In many transactions involving the purchase and sale of a business, the seller may not own the property where the business is carried on but may have an existing lease of the property. In a situation where there is a lease, the buyer often requires the continuation of the lease in order to carry on the business after the completion of the transaction. This can involve an industrial, retail or office lease. Take, for example, the purchase of a warehouse and distribution business, the purchase of a chain of restaurants or retail stores, or even the purchase of a professional or other service firm. In each of these cases, the lease will likely be a key element to the ongoing operation and ultimately the success (or failure) of the business. It is important, therefore, to carry out a review of the lease. The extent and detail of the review will depend on the nature of the transaction. An experienced commercial leasing lawyer and commercial leasing agent are the best people to help and guide you through the lease review process. Set out below are a number of factors that should be considered in reviewing the lease. This is not an exhaustive list, and all factors may not apply to your lease review.
Lease and Parties
Begin your lease review by obtaining a complete copy of the lease, all lease extension and amending agreements, all prior assignments, subleases, estoppel certificates, leasehold mortgages, if any, and similar related documents. Note all the parties, beginning with the landlord and the tenant. The current landlord and tenant may be different from what is shown on the current lease documents. You will need to obtain the necessary documents in order to establish that you are dealing with the current landlord and the current tenant. There may also be an indemnifier or guarantor. There may even be a leasehold mortgage which will have to be dealt with as part of the transaction.
When you are determining the parties to the lease, it is important for your lawyer to carry out due diligence with respect to title and zoning. Even though the seller is not the owner of the property where the business is carried on, the seller, in our situation, has a leasehold interest. A leasehold interest is more than a contractual right; it is also an interest in land. In most cases, it is not necessary to carry out a full title search. As a matter of fact, it is rarely done. Most titles in Ontario are registered under the land titles system. (Based on most recently available information, approximately 96% of all properties in Ontario are governed by the provisions of the Land Titles Act). The title search will provide you with the name(s) of the current owner, any existing mortgagees (including leasehold mortgagees), and any registered restrictions affecting the property. It will also disclose whether notice of the lease has been registered. Notices of lease are particularly important where there is an extended term with extension and other special rights. This will be discussed more fully below. The current owner should be the landlord, but this is not always the case. The landlord may be a former owner or may even be a tenant under a head lease. This means that the lease being taken over is not a lease but a sublease. Any default by the sublandlord as tenant under the head lease puts the subtenant at risk unless there is a non-disturbance or similar agreement with the head landlord. Similarly, any default by the landlord under any existing mortgage or debenture can also put the tenant at risk, unless there is a non-disturbance agreement in place between the tenant and the mortgagee or debenture holder. All of this information is important in order to assess the extent to which the tenant’s leasehold interest may be at risk. Any termination or other forfeiture of the tenant’s leasehold interest will place the continuation of the business at risk.
Regarding use, there are three things to check. Check the permitted uses under the lease. Check the applicable zoning bylaws regarding permitted uses. Check the title search to determine if there are any exclusive or prohibited uses set out in any prior notices of lease or other instruments on title.
Most commercial leases, whether industrial, retail or office, are net leases; that is, there is a base (or minimum) rent component, as well as an additional rent component consisting of operating costs, realty taxes and utilities. Retail leases often include an additional percentage rent component. With respect to additional rent and percentage rent (if any), these amounts are based on current estimates and will be subject to adjustments after the completion of the current fiscal year. For that reason, it is important to include reciprocal undertakings to readjust these items of rent after closing. While the amount of base rent is a fixed amount, all other components of additional rent are variable, which from a realistic point of view means that these amounts will increase. Note the major items included in and excluded from operating costs, particularly the tenant’s obligation to pay its share of extensive capital repairs. Are utilities (in particular, electricity) separately metered or bulk metered? What is the amount of the management fee and to what items of additional rent is the management fee applied? These are some of the basic type questions that should be answered.
Determine if any deposits have been paid. If yes, there would be a credit to the seller provided the buyer obtains confirmation from the landlord that it is holding the deposit to the credit of the tenant. (This statement is usually included in the estoppel certificate discussed below.) The deposit may be in the form of a letter of credit which will have to be replaced by a letter of credit provided by the buyer’s bank and the old letter of credit surrendered to the seller.
It goes without saying that the location of the premises is of paramount importance. Look for a plan, sketch or other description that clearly outlines the extent of the premises. Base rent, additional rent and percentage rent (if any) are usually based on a price per square foot. The calculation of the area of the property being leased is therefore important. Try to obtain an area certificate that confirms the calculation of the area in accordance with the terms of the lease or, alternatively, confirmation of the area in the landlord’s estoppel certificate. There may be related facilities such as storage, parking and outdoor areas that should also be checked. In many cases, storage and parking are covered by separate licenses. Ensure that these licenses have been included in the lease documentation that you received at the beginning of the transaction and that the leases or licences of storage, parking and outside areas can be assigned.
The remaining term of the lease and any unexercised extension rights should be carefully noted. Pay close attention to the conditions of exercising any extension rights. Many leases have provisions that make extension rights non-assignable.
The assignment and sublet provisions require careful scrutiny not only to determine whether the landlord’s consent is required but also what conditions can be imposed by the landlord in giving its consent. The place to start when reviewing these provisions is the definition of “assignment” and “sublease”. Quite frequently the defined term “transfer” is used to include not only an assignment and sublease but also a change of corporate control. In the more “landlord friendly” leases, it is common to find a landlord’s termination right in the event a tenant requests consent to transfer the lease. This would be an obvious “deal breaker” if the lease is essential to the continued operation of the business. The same “landlord friendly” leases often give the landlord the opportunity to amend the terms of the lease and to require additional financial security. It is evident that the landlord’s cooperation in providing its consent on reasonable terms is a critical part of the transaction. Assessing the position of the landlord is one of the critical first elements of the entire transaction where consent to the transfer is required. Even if no consent is required, there will likely be a provision requiring notice to the landlord along with an assumption agreement to be entered into between the landlord and the buyer. Such terms are not particularly onerous. What can become an issue in many transfers is the loss of special rights under the lease. The possible loss of extension rights has already been discussed. Other special rights such as tenant signage, expansion rights, exclusive uses, audit rights, and parking are a few of the more common examples of special rights that may be lost in the event of a transfer. Look for defined terms such as “required conditions” or “threshold conditions” in the lease that set out a variety of requirements that must be met before these special rights can be exercised.
What is also important from a buyer’s perspective is to obtain an estoppel certificate from the landlord. It may be surprising to some that a tenant may not have the right to require the landlord to provide an estoppel certificate. In many “landlord friendly” leases, only a landlord has the right to require the tenant to produce such a certificate and, as indicated, such right to a certificate is not necessarily reciprocal. The main point to remember is that the landlord’s cooperation is essential in these transactions for a variety of reasons.
The distinction between tenant leasehold improvements and trade fixtures is by no means clear-cut. The point to remember is that in most, if not all, leases there are both leasehold improvements and trade fixtures. Many leases will contain a somewhat circular definition of leasehold improvements similar to the following:
“Leasehold Improvements” means all fixtures, improvements, installations, alterations and additions from time to time made, erected or installed by or on behalf of the Tenant or any former occupant of the Premises, including doors, hardware, partitions (including moveable partitions) and wall-to-wall carpeting, but excluding trade fixtures and furniture and equipment not in the nature of fixtures;
Many commercial leases provide that the landlord is the owner of all leasehold improvements regardless of who paid for them. This may be an important element when determining the allocation of any purchase price with respect to leasehold improvements. (Note that many commercial leases contain restrictions on tenants obtaining any compensation for leasehold improvements.) Also, leasehold improvements constitute alterations that, in most cases, require the landlord’s consent. If an existing tenant has carried out alterations to the premises without the required consent, the assignee tenant will be at risk unless the estoppel certificate confirms that all leasehold improvements have been approved. Having confirmation that all leasehold improvements have been approved does not, however, protect the assignee tenant from any restoration obligation. The restoration obligation is discussed below. With respect to trade fixtures and other personal property, these may be subject to a general security agreement provision found in some commercial leases. Such provisions will likely conflict with other security agreements between the buyer and its lender.
Other Clauses to Look For
(i) Sale Demolition
The effect of this clause is to allow the landlord to terminate the lease in the event of any sale of the property or any demolition of the building. Obviously such a clause can have a serious impact on the tenant’s ability to continue to operate the business.
(ii) Repair Obligations
Repair obligations vary considerably from one lease to the other. In order to make sense of these obligations, check the definition of the premises which sets out the boundaries or limits. The repair obligations with respect to the premises would only apply within those boundaries or limits. For example, if the upper limit extends to the underside surface of the ceiling tile, the space between the ceiling tile and the ceiling slab would not form part of the premises. Ideally, the tenant would only want to be responsible for interior non-structural repairs and ordinary cleanliness.
The requirement for the tenant to restore and return the premises to a base building condition on termination can be a very costly obligation for a tenant, especially when there have been significant leasehold improvements and other alterations.
(iv) Post-Dated Cheques
Surprisingly, most commercial leases still contain a requirement for post-dated cheques although as a matter of practice, few landlords enforce this provision. The more current requirement is to provide for payment by way of automatic debit and this may be problematic for some tenants.
(v) Risers and Conduits
The right to access and use the risers and conduits in a building is not necessarily assured. While such access may not be much of an issue in industrial and retail premises, it can definitely be an issue in office buildings, in particular, older office buildings. There may be no room for additional wires or cabling and this would be a serious impediment to the tenant’s ability to communicate electronically. It should not however be an issue for an existing lease situation where all the cables and wires are presumably already in place. It may become an issue in the event the tenant assignee needs to upgrade its communication systems.
(vi) Environmental Audits
Many industrial leases include the right of the landlord to require an environmental audit. Not only is there a significant cost involved, there is also the potential risk that the tenant assignee may be held responsible for environmental contamination caused by previous tenants. Depending on the nature of the business transaction, it may be appropriate for an environmental audit to be carried out before the completion of the transaction as protection for the tenant assignee.
(vii) Repayment of Improvement Allowance
In many commercial leases, new tenants may have benefited from a leasehold improvement allowance. Normally, the cost of the leasehold improvement allowance is included in the base rent amortized over the initial term of the lease. Some leases however do not blend the leasehold improvement allowance into the base rent and treat such allowance as a debt repayable in addition to the base rent. While the end result may be the same, it may be appropriate, depending on the nature of the business transaction, to adjust for such debt in a different manner than the base rent.
The landlord’s right to relocate is found frequently in commercial leases of tenants occupying smaller premises. If there is a relocation clause and the premises in their current location are of considerable importance to the ongoing business operation, the tenant assignee will be at risk. Location can be particularly important to a retail tenant. Despite the risk involved, it is rare to find a commercial lease where a landlord does not pay the cost of the relocation.
(ix) Insurance Requirements
The first step in dealing with the tenant’s insurance requirements is to bring it to the attention of the tenant’s insurance advisors to ensure that the proper insurance will be in place and a certificate of insurance provided in order to provide evidence to the landlord that this requirement has been met. In this context, the insurance coverage placed by the tenant assignee (or by any tenant, for that matter) should not only look to the minimum requirements of the lease but also to the extent and nature of the risks that are allocated to the tenant under the lease. For example, if the lease requires the tenant to obtain commercial general liability insurance in an amount not less than $2 million on the one hand and, on the other hand, allocates all of the risk to the tenant for any losses that may be incurred in the premises, however caused, together with a complete indemnity of the landlord, it is quite likely that an insurance advisor would recommend a greater amount of insurance. The main point to remember is that the insurance provisions cannot be viewed in isolation, but must be considered in light of all of the related provisions such as landlord releases and indemnities.
Expansion rights can be covered in a number of different ways. Keeping in mind that this right and other special rights may be limited in their application to tenant assignees, there are basically three different types of expansion rights:
This right allows the tenant during a certain period of time on giving of prescribed notice to expand its premises into a particular location usually adjoining the existing premises.
(b) Right of First Refusal
This right allows the tenant to match any offer received by the landlord with respect to a designated area (usually adjoining). The landlord is required to give notice of such offer to the tenant and the tenant has a prescribed period time in which to respond.
(c) Right of First Offer
This right requires the landlord to offer any available space to the tenant at fair market value before offering such space to third parties.
While the option is likely the most valuable of the various expansion rights, the others should not be discounted. All are valuable tools to allow for future growth.
(ii) Contraction/Partial Surrender
This right is the reverse of the expansion right. It allows the tenant, on giving notice of a prescribed (usually lengthy) period, to give back part of its premises to the landlord usually on payment of a termination fee. It is not often found in commercial leases and is usually tenant specific, that is, it cannot be assigned to subsequent tenants.
(iii) Early Termination
This is a variation of the contraction right in that it allows the tenant to advance the expiry date of the lease on payment of a prescribed termination fee and on giving a prescribed period of notice. As with the contraction right, the early termination right is usually tenant specific.
The audit right is a valuable tool for any tenant to control the amount of additional rent payable under the lease. The amount of operating costs, property taxes and even utilities are all determined by the landlord and those employed or retained by the landlord. The information provided by the landlord to the tenant at the end of each fiscal year can be sketchy and light on details. The tenant right to audit gives the tenant the opportunity to satisfy itself. The cost of the audit is normally borne by the tenant but many leases provide that if there is an error or other discrepancy greater than a certain percentage, the landlord will pay.
(v) Self Help
It is safe to say that all commercial leases allow the landlord to perform the tenant’s obligations if the tenant fails to do so. For example, if the tenant fails to repair or maintain its premises in accordance with the requirements under the lease, the landlord, after notice, can do so and all amounts spent by the landlord in carrying out the tenant’s work (and usually an additional 15% administration fee) are added to the rent and can be collected as rent. It is very seldom that a tenant has a reciprocal right to perform a landlord’s obligations if the landlord fails to do so. In many situations, it is not practical to have such a self-help right in a multi-tenant facility. The self-help right is usually found in large single tenant facilities or large retail stores where a tenant would have considerably greater negotiating clout than most other tenants.
A tenant right to install its trade name, logo or other identifying sign on the exterior of a building or other prominent place is of considerable value, especially to retail tenants. As with other special rights, such signage rights are often not transferable to assignees or subtenants.
The right of a tenant to an exclusive use within a building or shopping center is equally important, especially to retail tenants. Commercial landlords tend to be very careful about how such rights are negotiated. As can be expected, there are numerous conditions similar to “required conditions” referred to earlier.
(viii) Purchase Option
It is very unlikely that a lease will contain a purchase option, in particular, in multi-tenant facilities.
(ix) “Go Dark”
One of the standard default provisions in a commercial lease arises when the premises become vacant and unoccupied, usually for a period in excess of 10 days. A “go dark” right allows the tenant to vacate the premises and, so long as all the rent is paid and all other obligations are performed, it does not constitute a default under the lease. This right may become a valuable asset to some tenants as part of a business restructuring or similar undertaking.
(x) Roof Top/Generator
The right of access to the rooftop and other restricted areas not included in the definition of premises is a valuable right for those tenants who need to install telecommunications equipment and backup generators in order to ensure continued business operations.
Unfortunately there is no “fast track” process for carrying out a lease review. It is not advisable to rely on third party lease summaries. The better course of action would be to retain a commercial leasing lawyer or agent to review the lease and determine the tenant’s rights and obligations with respect to each of the factors listed above, as well as any others that are unique to your transaction. This will provide a reliable assessment of a key element of the business being purchased.