Chapter 19 DRAFTING AND NEGOTIATING COMMERCIAL LEASE

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Chapter 19 DRAFTING AND NEGOTIATING

COMMERCIAL LEASE

Synopsis

PART A: TRANSACTIONAL CONTEXT

§ 19.01 Transactional Context—Drafting and Negotiating Commer-cial Lease

PART B: DRAFTING AND NEGOTIATING VARIOUS FORMS OF COMMERCIAL LEASE

§ 19.02 Checklist for Drafting and Negotiating Various Forms of Commercial Lease

§ 19.03 Negotiating Office Lease

§ 19.04 Considering Store Lease Provisions § 19.05 Advising About Shopping Center Lease

[1] Considering Mix of Shopping Center Tenants

[2] Negotiating Initial Occupancy or Continued Occupancy Rates

[3] Using Reciprocal Easement Agreement Instead of Shop-ping Center Lease Upstate

§ 19.06 Considering Commercial Loft and Industrial Lease Provisions

§ 19.07 Establishing Obligations Under Net Leases

§ 19.08 Negotiating Ground Lease Insurance and Appraisal Provisions

[1] Defining Ground Lease and Obtaining Insurance Coverage

[2] Negotiating Appraisal Provisions in Ground Lease § 19.09 Providing Purchase Options and Rights of First Refusal

[1] Drafting Option to Purchase Large Structures Demands Attention to Detail

[2] Drafting First Refusal or First Privilege Options PART C: DRAFTING AND NEGOTIATING TERM AND

PAY-MENT PROVISIONS IN COMMERCIAL LEASE

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§ 19.10 Checklist for Drafting and Negotiating Term and Payment Provisions in Commercial Lease

§ 19.11 Describing Demised Premises § 19.12 Determining Lease Term

§ 19.13 Negotiating Lease Term Commencement § 19.14 Providing for Renewals and Options to Renew

§ 19.15 Establishing Base Rent in Commercial Lease Negotiations [1] Negotiating Rent Clauses, Percentage Arrangements,

Escalation Clauses

[2] Tendering Rent Checks for Less Than Full Amount [3] Considering Tax Impacts of Periodic Rent Payments § 19.16 Negotiating Percentage Rent Lease Clauses

[1] Determining Formula for Setting Guaranteed Minimum Rent

[2] Specifying Time of Percentage Rent Payment and Avail-ability of Financial Records

[3] Adding Additional Restrictions and Exceptions § 19.17 Determining Structure of Escalation Clauses

[1] Defining Operating Expenses in Escalation Clause [2] Requiring Statement for Calculating Operating Expenses [3] Selecting Mechanism for Rent Increases Under

Escala-tion Clause

[4] Negotiating Pay Now, Fight Later Clauses § 19.18 Structuring Security Deposit Clauses

§ 19.19 Establishing Guarantor Obligations

PART D: DRAFTING AND NEGOTIATING RESTRICTION, AL-TERATION, AND REPAIR PROVISIONS IN COMMER-CIAL LEASE

§ 19.20 Checklist for Drafting and Negotiating Restriction, Alter-ation, and Repair Provisions in Commercial Lease

§ 19.21 Negotiating Use Restrictions

[1] Considering Landlord and Tenant Use Needs [2] Ensuring Tenant’s Intended Use Is Permissible [3] Negotiating Sign Requirements

§ 19.22 Drafting Non-Competition and Radius Restrictions on Ten-ant’s Business

§ 19.23 Defining Operating Covenants Governing Tenant’s Business

19–2 NEW YORK REAL PROPERTY

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[1] Negotiating Operating Covenants in Shopping Centers [2] Using Reciprocal Easement Agreements

§ 19.24 Prohibiting Businesses Competing with Retail or Shopping Center Tenant

§ 19.25 Allocating Costs of Complying with State and Federal Laws [1] Defining Conditions Under Which Each Party Is

Re-sponsible for Work

[2] Bearing Compliance Cost in Net Leases of Entire Buildings

[3] Subjecting Parties to ADA Compliance Costs § 19.26 Providing for Alteration and Improvement Rights

[1] Establishing Parameters of Tenant’s Right to Make Alterations

[2] Reviewing and Negotiating Work Letters [3] Providing for Inspections and Punch List Items [4] Considering Tax Treatment for Tenant Alterations § 19.27 Determining Repair and Maintenance Obligations

[1] Defining Structural Elements and What Constitutes Premises

[2] Negotiating Repair Obligations Under Long Term and Net Leases

[3] Specifying Responsibility for Maintaining Premises § 19.28 Incorporating Mechanics’ Lien Provisions into Repair,

Al-teration, or Compliance Clauses

PART E: DRAFTING AND NEGOTIATING ANCILLARY SER-VICE, TAX, AND INSURANCE PROVISIONS IN COM-MERCIAL LEASE

§ 19.29 Checklist for Drafting and Negotiating Ancillary Service, Tax, and Insurance Provisions in Commercial Lease § 19.30 Maintaining and Altering Common Area and Parking Space § 19.31 Offering Utilities and Energy to Tenant

[1] Purchasing Electricity [2] Allocating Electricity Costs

[3] Charging for Water Usage and Being Aware of Client’s Technological Needs

§ 19.32 Providing Heating, Ventilation, Air Conditioning, and Other Services

§ 19.33 Negotiating Real Property Tax Payment Responsibility

DRAFTING AND NEGOTIATING COMMERCIAL LEASE

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§ 19.34 Structuring Insurance Provisions

[1] Defining Nature and Amount of Property Insurance [2] Determining Insurance Cost and Cost Increases [3] Drafting Indemnification Clauses

PART F: DRAFTING AND NEGOTIATING COMMERCIAL LEASE PROVISIONS CONCERNING CONTINUED OCCU-PANCY AND DEFAULT

§ 19.35 Checklist for Drafting and Negotiating Commercial Lease Provisions Concerning Continued Occupancy and Default § 19.36 Delineating Rights in Event of Condemnation

§ 19.37 Establishing Obligations and Recovery for Destruction of Premises

§ 19.38 Negotiating Subletting and Assignment Rights

§ 19.39 Prescribing Arbitration and Appraisal Remedies If Disputes Occur

§ 19.40 Defining Default Responsibilities and Notice Requirements [1] Requesting Notice and Remedies

[2] Calculating Holdover Cost and Selecting Arbitration over Litigation

[3] Preserving Purchase and Renewal Rights Through Yel-lowstone Injunction

[4] Requiring Specific Performance and Attorneys’ Fees § 19.41 Requesting Documents in Sale or Mortgage of Landlord’s

Interest

[1] Requesting Estoppel Certificates from Tenant

[2] Executing SNDA Agreements with Mortgage of Land-lord’s Interest

§ 19.42 Permitting Mortgage of Long-Term Leasehold

PART G: DRAFTING AND NEGOTIATING OTHER COMMER-CIAL LEASE PROVISIONS

§ 19.43 Checklist for Drafting and Negotiating Other Commercial Lease Provisions

§ 19.44 Identifying Tenant’s Broker

§ 19.45 Determining Landlord’s Access to Premises, Representa-tions, Warranties, and Waiver

[1] Defining Landlord’s Right to Enter Premises

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[2] Setting Forth Prior Oral or Written Understandings [3] Failing to Insist on Strict Performance Not Waiver § 19.46 Dealing with Bankruptcy, Fees, Expenses, and Waiver of

Jury Trial

§ 19.47 Coping with Failure to Give Possession and Inability to Perform

§ 19.48 Enforcing Rules and Regulations § 19.49 Relocating Tenants

§ 19.50 Understanding Execution, Recording, and Priority of Lease

DRAFTING AND NEGOTIATING COMMERCIAL LEASE

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PART A: TRANSACTIONAL CONTEXT

§ 19.01 Transactional Context—Drafting and Negotiating Commercial Lease

Chapter 19 focuses on the issues faced by attorneys who draft and negotiate commercial leases when representing landlords and tenants in commercial real estate leasing situations.

Though there are many common characteristics, each of the various types of commercial property, including office, store, shopping center, commercial loft, and industrial, requires a special-ized lease. Net leases and ground leases have special provisions of which counsel must be aware. Purchase options and rights of first refusal are often included as clauses in a commercial lease. Set forth is a section-by-section analysis of many of the provisions common in most commercial leases and how attorneys can deal with the issues those provisions raise.

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PART B: DRAFTING AND NEGOTIATING

VARIOUS FORMS OF COMMERCIAL LEASE

§ 19.02 Checklist for Drafting and Negotiating Various Forms of Commercial Lease

M Negotiate office lease. See § 19.03 below.

Inform client that typical office lease provides full range of services to tenant, including heat, air condi-tioning, cleaning, elevators, and water for ordinary lavatory purposes.

Explain that, as incentive to signing lease, landlords usually offer:

Work letter describing amount of standard alter-ations landlord will provide;

Procedure for preparing and approving plans and specifications for improvements; and

Pricing and payment details for above standard improvements desired by tenant.

Negotiate rent escalation provisions relating to future increases in operating expenses, electricity, and real property taxes.

Establish prior approval and consent requirements for alterations, assignment, and subletting of premises.

M Address issues involved with store lease. See § 19.04

below.

Inform client that typical store lease provides limited services by landlord, including heat and water for ordinary lavatory purposes, water meter installation, and delivery of bare shell of space.

Ensure that clients know tenant is responsible to im-prove space at its expense, clean and air condition its space, erect and maintain signs and exteriors, extermi-nate vermin, replace damaged plate and other glass, and install any required sprinklers.

§ 19.02 DRAFTING AND NEGOTIATING COMMERCIAL LEASE

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Advise that store leases often provide guaranteed mini-mum rent plus percentage of tenant’s income, with controls on manner of business operation, proper re-cord-keeping, and radius restrictions under which ten-ant will not be allowed to compete with itself. Determine whether landlord will be permitted to lease to competing businesses.

Discuss possibility of larger retailers seeking long-term lease and requesting right to freely assign or sublease without landlord unreasonably withholding consent.

M Advise concerning issues involved with shopping center

lease. See § 19.05 below.

Determine and negotiate restrictions on type of business tenant can conduct on premises and within specified distance from premises. See § 19.05 [1] below. Review and negotiate shopping center lease and, any attached agreements including work letters and recipro-cal easement agreements as to use, maintenance, and repair of common areas. See § 19.05 [1] below. Determine whether shopping center lease will contain clause conditioning tenant’s initial or continued pancy on continued occupancy of key tenant or occu-pancy of specified percentage of space. See § 19.05 [2] below.

Negotiate issues involved with requiring membership in merchant’s association, including membership being contingent upon certain percentage of stores joining association. See § 19.05 [2] below.

Decide whether reciprocal easement agreement should be used rather than traditional shopping center lease (primarily used in upstate New York). See § 19.05 [3]

below.

M Address issues involved with commercial loft and industrial

leases. See § 19.06 below.

Inform client that typical commercial loft lease pro-vides various services, including passenger elevator,

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freight elevator, heat, and water for ordinary lavatory purposes.

Ensure that clients know tenant is responsible to clean and air condition its space, pay for water usage based on meter, replace damaged plate and other glass, and install any required sprinklers.

Determine whether large-scale industrial use and lease of entire building is involved to anticipate tenant’s substantial responsibility for repairs, maintenance, and extensive alterations.

Investigate environmental and zoning issues often present in large-scale industrial uses and negotiate legal compliance clauses accordingly.

Negotiate utilities provisions, particularly in multi-tenant buildings.

M Establish obligations of parties under net lease. See § 19.07

below.

Define net lease factors including assumption of opera-tion costs, risk of loss in case of fire or casualty, and repairs.

Explain to client difference between net net and triple net leases where tenant assumes all costs except debt service, and pure net lease, where tenant can also pay debt service requirements.

Request right to audit landlord’s books if tenant paying landlord’s expenses under net lease.

Specify obligations of parties since disputes often arise because net, net net, and triple net leases do not have universal meaning.

M Negotiate ground lease insurance and appraisal provisions.

See § 19.08 below.

Advise client that ground leases apply to unimproved land, vary from 50 to 99 years or longer (under 50 years in upstate New York), and are generally structured as net leases. See § 19.08 [1] below.

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Inform client that tenant is usually given broad use clause, liberal right to sublease, and right to erect, alter, use, and demolish structures. See § 19.08 [1] below. Determine whether demolition and construction are contemplated and ensure that tenant provides casualty and liability coverage once building is complete. See § 19.08 [1] below.

Explain that appraisal determines fair market rental value of land and periodic adjustment of rent in ground lease. See § 19.08 [2] below.

Negotiate provision describing standard to be applied by appraiser as that standard is crucial. See § 19.08 [2] below.

M Discuss purchase options and rights of first refusal. See

§ 19.09 below.

Ensure that time is of essence for exercise of option or right of first refusal. See § 19.09 [1] below. Emphasize and carefully monitor financing details, insurance, waiver of subrogation, impact on other tenants, and operative options inherent in purchase option negotiations. See § 19.09 [1] below.

Draft purchase option with same attention to detail as contract of sale. See § 19.09 [1] below.

Ensure client understands that first refusal or first privilege options grant qualified right to purchase exercisable only if landlord decides to sell at specified price or price agreed to by bona fide third party. See § 19.09 [2] below.

Ensure any deal agreeable to third party is available to tenant possessing right of first refusal. See § 19.09 [2] below.

M Search Advisor:

Real & Personal Property Law > Landlord & Tenant > Commercial Leases

Real & Personal Property Law > Sales, Exchanges & Remedies > Options

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M Investigate Parties on lexis.com®. See § Intro.09 above.

§ 19.03 Negotiating Office Lease

A typical office lease provides a full range of services to the tenant, including heat, air conditioning, cleaning, elevators, and water for ordinary lavatory purposes. The landlord usually offers a work letter describing the amount of standard alterations that the landlord will provide as an incentive to sign the lease, a procedure for preparing and approving plans and specifications for the improvements, and pricing and payment for above standard im-provements desired by the tenant.

t Warning: The lease usually includes a rent escalation

provision with respect to future increases in operating expenses, electricity, and real property taxes. Conse-quently, tenant’s attorney should carefully review all escalation provisions.

Landlords insist on prior approval of alterations to the premises and to assignments and subletting of the premises. Some small businesses choose to rent a larger suite (which may cost somewhat less per square foot) and then defray the cost by subleasing portions of the premises to others. For these tenants, the right to sublease may be of major importance.

z Strategic Point: Tenant’s counsel, particularly when

electing to rent a larger suite, should negotiate with the landlord to not unreasonably withhold consent to assign-ments and subletting.

PRACTICE RESOURCES:

● Warren’s Weed: New York Real Property Ch. 81 (Leasing

of Property: Assignments and Subleases).

● Warren’s Weed: New York Real Property § 82.14 (tenant’s

right to make alterations).

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● New York Practice Guide: Real Estate § 25.05 [2][b][ii]

(PG: offices), § 25.03 [3][a] (escalation clauses), § 25.03 [4] (alterations of premises), § 25.06 [2][d] (escalation clauses), § 25.06 [8] (utilities and energy), § 25.07 [1] (Form No. 25-1: Office Lease), § 28.01 (assignments and subleases), § 28.02 (commercial leases: assignments and subleases), § 28.04 (Checklist: Drafting Assignment or Sublease Clause; Commercial Leases and Residential Leases Not Covered by RPL § 226-b).

● Steinman’s Bergerman and Roth, New York Real Property

Forms Annotated Form No. 209 (Office Lease).

§ 19.04 Considering Store Lease Provisions

A typical store lease will provide for limited services by the landlord, including heat and water for ordinary lavatory purposes. A water meter will usually be installed, with the tenant directly paying for water usage. The tenant under a store lease is responsible to perform the following:

1. Clean and air condition space;

2. Erect and maintain signs and exterior (including sidewalks); 3. Exterminate vermin; and

4. Replace damaged plate and other glass.

The landlord will usually provide a bare shell of space that the tenant must improve at its expense, with plans subject to landlord approval. The tenant will likely be responsible for installation of any required sprinklers.

Many store leases provide a guaranteed minimum rent plus a percentage of the tenant’s income, which represents an incentive for landlords to be concerned with the manner of operating the business (hours, etc.) and expect proper record-keeping to establish the rent amount on a reliable basis. The landlord may be interested in radius restrictions where the tenant will not be allowed to compete with itself in a manner possibly reducing the percentage rent yield. On the other hand, tenants may want to ask the landlord not to lease to competing businesses.

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Larger retail tenants will seek long-term leases and demand the right to freely assign or sublease. The leasehold may be one of the most important assets involved in a proposed business sale. The landlord will want to maintain as much control over assignment or subletting as possible, but should not unreasonably withhold its consent.

z Strategic Point: It is good practice for tenant’s attorney

to write into a store lease objective standards for determin-ing when a landlord must act reasonably with respect to a request for assignment, for example, net worth values of the tenant before and after assignment.

● Warren’s Weed: New York Real Property Ch. 56 (Fixtures). ● Warren’s Weed: New York Real Property § 82.14 (tenant’s

● New York Practice Guide: Real Estate § 25.05 [2][b][iii]

(PG: shopping centers and stores), § 25.03 [a] (percentage lease), § 25.03 [4] (alterations of premises), § 25.03 [8] (use of leased premises), § 25.06 [2][c] (percentage rents), § 25.06 [3] (alterations and improvements), § 25.06 [10] (use of leased premises), § 25.07 [2] (Form No. 25-2: Store Lease), § 25.08 [2][b] (percentage lease).

Forms Annotated Form No. 201 (Retail Store Lease), Form

No. 223 (Rent), Form No. 224 (Rent), Form No. 244 – Form No. 256 (uses and operations), Form No. 260–Form No. 273.1 (repair and alterations), Form No. 294 – Form No. 295.3 (assignment and subletting).

● Partnership Law § 11 (gross receipt sharing not

partnership).

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§ 19.05 Advising About Shopping Center Lease [1] Considering Mix of Shopping Center Tenants

A shopping center is unique in that the stores depend upon each other. For example, a small boutique may rely upon an anchor tenant (usually branch of department store chain).

z Strategic Point: Both the landlord and tenant are

particularly concerned with the tenant mix at the shopping center. Accordingly, tenant’s counsel should negotiate to restrict the landlord’s ability to lease to the tenant’s competitors, and landlord’s counsel should negotiate for restrictions on the type of business the tenant can conduct both on the premises and within a specified distance from the shopping center (radius restrictions).

In addition to very specialized leases, shopping centers often have other agreements, including work letters describing the landlord’s finished work and reciprocal easement agreements as to use of the shopping center’s common areas.

[2] Negotiating Initial Occupancy or Continued Occupancy Rates

Tenants are also concerned with the viability of the shopping center as a whole. Business for each tenant in a fully-rented shopping center (which attracts large number of buyers) is likely to be more profitable than when many of the stores are empty. Thus, a tenant may ask for clauses conditioning the initial occupancy, or continuance of occupancy, upon the continued occupancy of a particular tenant or the continued occupancy by other tenants of a specified percentage of the shopping center space.

z Strategic Point: If the landlord proposes mandatory

membership in a merchants’ association, often requiring that tenant’s participate in and pay for certain shopping

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center promotional activities, tenant’s counsel should nego-tiate for membership being contingent upon a certain percentage of stores joining, and for reasonable, fairly enforced, rules.

[3] Using Reciprocal Easement Agreement Instead of Shopping Center Lease Upstate

In upstate New York, it is common for a Reciprocal Easement Agreement (REA) to take the place of a shopping center lease. The REA covers many of the same business points addressed in a shopping center lease. Reciprocal Easement Agreements involve the developer and large, anchor stores as owners with the developer then leasing its space to small tenants. The REA provides for reciprocal easements over the property of each owner for the following:

1. Ring roads;

2. Ingress, egress, and access; 3. Parking;

4. Repair of parking lots (including right of self help); and 5. Maintenance, repair, replacement, and related matters. The REA usually contains operating covenants whereby each owner agrees to operate a retail store for a certain number of years, sometimes specifying the store name. The REA is superior in priority to the lien of construction and superior in priority to permanent loans on the property of each owner, and is thereby not cut off by foreclosure of any one or more of those loans.

● Warren’s Weed: New York Real Property Ch. 56 (Fixtures). ● Warren’s Weed: New York Real Property § 82.14 (tenant’s

right to make alterations), § 84.07 (shopping center lease provisions).

● New York Practice Guide: Real Estate § 25.05 [2][b][iii]

(PG: shopping centers and stores), § 25.03 [3][a] (percent-age lease), § 25.03 [4] (alterations of premises), § 25.03

§ 19.05[3] DRAFTING AND NEGOTIATING COMMERCIAL LEASE

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[8] (use of leased premises), § 25.06 [2][c] (percentage rents), § 25.06 [3] (alterations and improvements), § 25.06 [6] (common areas and parking), § 25.06 [10] (use of leased premises), § 25.08 [2][b] (percentage lease), § 25.08 [6] (common area clause for shopping center).

● Real Estate Financing: Text, Forms, Tax Analysis § 14.06

(leasing shopping center: financing issues).

Forms Annotated Ch. 3B (Shopping Center Lease

Checklist).

Forms Annotated Form No. 200.14 (Lease to Anchor or Key

Tenant: Shopping Center to be Built), Form No. 200.15 (Landlord-Oriented Shopping Center Lease), Form No. 200.16 (Tenant-Oriented Shopping Center Lease), Form No. 223 (Rent Based on Net Profits), Form No. 224 (Percentage Rent Rate Based on Gross Sales), Form No. 244 – Form No. 256 (uses and operations).

§ 19.06 Considering Commercial Loft and Industrial Lease Provisions

Commercial loft leases will often provide for a range of services, including passenger elevator, freight elevator, heat, and water for ordinary lavatory purposes. A water meter will usually be installed, with the tenant paying directly for its water usage. The tenant is also responsible for cleaning and air conditioning its space, replac-ing damaged plate and other glass, and installreplac-ing any required sprinklers. Depending on the market, standard tenant improvements may be offered by the landlord.

Large-scale industrial uses may involve the leasing of entire buildings. In such cases, the lease usually requires the tenant to assume substantial responsibility for repairs and maintenance. Extensive tenant alterations are usually involved.

t Warning: Legal compliance clauses relating to utilities

are important elements in industrial park or multi-tenanted

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single building lease negotiations since large-scale indus-trial uses tend to raise environmental and zoning concerns. For example, where one tenant uses a particularly large supply of electric current, both the landlord and other tenants will expect the tenant to pay a fair share of costs.

● New York Practice Guide: Real Estate § 25.05 [2][b][iv]

(PG: industrial leases), § 25.03 [4] (alterations of premises), § 25.03 [5] (obligation to repair premises), § 25.06 [3] (alterations and improvements), § 25.06 [4][d] (commercial leases, repairs and maintenance), § 25.06 [8] (utilities and energy).

Forms Annotated Form No. 205 (Loft Lease), Form No. 260

– Form No. 273.1 (repair and alterations).

§ 19.07 Establishing Obligations Under Net Leases

Generally, under a net lease, the landlord is guaranteed a specified return and the tenant assumes full operation cost and risk of loss in case of fire or other casualty. The net lease tenant is responsible for all repairs, in some instances including those repairs deemed structural (roof, exterior walls, etc.). In net net or triple net leases, the tenant assumes all costs except debt service. In pure net leases, the tenant may even pay the debt service requirements on the mortgage. Since a net lease involves the tenant’s payment of landlord’s expenses, tenant’s attorney should request the right to audit the landlord’s books.

z Strategic Point: The terms net lease, net net lease, and

triple net lease do not have universal meaning and conse-quently counsel must be precise in establishing the respec-tive obligations of each party to avoid disputes.

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● New York Practice Guide: Real Estate§ 25.05 [2][b][v]

(PG: net leases), 25.03 [5][a][i] (common law repair obliga-tions), § 25.06 [3] (alterations and improvements), § 25.06 [13] (destruction of or damage to premises by fire or other casualty), § 25.08 [3][c] (Form No. 25-24: Agreement by Lessee to Alter Building), § 25.08 [4][d] (Form No. 25-28: Tenant’s Obligation to Repair Premises: Landlord’s Right on Tenant’s Default), § 25.08 [12][b] (Form No. 25-66: Destruction or Damage: Full Risk of Loss Upon Tenant).

Forms Annotated Form No. 218 – Form No. 233 (Rent),

Form No. 252, Form No. 252.1, Form No. 252.2 (legal compliance), Form No. 298.1 – Form No. 299.2 (liability allocation), Form No. 260 – Form No. 273.1 (repair and alterations), Form No. 291, Form No. 292, Form No. 293 (insurance).

§ 19.08 Negotiating Ground Lease Insurance and Appraisal Provisions

[1] Defining Ground Lease and Obtaining Insurance Coverage

A ground lease, defined broadly, is any lease for rental of unimproved land. Ground leases downstate vary in term from 50 to 99 years or longer and are generally structured as net leases. In upstate New York, the term of a ground lease is usually less than 50 years, often 20 to 30 years, depending upon the type of leasehold financing available.

Ground lease tenants are generally given a substantial amount of control over the property through a broad use clause; liberal right to sublease; and right to erect, alter, use, and demolish structures.

t Warning: Landlord’s attorney in a ground lease should

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ensure that the tenant procure insurance coverage where demolition and construction are contemplated.

During construction, the tenant is generally required to maintain liability, workers’ compensation, and builder’s risk coverage. Once the building is complete, the tenant should be required to provide casualty and liability coverage, with coverage periodically adjusted to reflect the current property value.

[2] Negotiating Appraisal Provisions in Ground Lease

z Strategic Point: Ground leases characteristically

pro-vide for periodic adjustment of rent, based on the fair market rental value of the land. The value is usually determined by appraisal. Consequently, it is crucial that counsel carefully negotiate lease provisions detailing the standard to be applied by the appraiser.

A properly drawn appraisal provision should state the following: 1. Whether land is to be valued for highest and best use,

regardless of use then made of property;

2. Whether land should be valued as unencumbered by then-existing improvements; and

3. Whether land should be valued without regard to then-existing subleases.

To the extent the land is valued without regard to the then-existing improvements and leases, the tenant assumes the risk of obsolescence of use and risk of improvements and subleases that lower the property value due to below-market rents. The appraisal clause usually provides for an arbitration procedure, with each party appointing an appraiser, and a mechanism for resolving the inevita-ble difference between appraisals.

● Warren’s Weed: New York Real Property § 84.14, § 84.15

(term of ground lease and general provisions).

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● New York Practice Guide: Real Estate § 25.05 [2][b][vi]

(PG: ground leases), § 3.26 [10][c][iii] (mortgaging of fee), § 25.08 [4][d] (Form No. 25-28: Tenant’s Obligation to Repair Premises: Landlord’s Right on Tenant’s Default), § 25.08 [12][b] (Form No. 25-66: Destruction or Damage; Full Risk of Loss Upon Tenant), § 28.04 (Checklist-Drafting Assignment or Sublease Clause; Commercial Leases and Residential Leases Not Covered by RPL § 226-b).

● Real Estate Financing: Text, Forms, Tax Analysis § 7.05

(important ground lease provisions).

Forms Annotated Form No. 202 (99 Year Lease), Form No.

260 (Covenant by Lessee to Make Repairs), Form No. 267 (Lessee to Alter Building and Assume All Costs), Form No. 270.2 (Lessee to Furnish Bond to Secure Lessor Against Mechanics’ Liens).

● LexisNexis AnswerGuide New York Civil Disclosure § 2.16

(obtaining insurance policy contents).

● IRC § 162, § 178, § 469 (tenant tax deductions, tenant’s

writing-off acquisition cost, portfolio income).

§ 19.09 Providing Purchase Options and Rights of First Refusal

[1] Drafting Option to Purchase Large Structures Demands Attention to Detail

s Timing: Landlord’s attorney should make time of the

essence for exercise of any option or right of first refusal.

For large shopping centers, high-rise office buildings, and other large structures, an option to purchase demands that attorneys devote particular attention to the following:

1. Financing; 2. Insurance;

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3. Waiver of subrogation; 4. Rules and regulations;

5. Impact upon other tenants; and

6. Myriad problems that may arise if option becomes operative.

z Strategic Point: Drafting an option to purchase

de-mands as much attention to detail and minutiae as a contract of sale and should be approached by counsel with the same level of precision.

Issues of price and other terms are sometimes left for later negotiation with the provision that if the parties are unable to agree, the dispute will be resolved by arbitration or appraisal.

● Warren’s Weed: New York Real Property §§ 32.145 –

32.154 (options), §§ 101.11 – 101.16 (options contained in leases).

● New York Practice Guide: Real Estate § 29.02 (purchase

options), § 29.06 (Checklist for Option to Purchase), § 29.09 [1] (Form No. 29-7: Lease Clause Providing for Tenant’s Option to Purchase with Contract of Sale At-tached), § 29.09 [2] (Form No. 29-8: Tenant’s Option to Purchase), § 29.09 [3] (Form No. 29-9: Tenant’s Option to Purchase: Nature of Title to be Transferred), § 29.09 [4] (Form No. 29-10: Subtenant’s Option to Purchase Sublan-dlord’s Interest in Ground Lease), § 29.09 [7] (Form No. 29-13: Option to Purchase at Appraisal Price).

Forms Annotated Form No. 277 (Tenant’s Option to

Pur-chase (first refusal), Form No. 277.1 (Option to PurPur-chase at Stated Price), Form No. 277.2 (Option to Purchase at Stated Price with Reduction for Damage), Form No. 278 (Purchase Price Subject to Increase by Index), Form No.

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278.1 (Option to Purchase After Lessor’s Election to Cancel Lease on Bona Fide Sale), Form No. 340 (Notice of Election to Purchase Leased Premises).

● GOL § 5-703, § 5-1103 (statute of frauds, modifications

not invalid for lack of consideration).

[2] Drafting First Refusal or First Privilege Options

First refusal or first privilege options to buy are valid, but grant a qualified right to purchase exercisable only if the landlord decides to sell at either a specified price or one agreed to by a third party, and the lessor cannot be compelled to sell. With large buildings and developments leased to numerous tenants, price may be only one of a number of vital factors considered.

Any deal agreeable to a third party must be made available to a tenant who has a right of first refusal, unless provision to the contrary is specifically included in the option clause. The offer of the third party must be bona fide, which may be difficult to ascertain and give rise to possible litigation. The landlord should exclude transactions with its affiliates. Proper safeguards inserted into the option agreement can narrow possible areas of controversy. An option or right of first refusal may run afoul of the Rule Against Perpetuities if it may be exercised beyond lives in being plus 21 years.

● Warren’s Weed: New York Real Property §§ 32.145 –

32.154 (options), §§ 101.11 – 101.16 (options contained in leases).

● New York Practice Guide: Real Estate § 29.02 (purchase

options), § 29.02 [4] (first refusal options), § 29.07 (Checklist for Exercise of Right of First Refusal), § 29.09 [5] (Form No. 29-11: Tenant’s Right of First Refusal), § 29.09 [6] (Form No. 29-12: Tenant’s Right of First Refusal to Purchase at Stated Price), § 29.09 [7] (Form No. 29-13: Option to Purchase at Appraisal Price).

Forms Annotated Form No. 277 (Tenant’s Option to

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Purchase: First Refusal), Form No. 277.1 (Option to Pur-chase at Stated Price), Form No. 277.2 (Option to PurPur-chase at Stated Price with Reduction for Damage), Form No. 340 (Notice of Election to Purchase Leased Premises).

● GOL § 5-703, § 5-1103 (statute of frauds, modifications

not invalid for lack of consideration).

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PART C: DRAFTING AND NEGOTIATING

TERM AND PAYMENT PROVISIONS IN

COMMERCIAL LEASE

§ 19.10 Checklist for Drafting and Negotiating Term and Payment Provisions in Commercial Lease

M Ensure that demised premises is adequately described. See

§ 19.11 below.

Advise client that amount of square feet in demised premises should not be relied upon if represented because rentable square feet is artificial amount greater than usable area.

Ensure that base rent is stated as flat amount instead of amount based on square footage.

Expect that office space in New York City will be rented based on rentable square feet.

Counsel that tenant should and often does ask landlord for loss factor.

M Establish length of lease term. See § 19.12 below.

Negotiate length of lease term in conjunction with provisions governing commencement. In absence of formal agreement, certain legal rules may control com-mencement or length of term.

M Prepare client for commencement of term. See § 19.13

below.

Caution client that obligation to pay rent usually coin-cides with commencement of lease term, even if tenant does not take possession at that time.

Consider conditioning commencement of shopping center lease term on commencement of operations of anchor tenants or other stores.

Define terms specifically where lease commencement date is dependent upon substantial completion of construction.

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Negotiate remedies for late commencement, including rent abatement, cancellation rights, liquidated damages, and term extensions.

M Anticipate issues involved with renewals and options to

renew. See § 19.14 below.

Ensure client is aware that renewal or extension can be provided for in original lease, may be on same or different terms, and, along with options and rights of first refusal, can be conditioned on tenant not being in default.

Determine whether renewal clause takes form of right of first refusal, thus obligating landlord to renew with tenant upon terms third party accepts.

Inform client that, barring express or implied agreement to contrary, lease lacking renewal clause becomes month-to-month tenancy at end of term where tenant remains in possession.

M Negotiate base rent provisions. See § 19.15 below.

Ensure that base rent clause clearly states annual rent and amount due per installment, along with specific grace period. See § 19.15 [1] below.

Negotiate for grace periods of 15 days for payment defaults (5–10 days upstate) and 30 days for other defaults. See § 19.15 [1] below.

Negotiate possibility of free rent period allowing time to prepare space and as inducement to renting. See § 19.15 [1] below.

Determine whether lease will include acceleration clause allowing landlord to accelerate rent due date and sue for future rents. See § 19.15 [1] below.

Establish that payments due from tenant to landlord other than base rent be recited as additional rent. See § 19.15 [1] below.

Specify whether payment by tenant of lesser amount than amount stipulated will impair landlord’s right to collect additional amounts due, and whether landlord

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can deposit tenant’s check without prejudice to land-lord’s rights. See § 19.15 [2] below.

Consider and inform clients concerning tax impacts of periodic rent payments. See § 19.15 [3] below.

M Define percentage rents under percentage rent lease. See

§ 19.16 below.

Ensure that percentage rent lease contains carefully drawn and detailed procedures to avoid disputes as to definition of terms. See § 19.16 [1] below.

Explain that percentage rent lease provides that all or part of rent will be based upon percentage of tenant’s gross or net income from its business, and usually carries guaranteed minimum. See § 19.16 [1] below. Determine appropriate formula to use in calculating guaranteed minimum rent. See § 19.16 [1] below. Define types of sales included and excluded from calculation of gross sales. See § 19.16 [1] below. Specify time when percentage rent payment will be due. See § 19.16 [2] below.

Inform client of need under percentage rent lease to keep regular and accurate records of gross sales, copies of income and sales tax returns, and financial state-ments. See § 19.16 [2] below.

M Draft escalation clauses and define related matters,

includ-ing audits and exclusions from cost. See § 19.17 below. Negotiate terms of escalation clauses designed to cover increasing costs of owning and operating building, including pass-throughs of increases in actual operating costs. See § 19.17 [1] below.

Specify allowable exclusions from cost. See § 19.17 [1] below.

Determine rights of tenant to audit operating costs and establish level of increase required before tenant can audit. See § 19.17 [2] below.

Determine whether statements of operating costs will be prepared by independent managing agent or CPA

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and if tenant has right to audit operating costs. See § 19.17 [2] below.

Consider alternative escalation clauses that include escalating rent by same percentage as increases in components of expenses, including union wages or pegging escalation to inflation index. See § 19.17 [3]

below.

Ascertain need for pay now, fight later clause in anticipating escalation clause disputes. See § 19.17 [4]

below.

M Establish form and features of security deposits. See

§ 19.18 below.

Inform client that commercial leases are not covered by all tenant-protection provisions of law governing security deposits, including interest payment requirement.

Determine form of security deposit, which can include deposited cash, irrevocable letters of credit, marketable securities, and security interests in tenant’s movable trade fixtures.

Ensure receipt of notice for any sale of property and written evidence that purchaser has assumed obligation to return security deposit.

Negotiate whether deposit will burn down after period of satisfactory performance.

M Consider and negotiate various types of guarantees. See

§ 19.19 below.

Seek absolute and unconditional guarantee of payment as this is preferable to guarantee of collection.

Caution that absolute and unconditional guarantee of payment, unlike guarantee of collection, will prevent guarantor from invoking tenant defenses. Consider Good Guy Guarantee as compromise and explain that it continues only until tenant physi-cally and legally surrenders premises vacant, in

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satisfactory condition, and free of occupancy rights.

Draft guarantee to cover lease modifications or extensions.

Counsel client that guarantee may induce landlord to rent to start-up business.

M Search Advisor:

Real & Personal Property Law > Landlord & Tenant > Commercial Leases

Real & Personal Property Law > Sales, Exchanges & Remedies > Options

§ 19.11 Describing Demised Premises

The demised premises should be carefully described in the lease, to avoid later disputes. A lease of land should use a metes and bounds description, or a reference to a lot on a filed map. A lease of space, for example, an office or store lease, will usually refer to a space by number or to an attached floor plan.

Since the method of measuring square footage of the premises is not always clear, most landlords are reluctant to represent in writing that the premises contain a particular number of square feet, even though the base rent and escalation provisions are commonly based on the landlord’s square footage calculation.

t Warning: Rentable square feet is an artificial

measure-ment used to calculate the rent per square foot. The tenant should not order carpeting based on the rentable square feet.

Office space has customarily been rented in New York City based on rentable square feet, an artificial measurement based on the size of the space, but also containing various additions for a share of space devoted to air conditioning and other factors. Some landlords simply declare that the square footage figure is how they calculate the rent on a take it or leave it basis, and average tenants

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generally do not win arguments with landlords about this issue. The mathematical result of increasing the square footage above the actual footprint of the space is to lower the dollars per square foot of rent charged.

z Strategic Point: Landlords should be careful to state

base rent as a flat amount, not an amount based on square footage, to avoid controversy about the measurement. Tenants can compare space in different buildings by asking each landlord what the loss factor is between rentable and usable square footage.

● Warren’s Weed: New York Real Property § 84.02 (rent and

related obligations).

● New York Practice Guide: Real Estate § 25.05 [2][b][i][G]

(quantity of space leased), § 25.07 [1] (Form No. 25-1: Office Lease, Witnesseth Clause), § 25.07 [2] (Form No. 25-2: Store Lease, Witnesseth Clause).

§ 19.12 Determining Lease Term

s Timing: Under the statute of frauds, a lease exceeding

one year cannot be created without an agreement in writing.

The length of the lease, though basic, often must be negotiated in conjunction with provisions governing commencement, which can be complicated when the premises are not ready for occupation. In absence of a formal agreement, certain legal rules control.

s Timing: An agreement for occupation of real estate

in New York City that does not specify duration of the occupation will be deemed to continue until the October

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1st following the time possession commences under the agreement.

A periodic tenancy (month-to-month, quarter-to-quarter, or year-to-year) can be created by design and intent, or entry under an invalid lease. An entry by a tenant under an invalid oral lease, void under the statute of frauds, was held in one case to create a tenancy-at-will, which was converted to a periodic tenancy as a result of parties actions. Where a tenant whose term is longer than one month holds over after expiration of the term, unless the parties agree otherwise, a month-to-month tenancy will be created by the tenant’s payment and landlord’s acceptance of rent after lease expiration.

● Warren’s Weed: New York Real Property § 80.11 (statute

of frauds), § 80.12, § 80.13, § 80.14, § 80.15 (short-term or indefinite tenancies), § 80.24, § 80.25, § 80.26 (cove-nant to deliver possession).

● New York Practice Guide: Real Estate § 25.01 [2] (statute

of frauds), § 25.03 [2][a][ii] (effect of rule against restraints on alienation), § 25.06 [1] (lease commencement), § 25.07 [1] (Form No. 25-1: Office Lease ¶ 24), § 25.07 [2] (Form No. 25-2: Store Lease ¶ 21, ¶ 23), § 25.08 [1] (commence-ment of term).

Tenant: Shopping Center to be Built, Article 2), Form No. 200.15 (Landlord-Oriented Shopping Center Lease, Article 3), Form No. 200.16 (Tenant-Oriented Shopping Center Lease, Articles 3 and 8), Form No. 201 (Retail Store Lease, Article II), Form No. 205 (Loft Lease, Witnesseth Clause), Form No. 209 (Office Lease, Article 2).

● EPTL § 6-1.1(5) (tenancies from period to period). ● RPL § 223-a (implied covenant to deliver possession at

beginning of term).

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● RPL § 232 (termless leases continue until next October 1st

in New York City).

● RPL § 232-c (month-to-month tenancy implied after

holdover).

§ 19.13 Negotiating Lease Term Commencement

The obligation to pay rent usually coincides with commencement of the term, whether or not the tenant takes possession at that time.

s Timing: In shopping centers, tenants may want to

condition lease commencement on commencement of operations of anchor tenants or other stores.

When the lease commencement date depends upon substantial completion of construction, it is important to define the terms. The time of commencement may be keyed to procurement of a tempo-rary or permanent certificate of occupancy, or other factors more specifically related to the tenant’s business. A central factor is whether it is the landlord or tenant who will be doing construction. Where the existing premises are currently occupied by a prior tenant whose lease will soon expire, provision should be made to cover delays, especially where summary proceedings are required. Leases include a variety of remedies for late commencement, including the following:

1. Rent abatements; 2. Cancellation rights; 3. Liquidated damages; and 4. Term extensions.

RPL § 223-a provides that, unless otherwise agreed, there is implied in every lease a covenant that the landlord will deliver possession at the beginning of the term. Landlords not wanting to be bound by this section will ask for a recitation that the lease provision agreed upon is an express provision contrary to RPL § 223-a.

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● Warren’s Weed: New York Real Property § 80.24, § 80.25,

§ 80.26 (covenant to deliver possession).

● New York Practice Guide: Real Estate § 25.06 [1] (PG:

lease commencement), § 25.07 [1] (Form No. 25-1: Office Lease, Witnesseth and ¶ 24), § 25.07 [2] (Form No. 25-2: Store Lease, Witnesseth and ¶ 23), § 25.08 (commencement of term clauses), § 25.08 [1][b] (Form No. 25-4: Delivery of Possession, Alternative Remedy Provisions), § 25.08 [1][c] (Form No. 25-5: Failure to Give Possession, Abate-ment with no Landlord Liability).

Tenant: Shopping Center to be Built, Articles 2 and 8), Form No. 200.15 (Landlord-Oriented Shopping Center Lease, Article 3), Form No. 200.16 (Tenant-Oriented Shopping Center Lease, Articles 3 and 8), Form No. 201 (Retail Store Lease, Articles II and III), Form No. 205 (Loft Lease, Witnesseth and ¶ 24), Form No. 209 (Office Lease, Articles 2 and 4), Form No. 317 (No Liability Upon Lessor’s Failure to Deliver Prompt Possession).

● EPTL § 9-1.1 (rule against perpetuities: leases need

ascer-tainable beginnings).

● RPL § 223 (rescission right for failure to deliver).

● RPL § 223-a (implied covenant to deliver possession at

beginning of term).

§ 19.14 Providing for Renewals and Options to Renew

There is no right to renew or extend a commercial lease except by agreement of landlord and tenant. Renewal or extension may be provided for in the original lease and may be based on the same or different terms (for example, different rate of rent). Some landlords condition renewal, option, and right of first refusal rights on the tenant not being in default.

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Automatic renewal clauses ordinarily provide that the lease is renewed for the same period or a specified number of years on the same terms, unless the tenant gives notice of intention not to renew within a certain period prior to expiration. Automatic renewal clauses have fallen from favor because of GOL § 5-905.

s Timing: GOL § 5-905 requires landlords to notify

tenants, in writing, of an automatic renewal provision not more than 30 days nor less than 15 days prior to the deadline for tenant’s notification of intent not to renew. If the landlord fails to notify the tenant, a renewal cannot be claimed by the landlord, but the tenant does not lose the right to renew.

Renewal clauses sometimes take the form of a right of first refusal. Such a qualified, contingent option may or may not contain terms applying in the event the contemplated contingency occurs. In some instances, this right of first refusal merely grants a privilege to negotiate for renewal, with an implied obligation of the landlord to renew with the tenant upon terms that a third party accepts. Such privilege to negotiate arrangements should be avoided due to their inherent uncertainty and enforcement difficulties.

s Timing: All leases having no renewal clause,

auto-matic or otherwise, become month-to-month tenancies upon expiration of the term if the tenant remains in possession, unless there is an express or implied agreement to the contrary.

● Warren’s Weed: New York Real Property § 101.16 (option

to lease property; renewals).

● New York Practice Guide: Real Estate § 29.01 (renewals),

§ 29.04 (Checklist for Lease Renewal Clause), § 29.06 (Checklist for Option to Purchase), § 29.08 [1] (Form No.

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29-1: Lease Clause Providing for Agreement to Renew for Stated Period), § 29.08 [2] (Form No. 29-2: Rent to be Agreed Upon by Parties), § 29.08 [3] (Form No. 29-3: Rent Set by Consumer Price Index), § 29.08 [4] (Form No. 29-4: Rent to be Set by Appraisal), § 29.10 (Form of Arbitration).

Tenant: Shopping Center to be Built, Article 5), Form No. 200.15 (Landlord-Oriented Shopping Center Lease, Article 4), Form No. 200.16 (Tenant-Oriented Shopping Center Lease, Article 4), Form No. 209 (Office Lease, Article 46), Form No. 274, Form No. 275, Form No. 276.1 (renewal provisions), Form No. 323 (Lease Option Agreement).

● GOL § 5-905 (automatic renewal clauses).

● RPL § 232-c (month-to-month tenancy implied after

holdover).

§ 19.15 Establishing Base Rent in Commercial Lease Negotiations

[1] Negotiating Rent Clauses, Percentage Arrangements, Escalation Clauses

Recently, it has become more common for the base rent to be merely one of many factors considered in commercial lease negoti-ations. A variety of percentage arrangements and escalation clauses have been added, including percentage leases with a minimum base rent, and fixed lease rentals that additionally require tenants to pay all or part of tax and insurance costs, or often all or a proportion of increases in maintenance cost.

z Strategic Point: Landlord’s counsel should require that

all payments due from the tenant other than base rent be recited as additional rent so that summary proceedings can be instituted where the tenant is in default on any of the financial obligations under the lease terms.

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The rent clause should clearly state the annual rent and amount due per installment (usually monthly). If the lease is to begin and end during the middle of a month, a provision can be inserted for proration of partial months. The lease should provide a due date for installments and usually includes a specified grace period, after which late charges apply.

s Timing: The tenant should ask for grace periods of 15

days for payment defaults and 30 days for other defaults. Upstate, grace periods of 5 to 10 days for payment defaults and 30 days for other defaults are common.

The lease should also include an acceleration clause, allowing the landlord to accelerate the due date of all rent payments and sue for future rents. Most leases grant a period of free rent at the beginning of the lease (sometimes at later times) to allow the tenant time to prepare the space or as a general inducement to sign the lease at the agreed rent.

z Strategic Point: Where the tenant asks for a long lease

or an extension of an existing lease, the landlord may ask for prepayment of rent. Before agreeing, tenant’s attorney should perform a title search to ascertain whether the landlord’s mortgage requires the mortgagee’s consent to any prepaid rent provision.

[2] Tendering Rent Checks for Less Than Full Amount

If there is a dispute or the tenant is having cash flow problems, the tenant may tender rent checks for less than the full amount. Regardless of the reason, the landlord will want to deposit tenant’s check without waiving its right to collect the balance. To do so, the landlord should insert a clause in the lease stating that no payment by the tenant or receipt by the landlord of a lesser amount than the amount stipulated shall impair the landlord’s right to collect any additional amounts due, and the landlord can deposit the tenant’s check without prejudice to the landlord’s rights.

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[3] Considering Tax Impacts of Periodic Rent Payments

Periodic rent payments are gross income to the landlord. Ad-vance payments of rent are treated differently. For example, if a tenant pays a lump sum to the landlord for a lease renewal, extension, or modification, the amount paid is not fully deductible by the tenant in the payment year, but must be amortized over the term of the extended or renewal lease. The landlord, however, may be required to report receipt of the full amount in the year of payment or accrual.

§ 82.03 (rent and related obligations).

● New York Practice Guide: Real Estate § 25.06 [2][a] (PG:

base rent), § 25.03 [3] (rent), § 25.07 [1] (Form 25-1: Office Lease, Witnesseth Clause and ¶ 1, ¶ 19, ¶ 25), § 25.07 [2] (Form No. 25-2: Store Lease, Witnesseth Clause and ¶ 1, ¶ 19, ¶ 24).

Tenant: Shopping Center to be Built, Article 3), Form No. 200.15 (Landlord-Oriented Shopping Center Lease, Article 5), Form No. 200.16 (Tenant-Oriented Shopping Center Lease, Article 5(A)), Form No. 201 (Retail Store Lease, Article IV), Form No. 205 (Loft Lease, Witnesseth Clause and ¶ 25), Form No. 209 (Office Lease, Article 3), Form No. 218 (Method of Rental Payments), Form No. 219 (Rent Payment Clauses), Form No. 220 (Installments with Provi-sion for Acceleration on Default), Form No. 226 (Clause on Effect of Rent Payment Different than Required Under Lease).

● IRC § 61(a) (rent payments are gross income). ● RPL § 235-c (unconscionability).

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§ 19.16 Negotiating Percentage Rent Lease Clauses [1] Determining Formula for Setting Guaranteed

Minimum Rent

In a business or commercial context, a percentage rent lease provides that all or part of rent will be based upon a percentage of the tenant’s gross or net income from its business, usually with a guaranteed minimum. Percentage rent leases require carefully drawn and detailed procedures to avoid disputes concerning the definition of the terms gross income or net income and require detailed procedures regarding methods and periods for applying the percentages to these amounts. Percentage rent leases commonly contain language indicating that no partnership has been created between the landlord and tenant.

Nearly all sales-based percentage leases contain a guaranteed minimum rent. A number of formulas can be used, including:

1. Straight percentage of tenant’s gross sales;

2. Percentage of gross sales in excess of specified dollar amount; or

3. Gross sales multiplied by specified percentage, less fixed rent.

Regardless of the formula used, gross sales must be carefully defined and should include, for example, credit sales; receipts from leases; layaway sales; orders taken on premises but filled else-where; and mail, telephone, and Internet orders. The tenant will insist on appropriate deductions from gross sales for items including:

1. Bad debts;

2. Returns and allowances; 3. Sales tax;

4. Employee discount sales or fringe benefits; 5. Bulk sales;

6. Costs of mail order sales; and 7. Credit sales.

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The landlord should exclude returns of items bought through a catalog or the Internet.

[2] Specifying Time of Percentage Rent Payment and Availability of Financial Records

The time of percentage rent payment must be specified, usually at a particular time following tenant’s calendar year or fiscal year. If percentage rent is paid quarterly, provision must be made for adjustment at year’s end. The tenant should be required to keep regular and accurate records of gross sales along with copies of income and sales tax returns. Many leases require financial state-ments, certified by officers of the tenant’s entity.

z Strategic Point: Although landlord’s counsel will want

the lease to provide for an audit of financial statements and records by a certified public accountant designated by the landlord, tenants attorney should negotiate to avoid such a clause since this can be very expensive.

Some percentage rent leases require that tenant pay the cost of an audit if it turns out the tenant has understated gross sales by a specified percentage or dollar amount. Tenant’s attorney should attempt to make this amount as high as possible during lease negotiation. Some leases provide that the landlord has a right to cancel if the tenant fails to achieve an agreed volume of sales within a stipulated time. It is standard practice in percentage leases to require the tenant to submit income tax returns for review by the landlord. The tenant should add a requirement that:

1. Landlord keep tenant’s financial information confidential; 2. Tenant may keep business records at cental location rather

than at store; and

3. Days and times that financial records must be available for inspection will be limited.

Landlord’s counsel should attempt to include a right to terminate (kick out right) if the percentage rent has not reached an agreed

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level by a certain date. Some leases provide for arbitration of disputes on percentage rent.

z Strategic Point: Since the minimum rent can rise over

time due to lease clauses calling, for example, for increases keyed to the Consumer Price Index, tenant’s attorney should negotiate a provision reducing or eliminating per-centage rent should the minimum rent reach a defined level.

[3] Adding Additional Restrictions and Exceptions

The percentage rent lease may also include a radius restriction on the tenant’s ability to conduct business at competing locations. In addition, the lease may require that tenant conduct business at specified times and may restrict subletting and assignment. The tenant should add exceptions for fire, strikes, illness, or closing of one or more of the anchor stores or a specified number of smaller stores.

§ 82.03 (rent and related obligations).

● New York Practice Guide: Real Estate § 25.06 [2][c] (PG:

percentage rents), § 25.03 [3][a] (percentage lease), § 25.08 [2][b] (percentage lease clauses), § 25.08 [2][b][ii] (Form No. 25-9: Merchants’ Association or Promotional Fund), § 25.08 [2][b][iii] (Form No. 25-10: Definition of Gross Sales), § 25.08 [2][b][iv] (Form No. 25-11: Percent-age Lease Reports, Records, and Inspections), § 25.08 [2][b][v] (Form No. 25-12: Percentage Clause Based upon Excess Drafting Guide Over Specific Volume), § 25.08 [2][b][vi] (Form No. 25-13: Additional Rent Based on Excess over Minimum Gross Sales), § 25.08 [2][b][vii] (Form No. 25-14: Additional Rent Based on Percentage of Sales in Excess of Minimum Rent), § 25.08 [2][b][viii] (Form No. 25-15: Percentage Rent Formula), § 25.08

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[2][b][x] (Form No. 25-17: Right to Cancel Percentage Lease).

Tenant: Shopping Center to be Built, Article 4), Form No. 200.15 (Landlord-Oriented Shopping Center Lease, Article 5(C)), Form No. 200.16 (Tenant-Oriented Shopping Center Lease, Article 5(B)), Form No. 223 (Rent Based on Net Profits), Form No. 224 (Percentage Rent Rate Based on Gross Sales).

● LexisNexis AnswerGuide New York Civil Disclosure

§ 16.13 (certifying business records).

§ 19.17 Determining Structure of Escalation Clauses [1] Defining Operating Expenses in Escalation Clause

The purpose of an escalation clause is to cover increasing costs of owning and operating a building, which reduce landlord’s net income. Some cost increases are covered by lease clauses providing for pass-throughs of increases in actual operating costs including utilities, labor, and taxes. However, certain items, for example, financing costs and capital construction costs, are usually not covered. Operating expenses must be carefully defined, with inclusions and exclusions specified (some are negotiable).

z Strategic Point: Escalation clauses should be carefully

reviewed, especially the base year. Some aspects may be negotiable, particularly the exclusions in calculating actual operating expenses.

Exclusions from operating expenses should cover the following: 1. Executive salaries;

2. Depreciation;

3. Brokerage commissions; 4. Debt service;

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5. Fees paid to landlord’s affiliates;

6. Costs covered by insurance and capital improvements; 7. ADA compliance;

8. Advertising; 9. Artwork;

10. Charitable or political contributions; 11. Environmental compliance costs; 12. Fines and penalties; and

13. Expenses related to specific tenants.

[2] Requiring Statement for Calculating Operating Expenses

Given rapidly rising costs encountered in recent years, landlords generally attempt to insert escalation clauses requiring tenants to share in cost increases. The landlord’s attorney should confirm with the landlord’s staff that the escalation clause reflects the landlord’s actual practice and that the landlord is capable of making the required calculations.

Tenants should require that the statement of operating expenses be prepared by an independent managing agent or CPA. The tenant should have the right to audit the landlord’s books, object to the landlord’s calculation within a specified time, and resolve any dispute through arbitration or litigation. Any right of the tenant to audit operating costs should be limited to cases where increases exceed a specified percentage. The landlord should try to prohibit contingent fee auditors, suggesting a national CPA firm instead. The tenant should be required to sign a confidentiality agreement for any audit and the tenant and its advisors should be prohibited from disclosing existence of any audit or its results. If any overcharges are less than three percent of total annual operating costs, the tenant should not be entitled to any correction or reimbursement of its audit costs.

Tenants usually agree to pay their proportional share of increases in actual operating expenses for the building over a base date (usually date of lease commencement). The tenant’s share should