schools may have instrument “petting zoos,” which expose children as young as preschool-age to different instruments by letting them touch them. Summer camps for elementary age children may allow a child to try an instrument for three or four weeks to see if they enjoy playing it.
Instrument rental companies may offer a one-month trial period. Or, they may allow a child to switch instruments if the first instrument they try isn’t a good fit.
It’s not as easy to try out commercial rental space as it is musical instruments. It’s expensive for the landlord to get the space ready for a tenant, and it’s expensive and disruptive to the tenant’s business to move into a rental space to try it out.
However, landlords and tenants have found a way to “try out” their relationship to see if it is a good fit. They use letters of intent (LOIs) to be sure they agree on basic lease terms before spending the time and thousands of dollars involved in negotiating a formal lease. Because an LOI isn’t legally binding, a tenant can move on to a different rental space if they aren’t able to negotiate an acceptable lease–just like a music student can move on to a different instrument.
This article is part of a series on Demystifying the Commercial Lease and discusses letters of intent. Previous articles in the series discuss Types of Leases and Common Area Maintenance Charges.
What is a Letter of Intent?
An LOI is a short written document signed by the landlord and tenant, which describes the basic terms of the lease. By signing an LOI, the landlord and tenant can make sure they agree to fundamental lease terms before taking the time and incurring the expense of preparing and negotiating a lease. At minimum, an LOI should describe what the tenant is leasing and how much it will cost.
Describing What the Tenant is Leasing
Commercial leases usually involve more than just renting space. The lease may describe tenant improvements (TI), the landlord’s customization of the space to meet the tenant’s needs. In addition, the lease may describe the tenant’s right to use property amenities, such as parking.
Description of Rental Space
The LOI should describe the space the tenant is leasing. How the LOI describes the space will vary based upon the individual property. The unit number may be sufficient if the units are well-defined and the size or shape or space won’t change with the TIs. However, if the tenant is renting only part of a floor or an existing space, then the LOI should describe the space. The description may be based upon square footage and location or a diagram attached to the LOI, but it needs to describe the space in sufficient detail so the parties know they agree.
Tenant Improvements
In office space, landlords frequently will provide a TI allowance to customize the space to the tenant’s needs. TI allowances are rare in other asset classes. The TI allowance may be stated as a total dollar amount or on a dollar-per-square-foot basis. If it is the latter, then the parties should agree on the square footage in the LOI.
In retail space, tenants more commonly pay for improvements to the rental space. Regardless, who will pay for improvements should be spelled out in a sentence in the LOI.
Parking
The LOI should describe what rights the tenant will have to parking spaces. That may include reserved spots or the right to share parking on a first-come-first-served basis. The LOI should state if the parking is included in the rent or whether the tenant must pay extra for it. If the tenant must pay extra, the LOI should describe how the parking charge will be calculated.
Term
The LOI should state the number of months or years the lease will be in effect. It also should state if the tenant can end the lease early and whether there is an early termination charge. The LOI also should describe whether the tenant can renew the lease at the end of the initial term.
Describing How Much the Tenant is Paying
Rent
An LOI should describe how much the tenant will pay the landlord, starting with rent. The LOI either should state a monthly rent amount or should explain how rent will be calculated. If there will be rent increases during the lease term, the LOI should say so and say how much the increase will be. If there are rent concessions (free rent), that should be in the LOI too.
In retail leases, there may be percentage rent where the landlord receives a percentage of the tenant’s gross revenue. If so, the LOI should include details about percentage rent, including any floors, the percentage, and whether it is based upon gross revenue or another number.
Common Area Maintenance
In some leases, the landlord pays the costs of running the “common areas” or shared areas of the building and then passes them through to the tenants. These charges, called common area maintenance (CAM) charges, might include things like utilities, cleaning maintenance, taxes, and insurance. The LOI should say whether the tenant will have to pay CAM charges and provide basic information about how the charges will be calculated.
Security Deposit
If the tenant is paying a security deposit, the LOI should state the amount of the deposit, when it is due, and the terms on which it is refundable.
Other Charges
If the tenant must pay any other charges, such as parking, separately metered utilities, or off hours utilities, it might be in the LOI. For instance, one landlord I represented provided HVAC only from 7 AM-7 PM, Monday through Friday. When it rented space to a 24-hour call center, the call center had to pay for HVAC for the landlord’s cost of providing utility service to the call center from 7 PM until 7 AM Monday through Friday and on weekends.
If the tenant must pay the costs of a particular property improvement, it should be in the LOI. For instance, once I negotiated a lease for a nail salon in a high-end shopping mall. Since acrylic nail application and maintenance can produce dust and a strong odor, the LOI stated that the landlord required that the salon install and pay for a special ventilation system.
Broker Commissions
The LOI should state which brokers have been involved in the lease negotiations and should state who will pay the broker. Usually, the landlord will pay the brokers.
Other Terms That Might be in an LOI
Tenant Expansion
If the tenant has an option to rent additional space, the LOI should describe the space and how rent will be determined. Any tenant right of first refusal on adjacent space also should be in the LOI.
Credit Requirements
If the landlord hasn’t already approved the tenant’s credit, the LOI should say this and explain what information the tenant needs to provide. If the landlord requires a personal guaranty from the owner of a small business other credit enhancement (e.g., lien on tenant property), the LOI should describe those terms.
Special Circumstances
Any important terms unique to the tenant must be included in the LOI. For instance, if the tenant wants to be able to assign the lease to an affiliate without landlord approval, or the tenant has the exclusive right to operate a particular type of business in a shopping center, the LOI should say so.
An LOI Isn’t a Binding Contract
A music student may not want to be committed to the first instrument they try. Likewise, although the LOI serves as a framework for the lease, the parties usually don’t want it to be a binding contract, even if it includes a few provisions the parties want to be binding. For instance, the LOI may include an exclusivity clause that prohibits the landlord from continuing to market the space while the parties are negotiating the lease.
Unfortunately, as discussed in my previous article Is Your Letter of Intent Permanent and Binding, sometimes LOIs contain language which transforms them into binding contracts, despite the parties’ contrary intentions. Involving and experienced real estate attorney before signing an LOI can help prevent this error and assure that the LOI includes key business terms.
© 2020 by Elizabeth A. Whitman
Any references clients and their legal situations have been modified to protect client confidentiality
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