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The “Art” of the Commercial Real Estate Lease Term Sheet

Experienced commercial real estate landlords and tenants, as well as their brokers and consultants (collectively, “CRE Professionals”), are well aware of the importance of the prospective landlord and tenant reaching agreement on a comprehensive term sheet (often referred to as a “letter of intent”) as part of the commercial space lease transaction process. The term sheet will be relied upon by both parties and their counsel as the “blueprint” of the material terms of the proposed lease. In reliance on that blueprint, the parties will commence spending considerable time and expense preparing, reviewing and negotiating the lease agreement, as well as the performance of landlord’s due diligence with respect to the tenant (and applicable guarantors), the performance of tenant’s due diligence with respect to the applicable leased premises, and the applicable party’s engagement of architects, engineers and contractors with respect to any proposed improvements to be made to the space. This reliance is irrespective of the fact that the term sheet is typically non-binding, other than, in some instances, specific provisions concerning exclusivity periods, confidentiality, brokerage indemnities and certain other deal-specific terms.

Without a term sheet accurately reflecting the material terms of the proposed lease, the risk of the lease transaction being delayed or even terminated at some point in the lease negotiation process —when substantial time and money has already been spent—is heightened considerably.

However, determining the “material terms of the lease” to be set forth in the term sheet for a space lease is an art, not a science. In particular, CRE Professionals are aware that they cannot attempt to cover every aspect (not even every material aspect) of a lease within the term sheet. Rather, the determination of what to negotiate into the term sheet involves an assessment and balancing of the risk of (i) having the lease preparation process delayed by excessive negotiation, stalemates on important issues or worse (i.e., losing the deal) due to an incomplete term sheet versus (ii) overly negotiating the term sheet and failing to move the transaction to the lease drafting stage in a timely fashion (which delay could even jeopardize the ability to get the lease transaction completed). In addition, in many cases, a strategic judgement will be made to purposely exclude a material term from the term sheet, with the intent to first raise the material term during the lease negotiation process and when the lease is closer to execution.

In almost every instance, certain terms of the lease will be included in the space lease term sheet as they represent the threshold, material terms of the lease, such as the identification of the landlord and tenant, identification of the space to be leased, the fixed rent (and any free rent or abatement periods), the lease term, and any landlord work obligations (or tenant improvement allowance). And many terms of the lease, subject to unusual deal specific issues, are generally recognized as not material enough to -affect the overall business deal, and are typically excluded from the term sheet, such as default and remedies, basic repair and maintenance obligations, and casualty and condemnation rights.

Over the years, in our real estate practice, we have found that there are several specific provisions of the lease commonly deliberated upon by landlords and tenants as part of the “art” of whether to include or exclude, as applicable, such provisions from the space lease term sheet. These provisions include the following: (i) use restrictions, (ii) assignment and subletting rights, (iii) lease term extension options and rights of first offers/refusals on expansion space, (iv) security deposits and required guarantees, and (v) permitted alterations. A discussion of these five material clauses is set forth below.

Use Restrictions

In certain contexts, such as office leasing, there will be little debate as to the proposed use of the space between the landlord and tenant, and little need to be concerned with specifying the permitted use at the term sheet stage. But especially in larger office leases, the tenant may have specialized needs, such as the need to have an operating kitchen, cafeteria or gym, that are material elements for its use of the space that it will want to raise at the term sheet stage.

In a retail lease and, in many instances in an industrial and warehouse lease, a landlord is most often well advised to be clear in the term sheet on any material limitations on the tenant’s permitted use, as a landlord may (a) have significant concerns over the control of the tenant mix at the property, (b) be required to change the certificate of occupancy, (c) be subject to use restrictions recorded against the property or required under other tenant leases or agreements, or (d) have a belief that certain uses could be destructive to the property’s market value. Likewise, it may be important for the tenant to have certainty, upfront, that all of its planned and potential uses of the property will be permitted under the lease. Depending upon the leverage the tenant has, it may also be concerned about how its business may change in the future, or its ability to assign or sublet the leased premises to a different user in the future; and, accordingly, the flexibility to alter its use (or allow its assignee or subtenant to engage in a different use) may be a materially enough element that it should be raised at the term sheet stage.

Assignment and Subletting

As is the case with almost all of the material terms of the lease, the ability of a tenant to negotiate assignment and sublet rights in a space lease will be driven primarily by the nature of the tenant, the length of the lease, and the size of the space relative to the property, as well as market conditions. When dealing with a small tenant, for a lease of a small portion of the applicable property and/or for a short lease term, it may be unnecessary to raise assignment and sublet rights in the term sheet. The tenant can expect that it will have little, if any, rights to freely assign or sublet the lease. The one caveat is that any tenant should consider the possibility that it may sell its business (including by merger, or by selling equity in the tenant) during the lease term. In that instance, the tenant (even in a “small lease”) may want to negotiate, upfront in the term sheet, the exclusion of the sale of its business from any assignment and sublet prohibition.

On the other end of the spectrum, when dealing with a more significant tenant, a lease of a substantial portion of the property and/or a longer lease term, the issue of assignment and sublet rights may be critical and material enough to warrant raising at the term sheet stage. A tenant under such a lease will need to consider, in addition to the sale of its business set forth above, (a) its potential need to sublet and/or license space in connection with its business plan, (b) flexibility to change its business plan, which may involve the need to sublet portions of the space, (c) the potential occupancy of the space by an affiliate of such tenant whether by sublease, assignment or license, and (d) its lease “exit” strategies; and in each of these contexts, to what extent it is willing to agree to be subject to the landlord’s prior consent (whether reasonable or not), landlord recapture rights, or the payment of any consideration or profits to the landlord. Even the landlord, in the context of a significant tenant or lease, may be well advised to set forth the assignment and sublet rights in the term sheet, being well-aware that these provisions can become a major issue if they are not resolved until lease negotiations. Depending upon the various factors affecting the parties’ negotiating leverage (as set forth above), the landlord can clarify such matters as in what instances the tenant will need the landlord’s consent to an assignment or sublet, whether the landlord will be required to be reasonable, whether and in what instances the landlord will have the right to recapture the leased premises, and any rights for the landlord to share in the profits of any assignment or sublet.

Extension Option and Right of First Offer/Refusal on Expansion Space

An important consideration for any tenant entering into a lease will be its need to continue in its space beyond the initial lease term, and its ability to expand the size of the space being leased as its business grows. These factors may be even more material in connection with a retail, industrial or distribution lease, where the need to relocate could be very costly (including the costs of entering into a new lease transaction, moving and space build-out costs, as well as the disruption to customers, suppliers, and employees).

If the tenant’s need to have an extension option on its lease term, or to have the right to expand into other space that becomes available during the lease term, is material to the tenant’s business plan, in almost all instance the tenant is well-advised to raise this item at the term sheet stage. There may be strategic reasons, in certain specific circumstances, why a tenant would want the landlord to get deeper into the leasing process before this right is raised. But these options, especially a right of first offer/refusal on expansion space, may have such a material impact on the landlord’s ability to maximize its rents at its property that it could significantly impact the landlord’s ability to agree to the lease transaction. Accordingly, first raising these concepts during the lease negotiation process puts the tenant at risk of a protracted negotiation (and even a stalemate and loss of the deal) relating to these concepts.

Security Deposit and Guarantees

Undoubtedly, a material consideration for any landlord will be the financial viability of the tenant and the need to have security enhancements to better ensure that the tenant will satisfy its obligations under the lease. The need for security will be significantly impacted by the lease-up costs the landlord will incur (i.e., brokerage fees, landlord’s work, and tenant improvement allowances, etc.) in reliance on the lease. In most instances, the need of the landlord to obtain an appropriate security deposit and/or have a financially acceptable guarantor guaranty all or a portion of the tenant’s obligations, the most common security enhancements for tenant obligations under leases, will be critical.

Accordingly, in almost all instances, the landlord is well-advised to raise any security deposit and guaranty requirements at the term sheet stage. There may be strategic reasons why a landlord would not want to specify these requirements at the term sheet stage. The most common reason we have seen is that the landlord wants to complete its financial due diligence while the lease is being prepared and negotiated. In those instances, the requirement of a security deposit (including whether cash, letter of credit or other form of deposit will be required) and/or a guaranty (including any basic terms, such as a “good guy” guaranty[1]), as the case may be, should at least be referenced in the term sheet. In addition, in those instances, the landlord should be aware of the risk of a protracted negotiation (and even a stalemate) relating to the terms of the security deposit and/or any required guaranty at a later point in the lease negotiation process.

Permitted Alterations

Any tenant who intends on making physical alterations to its leased space, as a prerequisite for the tenant’s use of its space, in most instances would be best served by having its initial work pre-approved by the landlord at the time it enters into the lease. Depending upon the circumstances, this pre-approval may range from approval of full-blown plans and specifications, to conceptual drawings, to providing a general description of the alterations and that the landlord will not unreasonably withhold its consent to approving the tenant’s alterations. At the term sheet stage, the tenant should consider whether its wants the landlord to be aware that it will be seeking such a pre-approval upon entering into the lease.

On the other hand, if the landlord is aware that a third-party consent may be required for approval of certain alterations, such as the approval of an adjacent owner under a covenant (often found in “reciprocal easement agreements”), an architectural review board (often found in condominiums and homeowners’ associations) or a particular governmental agency (such as the NYC Landmark’s Commission), the landlord may need to consider making the tenant aware of these requirements at the term sheet stage.

In most lease terms sheets, the parties will not cover the rules concerning ongoing general alteration rights. However, where the lease involves a longer lease term, a greater portion of the landlord’s property, and/or a more substantial tenant (in terms of both its financial and non-financial wherewithal), the tenant may be best served to clarify at the term sheet stage what non-structural alterations and structural alterations it will be permitted to make without landlord’s consent; or potentially with the landlord agreeing to not unreasonably withhold its consent to certain alterations.

For more information on the topics discussed in this update, please contact any member of Tannenbaum Helpern’s Real Estate Law practice or your usual contact at the firm.

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[1] A “good guy” guaranty is a guaranty of payment and performance of the lease, but the guarantor’s liability is generally limited to obligations that accrue under the lease prior to the tenant’s delivery of vacant possession of the leased premises to the landlord in the condition required under the lease. In almost every case, the guaranty requires prior notice (most typically, 60 to 180 days prior notice) of the guarantor’s election to return possession of the leased premises and cut-off its liability under the lease.

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Note from the Real Estate Group is a newsletter of Tannenbaum Helpern’s Real Estate, Construction and Environmental practice. It provides the latest perspectives on legal developments and market trends impacting real estate, construction and environmental related transactions and matters. To subscribe for the newsletter, send email to marketing@thsh.com.

07.22.2022  |  PUBLICATION: Note From The Real Estate Group  |  TOPICS: Real Estate, Construction, and Environmental  |  INDUSTRIES: Real Estate

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