Owners of residential and commercial property must be careful in preparing and signing leases with tenants. Beyond the dollars and cents of the agreement and the income or financial statement analyses, an owner must consider how to protect themselves before, during and after the term of the lease. This overview of commercial and residential leases highlights several common mistakes made by property owners when leasing to a tenant. This overview addresses these issues directly, but is not an all-inclusive summary with respect to important issues facing a residential or commercial landlord.
Owners of residential and commercial property must be careful in preparing and signing leases with tenants. Beyond the dollars and cents of the agreement and the income or financial statement analyses, an owner must consider how to protect themselves before, during and after the term of the lease. This overview of commercial and residential leases highlights several common mistakes made by property owners when leasing to a tenant. This overview addresses these issues directly, but is not an all-inclusive summary with respect to important issues facing a residential or commercial landlord. Leasing and contract preparation requires expertise—from the owner, from outside consultants and preferably from an experienced real estate attorney. While the author has substantial legal experience in real estate and leasing matters, this article should not be construed as formal specific legal advice to the reader, nor should the reader consider the author to be his/her attorney solely on the grounds of having read this article. Every owner, every tenant and every lease is unique and advice for particular circumstance really does require individual review and consideration.
Legal disclaimers aside, an owner who wants to protect themselves from potential liability and attorney’s fees (not to mention administrative headaches), should consider the issues detailed below with respect to the following 5 lease provisions, which commonly lead to substantial landlord mistakes:
1. Use Limitations
Overview: While the intended use of the property has undoubtedly been considered well in advance of the signing of the lease agreement, it is essential that an owner include detailed limitations on the tenant’s rights to use the premises. Due to assumptions, prior informal conversations and failure to consider potential ramifications, an owner may overlook this important portion of any lease.
Commercial Lease: A commercial lease should accomplish 4 things with respect to use of the property:
(1) Spell out the sole permitted use of the property by tenant. The lease should state simply what the property is to be used for (ex: retail clothing and apparel store, fast-food restaurant, general non-retail office space). Regardless of oral understandings, prior use or anticipated current use, the lease should bind the tenant to the designated use.
(2) Detail specific limitations to the use. The lease should spell out specific disallowed uses, which the owner wants to avoid on the property, that may typically arise in connection with the intended use (ex: no retail activity, limitations on signage or window usage, limitation on number of employees in office, prohibition on style of restaurant service, specifications regarding delivery hours, procedure and location, etc.)
(3) List Specific Prohibited Uses. The lease should explicitly prohibit any business or activity that is illegal or not permitted by zoning ordinances, any use of hazardous materials, any use not permitted due to an exclusive use of another tenant and other desired limitations such as prohibiting adult-oriented services and retail.
(4) Require Certain Obligations of Tenant. Tenant should be required to maintain the property in good and clean condition, operate during desired business hours, operate without substantial periods of closure and should be obligated to notify landlord in writing in the event of any changed or additional use of the premises.
Residential Lease: While residential use specifications and limitations do not need to be as detailed as those applicable to commercial leases, there are still significant considerations that must be made. A properly-drafted residential lease should consider the following use limitations and specifications
(1) Specify Residential Use. A residential lease should indicate that the property is to be used solely for residential purposes and for no business, retail or other commercial uses.
(2) Limit the Number / Type of Occupants. An owner should consider what limitations should be placed on the number of occupants, the relationship between occupants and the permissibility of overnight and/or long-term guests. Limitations on group gatherings may also be desirable depending on circumstances.
(3) Require Certain Obligations of Tenant. A residential lease should obligate the tenant to maintain the property in good and clean condition and may limit period in which the property can be left vacant during the term of the tenancy.
Required Insurance Provisions
Overview: A well-drafted lease should spell out the insurance requirements of both the owner and the tenant. A property owner must be diligent in being sure that its property (and pocketbook) are protected upon the occurrence of events ranging from a fire or a slip-and-fall accident to a disgruntled tenant or negligent (or malicious) acts of a tenant or other party.
Commercial Lease: A commercial lease should explicitly require the tenant to obtain multiple types of insurance. In order to be sure these protections are in place, the owner will want to insert a contract provision specifically requiring tenant to provide proof of insurance. Furthermore, the landlord should retain the right to purchase the insurance policies on tenant’s behalf (and charge tenant the cost) if tenant fails to provide this proof within a designated time frame. It is important that the relevant insurance policies become effective immediately upon tenants occupancy/use of the property. An owner of a commercial property will typically want to consider requiring the lessee to obtain the following types of coverage*:
(a) Commercial General Liability
(b) Commercial Property
(c) Workers Compensation
(d) Business Auto Liability
(e) Business Interruption and Extra Expense Insurance
Residential Lease: Insurance requirements in a residential setting are typically lighter than a commercial setting for obvious reasons, mostly having to do with the intended use of the property. However, an owner must consider requiring a residential tenant to obtain certain basic types of insurance policies. If these policies are required, the landlord should require that proof of insurance be provided to the landlord. The following basic coverage* should be considered in a residential setting:
(a) General Liability
(b) Real Property Insurance
(c) Renters Insurance
*Insurance limit amounts should be determined in consultation with a qualified professional.
Protections in the Event of Tenant’s Default
Overview: No matter how well-drafted a lease is or how well-situated a tenant might be, there will unfortunately be instances where a tenant defaults on its obligations under the lease. Whether due to cash flow shortfalls, misunderstandings regarding lease terms or simply a negligent (or malicious) tenant, every owner faces the very real risk of a tenant not living up to their contractual obligations. It should be noted that defaulting on a lease encompasses much more than late (or unpaid) rent—it also includes such events as misuse of the property, failure to obtain required insurance or violating other specific terms of the lease agreement.
Commercial Lease: A commercial lease should broadly define what constitutes default, including the following events/actions: (i) failure to make timely rental payments, (ii) failure to perform any covenants under the lease after a period of written notice from landlord, (iii) failure to perform any covenants under the lease which creates a hazardous condition which tenant fails to immediately cure upon notice from landlord, (iv) an event indicating tenant bankruptcy or other financial insecurity, including a writ of execution against the premises, and (v) tenant vacating the property for more than a designated period of days (usually 10 days). A properly-drafted lease should also detail the rights that the owner has against the property and the tenant, including the following:
(a) Owner has right to declare the lease terminated and repossess the property.
(b) Owner has the right to recover all amounts due under the lease and those that will become due.
(c) Owner has the right to recover the cost of any construction allowance or other costs associated with tenant entry into the lease.
(d) Tenant shall be responsible for all costs (including attorneys fees) expended by owner in the termination of the lease and vacation of the property.
(e) Owner may re-enter the premises and lease them to a new tenant.
(f) Tenant shall be responsible for all costs associated with re-leasing the property.
Residential Lease: While provisions in a residential lease will be quite similar to those in a commercial lease, there are some subtle differences, usually amounting to slightly simpler terms. A residential lease should broadly define what constitutes default, including the following: (i) failure to make timely rent payments, (ii) failure to perform any covenants under the lease after a period of written notice from landlord, (iii) an event indicating tenant bankruptcy, and (iv) the existence of a writ of execution against the premises or the tenant’s leasehold interest. A properly-drafted lease should also detail the rights that the owner has against the property and the tenant, including the following:
(a) Owner has right to declare the lease terminated and repossess the property.
(b) Owner has the right to recover all amount s due under the lease and those that will become due.
(c) Tenant shall be responsible for all costs (including attorneys fees) expended by owner in the termination of the lease and vacation of the property.
(d) Owner may re-enter the premises and lease them to a new tenant .
(e) Tenant shall be responsible for all costs associated with re-leasing the property.
Landlord’s Default: It is not typically necessary to include specific provisions regarding landlord default. In the event that tenant insists on such provisions, they should be narrowly defined with limited potential remedies granted to tenant. An attorney should be consulted.
Necessity of a Personal Guaranty
Overview: An owner must seriously consider a personal guaranty for both commercial and residential leases. A guaranty provides an owner with added security regarding payment of rent and other expenses (and liability) while also committing the tenant to further responsibility and investment in the use of the property. There are no practical downsides of a guaranty for an owner.
Commercial Lease: A commercial lease should be guaranteed by an individual with adequate financial security. This will often be the owner of the company, a major investor in the business or a person with a close personal relationship to the operator of the business. The traditional theory is that the closer the guarantor is to the operation of the business the better, as they will have a vested interest in the success of the business, which always benefits the landlord. An owner may consider waiving the necessity of a personal guaranty in the event the tenant company has sufficient cash flow and credit history, or in the event of a renewal with a trustworthy long-time tenant. The contents of a personal guaranty requires the advice of an experienced attorney.
Residential Lease: If a residential tenant does not have adequate income and/or personal credit history, an owner should seriously consider requiring a personal guaranty from a separate individual with more a more secure financial position. The content of a personal guaranty requires the advice of an experienced attorney.
Sale of the Property During the Lease Term
Overview: Any owner of property knows that the day will come when they will want to sell the property. With respect to the lease, the owner needs to be sure to protect its right to transfer (i.e. sell, give away, or transfer to a related business entity) the property while not terminating the lease. The following provisions will prove necessary to protect the owner’s right and ability to do so.
Commercial or Residential Lease: Four predominate issues arise in the event a landlord wishes to sell leased property: (i) the continuation of the lease, (ii) continued liability of the landlord, (iii) the obligations of the tenant with respect to the new owner and (iv) the providing of relevant lease information to prospective purchasers. To these ends, the following provisions should be included in both residential and commercial leases:
(1) Termination of Landlord’s Liability: “In the event of any sale or exchange of the premises by landlord and assignment by landlord of this lease, landlord shall be and is hereby entirely freed and relieved of all liability under any and all of its covenants and obligations contained in or derived from this lease arising out of any act, occurrence or omission relating to the premises of this lease occurring after the consummation of such sale or exchange and assignment.”
(2) Subordination and Attornment: “Upon written request of landlord, or any mortgagee or beneficiary of landlord, tenant shall in writing subordinate its right hereunder to the interest of any ground upon which the premises is situated and to the lien of any mortgage or deed of trust, now or hereafter in force, against the land and/or building on the premises and to all advances made or hereafter to be made upon the security thereof.”
(3) Power of Attorney: “Tenant hereby irrevocably appoints landlord as attorney-in-fact for tenant with full power and authority to execute and deliver in the name of tenant any instruments or certificates to carry out the intent of [the previous article]. If fifteen (15) days after the date of a written request by landlord to execute such instruments, tenant shall not have executed the same, landlord may, at its option, cancel this lease without incurring any liability on account thereof, and the term hereby granted is expressly limited accordingly.
(4) Estoppel Certificates: “Within ten (10) days after request therefor by landlord, tenant agrees to deliver to any proposed mortgagee or purchaser, or to landlord, a certificate in recordable form, certifying, if such be the case, that this Lease is in full force and effect and that there are no defenses or offsets thereto, or stating specifically those that are then claimed by tenant, and any other reasonable information requested for the proposed mortgagee, purchaser, or to landlord.”
(5) Transfer of Deposits: “Landlord shall deliver the funds deposited hereunder by tenant to the purchaser of landlord’s interest in the premises, in the event that such interest be sold, and thereupon landlord shall be discharged from any further liability with respect to such deposit.”