Rent – It is Not Always What It Appears To Be
People generally place a higher value on what they own than what someone else will pay for it. Real estate is no different. With commercial real estate, rents (which are the cash-flow source) play a critical role in the determination of the value of a commercial property. However, the mere statement in the lease of the annual rent payable should not be sufficient to satisfy a buyer/lender as to the expected cash-flow under the lease as other lease clauses may be present that will affect it.
When buyers/lenders turn their focus to lease review in the due diligence period, it should be with a view to identifying issues that may reasonably affect rental cash-flow. If clauses are identified with potential to affect the income stream, then the following options can arise:
A. termination of the deal;
B. reduced purchase price/loan amount;
C. in the case of a loan, the requirement for additional loan security over and above what
As a result, during the due diligence stage of a purchase or a loan commitment its vital to have proper lease due diligence carried out by experienced persons (i.e. internal or external counsel, law clerks, property managers, or leasing professionals) in order to identify hidden risks to the buyer/lender. Once identified, they would be raised with the
vendor/borrower and methods of eliminating/minimizing those risks can be discussed in order to avoid changes to the purchase price, loan amount, or loan security.
So, below are five of the more common “red flags” that buyers/lenders should look for when reviewing leases during the due diligence period since they can affect the “real” rental rate:
1. Set-off Right – these can be buried within a lease (usually around the default section) and provide the tenant with the ability to withhold or negate rent in whole or in part in certain circumstances such as landlord failure to repair, landlord default, anchor tenant “go dark” rights in a mall, to name a few. Large tenants with leverage usually fight for and quite often get set-off rights. These are like “the plague” to lenders but they are a reality.
2. Early Termination Right – if it’s for an anchor tenant then make sure its clear on how it is triggered (e.g. loss of anchor tenant in a mall, sale of business), that it has not been triggered yet, when the termination is effective, what if any fees are payable (such as repayment of the un-depreciated capital cost of any TIA), and whether there is a way to correct the trigger after it occurs and nullify the termination before the effective date.
3. Restoration – if the premises have been substantially renovated by the tenant or by the landlord on the tenant’s behalf, is there a restoration obligation on that tenant on lease termination/expiry? Is the tenant’s covenant sufficiently strong to protect the landlord or does the landlord have other security such as a Letter of Credit, to address it if the need arises? If not, then the restoration costs will be for the landlord (or lender) to incur in the future. Something as simple as a staircase connecting two floors can have a material restoration cost which arises at the end of the term and if the tenant is bankrupt and no security exists, then it falls to the landlord to deal with.
4. Future Capital Expenditures – occasionally you will find leases written to include an obligation on the landlord to spend a large amount of money at some point during the term for capital repairs (such as the roof or HVAC replacement). In some cases the cost may be for the landlord’s sole account. Even if it can be chargeable back, it may result in operating costs increasing to the point they are not competitive with the “going rate” in the area and thereby affect leasing.
5. Delayed Tenant Inducements – if rent free periods or leasehold allowance payments are staggered through-out the lease term, it is important they are identified and factored in to the pro-forma cash-flow estimates.
The Lesson: On any purchase or loan, make sure the major leases are reviewed by experienced leasing advisors to check for the issues noted above (in addition to the other usual business terms) to confirm what the real cash-flow is or might be. Sometimes you just may find a few “unpleasant” surprises but if addressed early enough with the vendor/borrower, and possibly the tenant in question, the purchase price/loan amount can be adjusted and still permit the transaction to proceed. Tenant estoppels will greatly assist in confirming the material lease terms….. but that is for another article.
Disclaimer: This article is for general information purposes only and not intended as or to be relied upon for legal advice. Consult with a lawyer for your unique situation.
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