Demystifying the Commercial Lease—Tenant’s Guide to Commercial Lease Modifications
In elementary school, many children play a musical instrument. They choose between violin and cello for orchestra and among flute, alto clarinet, trumpet, trombone, baritone, and percussion for band.
However, these few instruments aren’t sufficient for a full orchestra or band. There are four string instruments in the standard orchestra: violin, viola, cello, and bass. A concert band may have piccolos, flutes, oboes/English horns, bassoons, and types of clarinets and saxophones in every register (soprano, alto, tenor, and bass) in the woodwind section. The concert band’s brass section will include trumpets/cornets, French horns, several trombone types, baritones, and tubas.
During middle or high school, many students migrate from their elementary school instrument to another instrument. Violinists may switch to viola or cellists to bass. Flutists may take up oboe or bassoon, clarinets may move to the saxophone, trumpets to French horn, and baritones to tuba.
Often students make the change out of love for the new instrument that calls to them. Other times, a student may make a move for leadership opportunities. For instance, the stereotypical average violin player may become a stellar violist (hence the viola jokes). Or a student might prefer to be the only bass clarinet in a band, rather than one of eight or ten alto clarinetists.
Regardless of the student’s wishes, the school orchestra’s or band’s needs also are a factor in instrument switches. Orchestras frequently need more viola players. And bands may need students to play less common instruments, such as bass trombone or soprano clarinet.
Other times, the band’s or orchestra’s resources may dictate whether a student can change instruments. Or the cost of a change might be a barrier to changing instruments. For instance, the school may have only one soprano or bass clarinet. Or the school may have a limited number of large instruments like string basses or tubas, which students won’t carry to and from school even if they rent or buy their own instruments to play at home.
Tenants under commercial leases can be viewed like student musicians, with their landlords being like the orchestra or band. Tenants, like student musicians, have wants and needs. But like orchestras and bands, landlords have their own needs and limited resources.
Due to the economic downturn triggered by the COVID-19 pandemic, many businesses are finding that their current leases no longer meet their needs. In Can You Get Out of Your Lease Due to the Coronavirus Pandemic? I discussed when tenants may be able to cancel their leases.
But many tenants don’t want to cancel their leases – they just need changes so the lease arrangement better meets their needs. This article discusses how tenants can negotiate a lease modification by understanding their landlords’ needs.
Why Tenants Seek to Modify Their Leases
Tenants usually want to renegotiate leases to save money or because their rental space no longer meets their needs. With the pandemic, many tenants find they don’t need as much space as they did previously. Other tenants may discover they have open floor plans that no longer work for them given a post-pandemic environment.
Whether it is due to financial reasons or changed business needs, tenants are going to landlords in record numbers with requests to modify leases. Many tenants are very focused on their own needs with lease modifications and do not think about the landlord’s needs. A myopic viewpoint can make it difficult for a tenant to achieve its own goals.
This article is focused on how tenants can approach landlords. But landlords also must attempt to view the situation from the tenant’s perspective. A landlord that focuses entirely on its own business interests may find tenants aren’t likely to renew their leases. Plus, in challenging financial times, a landlord that refuses to be flexible can drive a financially-challenged tenant out of business.
Tenant Economic Needs
Most tenants who want to modify their lease need to lower their monthly rent payments. The primary economic parameters that can be modified to create a significant, immediate impact are:
rent per square foot
square footage
length of lease
Of these parameters, only a reduction in rent amount or square footage can immediately reduce a tenant’s monthly rent payments. Sometimes, the tenant’s situation may be so dire that rent abatement (forgiveness) may be the only feasible option.
Contract Requirements
When it comes to contract law, the landlord usually has the advantage. The tenant signed a contract, and the landlord may insist that rent be paid. Unless the landlord has breached the lease, for instance, by cutting services, the landlord holds most of the cards at the negotiating table.
That doesn’t mean that the landlord won’t recognize that a tenant that is paying some rent is better than a bankrupt tenant. But unless the landlord has breached the lease, tenants should realize they are in the weaker position.
Earlier, I talked about how myopic, one-sided thinking can be an obstacle to obtaining a modification. Also, a lease modification can’t be only one-sided. Basic contract law requires that there be quote consideration” or a quid pro quo for a contract to be effective. Therefore, tenants should expect to give the landlord something additional in exchange for the modification the tenant desires.
Frequently, a tenant who wants reduced rent or wants to take less space may need to accept a longer lease term period or, the tenant may need to provide additional collateral or security for the rent payments.
Most landlords will ask a tenant for financial statements and other documentation to demonstrate that the tenant needs a rent reduction. Although tenants might not want to share this information, these are reasonable requests, and tenants should provide this information. A landlord isn’t likely to give up its contractual rights unless the tenant demonstrates the alternative may be a tenant default or bankruptcy.
Landlord Economic Needs
Many people think of commercial landlords as large institutions with unlimited financial resources. This is rarely the case.
Small investor groups or closely-held companies with limited resources frequently own commercial real estate. Some commercial real estate is owned by individuals. Other times the real estate is owned by funds of individual investors or small partnerships.
Even when large institutional investors own the real estate, the ultimate owner is an individual. Large retirement funds such as CalPERS might own real estate, but their beneficiaries are state workers’ individual retirement funds.
Most commercial real estate is legally owned by special purpose entities (SPE). Owners don’t do this as part of a scheme to hide their identities. Most mortgage lenders require that the real estate be owned by a special purpose entity. Understanding the limitations of a special purpose entity can help a tenant know what it can (and should not) as the landlord to do.
A landlord may own many real estate SPEs. However, each SPE is expected to pay its own expenses from its revenues. Money from one SPE can’t be comingled or used to help another SPE financially.
Just like individual homeowners, landlords usually have mortgages to pay. But landlords also may have investors and owners to answer to. The landlord or its investors may have to put food on their tables and pay for their own families’ living expenses.
So, in challenging financial times, a landlord may be struggling as much as some tenants. If too many tenants don’t pay full rent, the landlord might face foreclosure.
Landlord Mortgage Lender Requirements
Mortgage lenders frequently impose significant restrictions on landlords’ ability to modify leases. A mortgage also might require the landlord to maintain the property’s financial performance at a particular level. Or the landlord may not be able to modify leases without the lender’s consent. Sometimes it can be difficult for the mortgage lender to obtain lender consent.
Tenants wishing to modify their leases should ask the landlord if there were any mortgage loan terms, they want the tenants to consider when negotiating. The landlord doesn’t have to give the tenants this information. But it can help the parties find common ground if the tenant understands what options aren’t available due to lender restrictions. And the landlord should appreciate the tenant’s desire to accommodate the landlord’s needs and its own.
Other Landlord and Tenant Considerations
Real estate commissions and tenant improvement costs also may affect lease modifications.
Many commercial leases were negotiated with a broker representing the landlord or tenant. That broker’s commission usually is based upon the rent payable over the entire lease term. However, the landlord usually pays this commission when the lease starts.
Particularly in office leases, it is common for a landlord to make tenant improvements on space to customize it to the tenant’s needs. Usually, this work will be completed before the tenant moves in. Like the broker’s commission, the landlord has to pay for this work (TI Expense) at the beginning of the lease. Sometimes, the landlord may borrow money to pay for the TI Expense.
Although the landlord pays these expenses, the landlord expects to recoup these expenses from the tenant over the entire lease term. Tenants who ask to modify their leases shouldn’t be surprised if the landlord wants to assure it is reimbursed for the broker commission and TI Expense. Therefore, any lease modification should account for the unamortized broker commission and TI Expenses.
Thinking Outside of the Box
For student musicians, some instrument changes are more common than others because they are easier to accomplish. For instance, a viola uses the same basic technique as a violin, except the viola is larger, and its music is written using a different clef. A switch from violin to trumpet would be more challenging because these instruments are played differently. But sometimes, a student might be best served by that challenging instrument switch.
This article focuses on common tenant and landlord needs and the more straightforward strategies to modify leases. Every situation is unique. If these don’t work for the situation, landlords and tenants should work with a real estate attorney to find a solution that works for them.
© 2021 by Elizabeth A. Whitman
Any references clients and their legal situations have been modified to protect client confidentiality.
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