Analyzing Lease Terms: What You Should Look for in a Lease
Published on May 8, 2012
In addition to securing the right type of tenant, a sufficient lease term and the right lease structure, the terms of your lease protect your rights and the value of your asset over the long run. The lease terms described in this section are not unique to triple net leases--they must be considered for any type of lease, including office, retail, industrial, and any other type of real property that has a longer-term lease attached to it.
Obligations: In any type of lease structure, it is important to understand the obligations of the tenant vs. the landlord. The obligations for both parties are essential to the proper administration and valid enforcement of a lease. For instance, if the landlord is required and fails to carry a certain level of insurance, the tenant may have the right to cease making rent payments or terminate the lease altogether. If the maintenance of the common areas of a property (shared by several tenants) is the landlord's obligation, certain leases may provide liability against the landlord if a failure to maintain common areas causes injury to a customer or employee or damage to a tenant's equipment or property. Each lease is unique and requires the landlord to fully understand the responsibilities of each party involved in the lease.
Liabilities: With any lease, it is important to ensure that your tenant's space and business are their responsibility. Typically, if you are the landlord, you will bear some structural risk, should something happen on your property that causes someone harm. However, do not allow operational risk of the tenant's business to fall back on you. Your lease should include clauses that hold you harmless from any operational risk related to your tenant's business. General tenant risks may include use of any physically or environmentally hazardous materials, work-related injuries, business-related lawsuits, or damage caused to a tenant's furniture or fixtures (the decorations, shelf space, inventory, signage, etc. a tenant places in and around their space) in the course of their operations. This is not a comprehensive list of liabilities, but we can furnish you with a more complete list that is located in most primary lease templates.
Lease Bumps: Unless you buy a long-term triple net property with an incredible discount to market price, it is essential that you look for a lease that includes contractually obligated increases to the lease payment throughout the lease term and in the lease options. These contractual increases in rent are called "lease bumps" and can make the difference between a good and bad investment.
The primary reason why lease bumps are necessary is to offset inflation. Each year, the dollar continues to lose more of its value and buying power. It is important that your rent payments are increasing so that the value of your income and your asset rise with inflation. Think of the difference between what $1 buys today vs. what it would have bought 50 years ago, 20 years ago, or even 10 years ago!
Now, think of a rent payment fixed at $30,000 for the past 20 years. Not only would the purchasing power be diminished--the asset would have had a very difficult time appreciating without an increasing income stream. If the lease payment increased by 1% annually for the past 20 years, it currently would be $36,605, a 22% increase over the original lease payment. The increased lease payment would translate into higher prices for the resale of the asset. We typically encourage our clients to target an average of at least 1-2% rent bumps per year, depending on the quality of the tenant.
Renewal Options: Renewal options give the tenant the right but not the obligation to renew their lease for specified terms and rates upon the expiration of their initial, fixed term. Properly structured renewal options give value to both the tenant and the landlord, as they provide a tenant surety of what their future rent costs will be without directly obligating them. They provide the landlord prior notice of a tenant's intentions of renewal before the lease term is up. This arrangement allows both parties to prepare for their longer-term obligations and needs. If the tenant renews, the landlord and tenant know exactly what their income and costs will be, respectively. If the tenant does not renew, the process can give the landlord enough time to try to find a replacement when the tenant's initial term expires.
Not all renewal options are created equal. A common example of the type of renewal option to avoid is the option structure typically associated with Walgreens' leases. Walgreens' leases can look initially attractive, with 15-25 years or more on the initial term. However, they then will attach 2 or 3 additional renewal options of 25 years to the initial term WITHOUT lease bumps. Regardless of the strength of the tenant, this means that the landlord could be stuck with 50-75 years of the same lease payment. This option is not only a poor hedge against inflation, but it greatly reduces your ability to resell the asset to a buyer for any profit in the distant future because the buyer will not want to be locked into the long-term nature of the fixed lease payments.
We encourage our clients to seek renewal options that total 5-15 years. In some circumstances, we have advised our clients to accept longer renewal options if the renewal options are favorable to the landlord, with sufficient increases in the rent obligations for each renewal period. Rent bumps must be sufficient over the lease term AND the option renewal periods to protect the investor from inflation and provide him a better chance of appreciation throughout the property's hold period.
Notice: Leases that require renewal or termination notices give landlords a cushion of time to know whether a tenant is renewing or prepare for a tenant's departure if they do not renew. Notice requirements oblige the tenant to make their intentions known typically 6-18 months prior to the end of their lease. The ability of a tenant to take advantage of options is often tied to notice requirements so that the tenant is motivated to make a decision ahead of time. Some notice requirements include penalties if a tenant does not give sufficient notice to the landlord according to the lease agreement.
Early Termination Options: Some leases include early termination options. These clauses allow a tenant to give notice within a specified timeframe and legally terminate a lease before their initial, fixed term is complete. Most early termination options will require a tenant's prior notice 6-18 months before the termination goes into effect and require an agreed-upon lump sum payment by the tenant in order to effect the termination. The lump sum payment helps offset the landlord's costs in finding a replacement tenant. It is smaller than a tenant's entire lease obligation, should they have remained in the lease for the full term.
We encourage clients to avoid leases with early termination options--especially given these current market conditions. Most tenants who have been lucky enough to have their fixed lease terms expire in this current economy have taken advantage of soft rental markets to cut their costs and negotiate significantly lower lease payments. We believe that it is important for our clients to bridge this difficult leasing environment with long-term leases that are fixed and free of any early termination options.
Co-Tenancy Clauses: Co-tenancy and other types of conditional "out" clauses can provide a back door for your tenant to get out of their lease. A co-tenancy clause allows a tenant to "go dark" (i.e., cease operations at that location) or terminate their lease if another major tenant located adjacent to their space "goes dark" or files for bankruptcy. For instance, a CVS located within a grocery-anchored shopping center may reserve the right to halt rent payments, shut down operations at your location, or even terminate their lease with you, should the grocery store that anchors that shopping center stop operations or go out of business.
Another type of co-tenancy clause allows a tenant to be freed from the obligations of their lease if a tenant in the same or similar type of business is allowed to take space in the same shopping center or directly adjacent to the original tenant. In other words, Pizza Hut would attempt to limit the ability for another pizza company, like Domino's, to move in right next door. These clauses give tenants protection and competitive advantages in their specific locations. The tenants can enact their right to terminate their leases if those clauses are employed. While these types of clauses are common in normal leases, it is important to be aware of and analyze the probability of such clauses being enforced.
Utilize a Professional
Though these are some of the primary aspects of a lease that you should understand and look for, this list is not fully comprehensive. Each tenant and lease is unique. There is always the risk that a tenant includes clauses that are unfavorable to the landlord or open the landlord to risks beyond their control. Seek professional counsel to review the full lease terms before finalizing a lease agreement or purchasing an asset with a lease in place.