There can be no doubt that national economic conditions and forecasts have become somewhat more tempered for 2001 and beyond. Many signs now point to the fact that the national economy is slowing and the Federal Reserve has lowered interest rates in order to energize the economy at all levels. Such macroeconomic factors will affect the commercial office leasing market across the nation for both landlords and tenants. Many cities are already experiencing a decline in tenant demand in the form of space reductions, employee lay-offs and overall conservative estimates of future job growth.

These economic realities create both opportunities and pitfalls for both landlords and tenants in a dynamic and ever-changing commercial real estate market. Outlined below are several practical concerns and "deal points" that both landlords and tenants will face in the immediate term. This brief outline is not intended as an exhaustive treatment of commercial leasing issues or critical lease points. Rather, it is intended to highlight several key concerns when commercial office leases are negotiated in this current economic climate, often with non-credit or technology tenants in a dynamic marketplace.


Practical Concerns and Real-Life Considerations

Credit of Tenants

Landlords will look increasingly to the underlying credit of tenants, whether such tenants are an established public or private company, a high growth start-up, professional services firm or long-established manufacturing enterprise. Landlords have become very sophisticated in learning much about all industry segments and the creditworthiness of tenants, including the capitalization, "burn-rate", product offerings and market position of potential tenants. Additionally, the widespread use of the Internet has allowed landlords to immediately access detailed financial information on public companies who are listed on any stock exchange, as well as detailed information about the products, technology and services of many non-public companies and related matters. It is often customary for landlords to inquire specifically about the rental history, identity and level of monetary and management commitment from investors, founders and capital partners of tenants.

Limitation of Rent Concessions and Tenant Inducements

Educated landlords will continue to limit free rent at the beginning of the lease term. Instead, landlords will opt for immediate rent payments in order to quickly establish a steady payment history from tenants. Landlords may offer free rent or other credits at the end of the term after a tenant has proven its creditworthiness. Landlords may also offer building standard tenant improvements in lieu of free rent, since such "hard" dollars will remain in the building and may potentially be reused by the landlord.

Sufficiency of Security Deposit

Nearly all landlords will require a security deposit sufficient to cover landlords' transaction costs, including, but not limited to, tenant improvements, brokerage fees and some factor relating to possible eviction costs and downtime.

The form of security deposit is also of significant consideration to both landlords and tenants. Security deposits can range from cash payments to letters of credit, lease bonds and corporate or personal guaranties. The parties should carefully consider the benefits and detriments of each form of security and the overall liquidity of such instruments.

Frequency and Quality of Tenant's Financial Reporting

Landlords are becoming increasingly adept at monitoring tenants' financial positions throughout the term of the lease as an early warning sign of failure or success. Landlords will often require such financial information in a detailed format of financial statements, profit and loss statements, bank references and related reports. A tenant with adequate negotiating leverage may limit the requests of such information by landlords in frequency and scope. As noted above, much information about public (and even some non-public companies) is available to landlords through the Internet and other financial reporting devices. Therefore, landlords may obtain a wealth of financial information from public sources at this time.

Net Worth of Tenant

Aggressive landlords in landlord-oriented markets have required some tenants to maintain and/or affirm their net worth and financial capability at the outset of the lease transaction and throughout the term. This requirement placed upon the tenant to maintain an adequate net worth is akin to a lender's requirement in a corporate financing regarding the maintenance of a certain debt coverage ratio or other financial benchmark to ensure that a technical default is not triggered under the operative legal documents.

Alternatively, a decline in the tenant's net worth may trigger a requirement for the tenant to increase its security deposit by a pre-agreed amount, or post a corporate or personal guaranty in order to provide adequate credit assurance to the landlord in order to continue with no default under the lease.

Utility Usage by Tenant

Landlords often require a tenant to disclose its specific operations and use within the premises as part of the lease document. In today's ever-changing utility market, landlords will gain control over the tenant and the building if a landlord sets maximum performance criteria and levels of consumption as to the utility service for the tenant as part of the lease. Should the tenant exceed such levels of consumption and/or capacity, the landlord is able to collect additional rent from the tenant for such items. This provision would protect landlords from excessive use around the clock and/or overpopulation by a high density of employees in overcrowded office space.

Tenant's Telecommunications Access to the Building and Project

Landlords are increasingly intent on controlling and profiting from the telecommunications aspects of office buildings. Therefore, landlords may require tenants to pay additional fees for Internet, data and roof-top installations unless the same are specifically stipulated in the lease document. It may also be critical for tenants to obtain redundant access or be permitted to introduce a "new" telecommunications carrier to the building without charge, fee or expense payable to the landlord. The Federal Communications Commission is currently in the process of adopting final rules to allow tenants more freedom in selecting telecommunications providers. As expected, this is currently a hotly contested topic between landlords, owners and tenants as users of both buildings and telecommunications services.

Landlord's Lien

In an effort to further guarantee rental income and lease security, landlords will often require a landlord lien on the tenant's furniture, fixtures and equipment. Educated tenants will thwart this request at all costs due to the cumbersome nature of the landlord retaining such an interest. An explicit grant of the landlord's lien may complicate the acquisition, disposition and financing of such furniture, fixtures and equipment over the term of the lease. A creditworthy tenant should expect to obtain a written and affirmative waiver of all of the landlord's right to retain a lien on such property, whether leased or owned by tenant and located in the premises.

Limitation Upon Subleasing and Assignment

This provision can be one of the most critical to the tenant and the landlord in the future control of the premises. The landlord will always seek to retain the right of recapture in order to control the leasing, subleasing and occupancy of the office building should the tenant either expand or contract rapidly, creating the need for a potential sublease.

Landlords may also strictly enforce their rights to retain profits in the event of a subleasing or assignment, and effectively eliminate the tenant's motivation to obtain the highest or best rental rate for such space. Furthermore, landlords will seek to limit the absolute number of subtenants or sub-occupants of the premises in order to maintain absolute control over the occupancy and use of the building.

Tenant Indemnification of Landlord

Savvy landlords have concluded that the indemnification by the tenant of the landlord in the lease should be very broad, and should include the activities of tenant and a wide range of contractors, agents, subtenants, assignees and/or service providers who have access to or legal rights of possession with respect to the premises. In today's dynamic marketplace, tenants often enter into joint venture, teaming and/or service agreements which integrate the involvement by and use of the premises for a wide range of individuals and affiliates. Therefore, the landlord's safest bet is to obtain a wide-ranging indemnification from the tenant should any detrimental act, injury or occurrence occur in or about the building or the premises.

Conclusion

Both landlords and tenants face different and challenging business and legal considerations when entering into a commercial lease transaction in a dynamic marketplace. Depending upon the specific submarket and location, tenants should be able to take advantage of stabilized rental rates and a moderate increase in landlord concessions in the near term.

Additionally, tenants should be in a favorable position when negotiating the legal and business points within the lease document, including, but not limited to, rights of expansion and renewal to accommodate future growth and space management. Landlords are reluctant to grant such rights in a very landlord-oriented market because such options benefit only tenants, and tend to encumber landlords' future leasing and flexibility in the building. Landlords may be forced in the near term to become somewhat more flexible with respect to accommodating creditworthy and financially stable tenants in order to assure the long-term occupancy of such tenants within quality office parks around the country. Savvy tenants with approximately three to seven years remaining on any existing lease commitments may be well advised to monitor the office leasing market closely and to contemplate early renewals, extensions and re-documentation of existing lease commitments in order to take advantage of a tenant-friendly office leasing marketplace.

About the Author

John G. Lavoie focuses his practice on real estate transactions with emphasis on the acquisition and disposition of commercial real estate. Mr. Lavoie is a member of the Bar in Virginia and the District of Columbia.

The attorneys in the real estate practice group at Watt, Tieder, Hoffar & Fitzgerald, L.L.P. counsel landlords, owners, tenants and users of commercial office, industrial and retail space on a daily basis in the Mid-Atlantic region and throughout the United States.

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