Contributed By Allen Matkins Leck Gamble Mallory & Natsis LLP
A lease allows a tenant to occupy a property under certain terms and conditions for a set period of time. There are ground leases, master leases, and space leases. Ground leases, in which a tenant leases the ground and develops the property, are becoming more common, and are generally 55 to 99 years long. Master leases, in which a tenant leases the entire building and then finds subtenants, are rare. Space leases, in which a tenant leases a particular space, dominate the market.
There are office, industrial and retail leases of commercial property.
Office leases are the most highly complicated and thus highly negotiated leases, and can run to hundreds of pages.
Industrial leases are less complicated, as the properties are used primarily for storage. Due to space limitations, industrial tenants are highly constrained and do not have much room for negotiation; hence these leases are shorter. Retail leases focus on terms and conditions to help maximize the retailer’s ability to sell product.
Commercial rents and lease terms are not subject to government regulation, but are dictated solely by market forces.
Traditional lease terms specify the size and location of premises, the rent, operating and tax expenses, the length of the term, the construction that the landlord will do to the space, and allowances – ie, funds given to the tenant to improve the space. The length of a lease is usually five to ten years, and sometimes 15 years.
Tenants repair their own premises. Landlords are responsible for all other repairs. This can be subject to negotiation – for example, whether a particular roof repair is considered building maintenance or a tenant responsibility. The best leases specify such costs in detail. In reality, landlord costs are passed through to the tenant in the form of rent.
Rent is paid monthly, due at beginning of the month, as well as operating expenses and taxes. Some leases may require one month’s rent in advance as a security deposit.
Rent escalates, typically by 3-4% on a yearly basis. These terms are written into the lease.
Rent increases during the term of the lease are by a negotiated percentage, as detailed in the lease. At renewal, the value of the space and thus the rent is determined by the fair market value.
In some jurisdictions, the property owner pays a gross receipt tax on rent. Because Prop. 13 has kept real estate taxes artificially low, some municipalities (especially those without real estate taxes) tax the rent. These costs tend to be passed through to tenants as part of the overall cost of the lease.
Other than rent, tenants pay a security deposit or credit enhancement, typically one or two months' rent. If a tenant has no credit history, it may be required to supply a guarantor or, more commonly, a letter of credit from a bank. Once tenants take possession, they need to pay insurance premiums and fund improvements.
Typically landlords pay these costs, but are reimbursed by tenants on a pro rata basis, either on top of the rent, or as costs built into the rent. Any increases in those expenses during the term of the lease would be paid pro rata by the tenants.
Telecommunications costs are typically paid directly by the tenant. Subject to reimbursement by the tenants, the landlord will typically pay utilities unless the tenant’s premise is separately metered, but this can be prohibitively expensive. If a tenant is leasing an entire building, it will typically contract directly with the utility supplier.
In retail properties, each tenant has a separate account, and the landlord pays for utilities and services for the common areas. In office buildings, the landlord pays these costs, subject to reimbursement by the tenants, typically based on their square footage. Water, sewer and garbage fees are paid by the landlord and subject to reimbursement via rent, on an equitable or proportionate basis.
Typically, the landlord insures the base, shell and core of the building. Improvements in the premises – the build out, which is typically tenant-specified – are covered by the tenant’s insurance. Tenants also insure their own personal property. In addition to casualty insurance and liability insurance for common areas, most landlords have earthquake insurance, and some have terrorism insurance. Casualty insurance is usually full replacement coverage, but earthquake coverage and deductibles vary widely.
California is a contract law state. Landlords typically limit tenants to the anticipated use for which the building was intended. Covenants, conditions and restrictions (known as CC&Rs) will outline acceptable and prohibited uses. Some may be imposed by jurisdictions. For example, there are municipal-specific laws about the types of businesses that can be near schools. Areas zoned for office use can only contain offices; R&D (research and development) areas can only be used for R&D. Some municipalities seeking to promote certain industries have further restrictions. For example, some areas in California are zoned and developed specifically for life sciences use.
Generally, aside from pre-approved cosmetic alterations, a tenant is restricted contractually from making alterations to premises without the review and consent of the landlord. Reasonable changes to paint, carpet and finishes are often negotiated, providing they do not affect the base, shell or core of the building.
Outside of zoning and use provisions and specific requirements that are part of a development agreement, there are generally no specific regulations or laws. In commercial settings, there is usually a waiver of the default provisions in the code that would apply to residential tenants.
Federal bankruptcy law prioritizes creditors, and could leave the landlord as an unsecured creditor. The court can compel the assignment of the lease through the bankruptcy court, which may circumvent many otherwise applicable landlord controls over an assignment. Any cash security deposit will likely be remitted to the bankrupt estate.
Under state law, Civil Code section 1951.2, a landlord is entitled to all of the consideration for the remaining term, less the amount that the tenant can reasonably establish the landlord would be able to offset, depending on the market, by re-leasing the property.
Bankruptcy claims are capped at 12 months of rent, or 15% of the total consideration remaining. While that establishes a maximum claim, the landlord remains an unsecured creditor. Further, the lease will be subject to an assignment if there is a new tenant entity, and contractual obligations may not apply.
Security can take the form of a cash security deposit, a third-party performance payment guarantee, or a letter of credit.
A tenant does not have the right to occupy the property after its lease expires or terminates, but a landlord can create a month-to-month tenancy. Any “holdover” occupancy would be subject to fines or higher rents, such as 150% of the rent. A tenant can also be liable for actual damages from loss of a subsequent lease due to inability to deliver possession to a subsequent tenant.
A landlord can provide the appropriate notice and file an unlawful detainer action, which is an eviction.
A landlord can terminate a lease when there is a material casualty for which the repairs will exceed a reasonable period of time, or a condemnation that materially affects the ability to conduct business. Casualty and condemnation events typically give either party the right to terminate the lease. A lease can also be terminated if a tenant defaults on payment or fails to satisfy the insurance requirements outlined in the lease. Further, economic or material non-economic defaults, such as violating the use provision, beyond applicable notice and cure periods can trigger termination. Landlords can be in default, too, for not making timely repairs, for example, or not providing consistently working elevators.
Subject to notice and cure provisions and unlawful detainer procedures, a landlord can force a tenant to vacate. The county sheriff handles the actual eviction. An uncontested unlawful detainer can typically result in a court order for eviction in 60 days. Successful contested detainers can take six months.
A municipality can condemn an unsafe building, forcing termination of the leases. The condemning authority is responsible for compensating the parties, based on fair market value. Landlords can seek compensation for loss of income and value of the property. Tenants whose leasehold is terminated can also make independent claims for the lost value of their leasehold.