September 27, 2007

Kenneth Neale authors article "Lease Issues For The Small Office Tenant1"

Arnold & Porter Article

By Kenneth A. Neale

September 27, 2007

As the office market tightens, the small office tenant is put in a difficult position when negotiating its office lease. On the one hand, the small office tenant usually does not want to spend a lot of time and legal fees in negotiating a lease. In addition, the tenant usually does not have sufficient leverage to demand many changes to the lease. On the other hand, office leases tend to be lengthy and notoriously one-sided in favor of the landlord. These facts, combined with lower vacancy rates and increased competition for office space in many markets, make negotiations difficult. This article discusses 12 issues that the small office tenant should focus on in reviewing and negotiating its office lease. Many of these issues should be raised at the letter of intent stage of lease negotiations

1. Use. Some leases limit use to "professional" or "executive" offices. The tenant will want the use clause to be as broad as possible (e.g., general office and related uses). This allows the tenant greater flexibility to make modest changes in its use of the premises and to sublease the premises or assign the lease if that becomes necessary. Even if the tenant intends to use the premises only for executive offices, a potential subtenant may have a need for general office space.

2. Operating Expenses. Most office leases require the tenant to pay its percentage share of building operating expenses (for full service or "gross" leases, the tenant pays its percentage share of increases in building operating expenses over those incurred by the landlord during a "base year"). Much time is spent negotiating exclusions to operating expenses. The key exclusions the tenant should focus on are: (i) capital expenditures (except capital expenditures -- amortized over their useful life --required to comply with new laws not in effect upon commencement of the lease, or those which reduce operating expenses in the building, but only to the extent of such reduction); (ii) costs of environmental remediation (such as asbestos and lead paint abatement); (iii) costs to fix building defects; (iv) costs (such as commissions and tenant improvements) relating to leasing space in the building; (v) costs covered by insurance or warranties; (vi) costs of earthquake insurance (unless also included in the base year); (vii) increases in real property taxes resulting from the sale of the building (landlords are very reluctant to give this exclusion, but it is a particularly important in a building with a low tax assessment if the law is such, as is the case in California, that the property will be reassessed to fair market value upon sale); and (viii) mortgage costs and ground rents. Also, for gross leases, operating expenses during the base year should be "grossed-up" to reflect at least 95% occupancy. Otherwise, operating expenses for the base year for a building with a high vacancy rate will be artificially low resulting in higher costs to the tenant in subsequent years. Another, simpler, approach is to negotiate a year-to-year cap on increases in operating expenses. A small tenant typically is not set up to audit operating expenses. A cap is a good way of protecting the tenants downside in the event of large increases in operating expenses such as those that occurred after 9/11.

3. Repairs and Violations of Law. A small tenant should only be responsible for ordinary repairs within the premises, not failures of building systems or capital replacements. In addition, a small tenant should not be expected to upgrade the building to comply with laws, including seismic laws or the Americans With Disabilities Act, even if such upgrades are triggered by the initial tenant improvements to the premises. A tenant should only be required to pay for upgrades that are triggered by additional (post-commencement) tenant alterations desired by the tenant or by the tenant's specific use of the premises.

4. Hidden Expenses. In addition to base rent and tenant's share of operating expenses, there are often other provisions in an office lease that require the tenant to make additional payments to the landlord. These could include payments for after-hours HVAC, additional janitorial services, "excess" electricity charges (see paragraph 5 below), and construction "supervisory" fees in the event tenant desires to make alterations to the premises. The tenant should review these provisions carefully. The landlord should pay for building standard light bulbs and ballast replacement and bathroom supplies. The tenant should try to eliminate construction supervisory fees – the landlord rarely provides significant services – or, at the very least, limit them to no more than 3%-5% of hard costs. The tenant should negotiate the "building hours" (including Saturday morning service) during which HVAC will be provided at no additional cost to tenant.

5. Electricity. Full service office leases in California typically include electricity charges as part of the operating expenses that are passed through to the tenant. Nonetheless, most office leases contain a provision allowing the landlord to charge the tenant for "excess" electrical usage. What is defined as "excess" depends on the lease. One large office landlord includes as part of its standard lease a provision that allows the landlord to charge the tenant for electricity used after 6:00 p.m. A tenant should not be charged for additional electricity unless it is materially beyond the scope of electricity needed for ordinary office usage. In addition, if a tenant is a large consumer of electricity due to its business operations (several computer screens per employee), the tenant will need to verify that the building can support such electrical usage and that the lease obligates the landlord to provide the required electrical capacity.

6. Assignment and Subletting. The assignment and assumption is one of the most negotiated provisions of an office lease. A tenant needs flexibility to sublease the premises in the event the premises no longer suit its needs. (See also paragraph 7 below.) A tenant also will want the ability to assign the lease, without landlord's consent, in the event of a sale of its business (whether by merger or otherwise). Many leases also allow the landlord to recapture the premises or terminate the lease in the event that tenant desires to assign or sublease. This could have a negative impact on a small tenant's ability to sell its business and, thus, should not apply in that circumstance. Finally, small tenants may need some flexibility in allowing business associates to use offices in the premises without the need to obtain landlord's consent.

7. Termination Rights. A small tenant (particularly if it is a new company) may need the flexibility of terminating its lease early either because it outgrows the space or it suffers a business setback and no longer needs or can afford the space. Under some circumstances, a tenant may be able to negotiate a right to terminate the lease early upon payment of a fee. Typically, such a fee would include reimbursing landlord for unamortized tenant improvement costs and commissions, plus some months' rent. An early termination right is particularly valuable in a difficult sublease market. If a tenant cannot get an early termination right, it should consider a shorter lease term, although this may reduce the amount of any tenant improvement allowance provided by the landlord.

8. Options to Expand or Extend. Ideally, a small tenant will have flexibility in extending the term of the lease and/or expanding the size of the premises. An option to extend should be at some percentage (e.g., 95%) of fair rental value. There should be an arbitration procedure if the parties cannot agree on the fair rental value.

9. Square Footage and Load Factor. Rents are generally determined based on the "rentable square footage" of the premises. The rentable square footage of the premises is always more than the "usable" square footage of the premises due to what is known as the "load factor." The load factor is a percentage of non-usable space (such as elevator lobbies, internal columns, common bathrooms and other common areas) that are allocated to the premises. Some buildings are more efficient than others and have lower load factors. Load factors could be particularly higher (e.g., 20-25%) on multi-tenant floors. When comparing buildings, the tenant should compare usable square footage, not rentable square footage.

10. Hazardous Materials. The hazardous materials that are most prevalent in office buildings are lead paint and asbestos. The existence of these materials could raise concerns among employees and cause significant additional expense in constructing tenant improvements and subsequent alterations. The landlord should accept full responsibility for costs of abating or remeditating pre-existing hazardous materials in the premises or the building.

11. Relocation. Most office leases contain a relocation provision which provides that the landlord may relocate the tenant to other space in the building. The landlord might wish to do this to make room for a larger tenant. The tenant should try hard to have this provision deleted. This is not always possible for a small tenant. In that case, the tenant should carefully negotiate the particulars of the relocation clause, including the length of the notice period, a "safe" period during which landlord could not relocate the tenant, full reimbursement of the expenses of relocation (including moving costs, telecommunications costs, stationery and losses attributable to down time), the condition of the substitute premises, and the location of the substitute premises (does the substitute premises have equivalent views?).

12. Waiver of Subrogation. An office lease should have a well-drafted mutual release and waiver of subrogation provision. The main purpose of such a provision is to protect the landlord and tenant from being sued by the other party or its insurance company in the event of damage to property that is insured by the insurance company. Thus, for example, if the tenant negligently causes a fire in an office building that results in $500,000 of damage that is covered by the landlord's insurance, this provision would provide that neither landlord nor landlord's insurance company could bring a claim against the tenant for that amount. This provision also works in favor of the landlord in the event that the landlord causes damage to tenant's property that is covered by tenant's insurance.

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There are undoubtedly other important issues that a small office tenant should consider in negotiating its office lease. In our experience, however, the 12 issues discussed above are among the most important.


1 For purposes of this article, we define a small office tenant is one that takes less than 5,000 square feet of space for five or fewer years.

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