10 Things to Consider in a Lease Agreement
Lease agreements form the backbone for the business relationship between the landlord and tenant. They can be lengthy and onerous documents, where legal challenges can exist if careful review and consideration aren't given. However, when properly vetted, the lease establishes expectations and protects each party's interests.
Below we have provided a few basic areas that warrant careful consideration when negotiating a lease agreement. It should be noted that a lease is a legal document and review by a legal expert is always recommended.
1) Who is the Entity Signing the Agreement and What is Their Overall Covenant?
Understanding who the other party is and their ability to pay their debts is principal to entering into an agreement. Is this a new business, or an established one? Does the operator have experience in this industry? If it is an established business, how strong is their reputation? Are major renovations to the space going to be required, and who will be paying for them? These are all important questions to ask before getting too far along with negotiations.
Often times, Landlords will request that a prospective tenant completes a credit check to satisfy themselves with the company’s, and/or individual’s creditworthiness. If the landlord is not satisfied there are measures that can be taken to mitigate some of their risk. These measures can include requesting a personal indemnification; increasing, or introducing a security deposit; or, requesting a letter of credit, to name a few.
2) Does the Individual Signing the Agreement Have the Authority to Bind the Company?
First, its important to ensure that the respective company names have been properly spelled in the agreement. Incorrect spelling can render an agreement null and void, or, make the signatory personally liable.
Next, ensure that the individual signing on behalf of the company has the authority to do so. Authorized officers will generally enter contracts on behalf of a company. If a company enters a contract without proper authority, the contract may still be enforceable. In order for it to be invalid, the company would be required to prove that the other party knew or should have known that the entity did not have authority to enter into a contract.
3) When is a Personal Indemnification Warranted?
Not all leases will call for a personal indemnification. They are commonly used when a company is new, or not well established and the Landlord requires added security in the event of a default.
A personal indemnification is a promise that an individual will ensure that a third party (tenant) fulfills their obligations under an agreement. Failing which, the individual will fulfill those obligations personally.
There is typically negotiation around the duration that an indemnification should run. Most landlords will request an indemnity for the duration of the lease term. Alternatively, the tenant may request a limited timeline, reducing their personal liability.
4) Does the Business Use Fit Within the Zoning By-Laws?
This item is often overlooked. Each municipality will have their own zoning by-laws which details the permitted uses. Careful consideration should be given to ensure that the intended business use is permitted. Failure to comply can lead to the inability to legally occupy the premises.
When the zoning by-law does not clearly state that a particular use may be permitted, a zoning compliance letter can be a good measure to ensure the municipality has reviewed and approved the proposed use. If a use does not fit within the existing zoning by-law a minor variance, or amendment to the zoning by-law may be required. This can be a lengthy process, with some costs involved. Both parties need to understand the time and financial considerations involved.
5) The Difference Between a Net Lease and a Gross Lease
Leases can be written either on a net, or gross basis. A net lease implies that the Tenant pays a base rental amount – effectively their cost to use the premises, plus the operating costs for the property on a proportionate share basis. If the operating costs for the property increase from one year to the next, the tenant is responsible to pay the difference.
In a gross lease the tenant pays a lump sum, which may, or may not be inclusive of utilities. Rather than separating the base rental amount and operating costs, the Gross rent is expressed as one number. The key difference from a net lease is that regardless of whether the landlord’s actual costs to operate the property increase, or decrease, the tenant pays the same fixed amount
The lease should clearly state the expenses to be paid by the landlord and tenant, respectively, and how they’re captured. For example, the tenant may not be responsible for the replacement of the HVAC unit, but their lease may state that the Landlord can recover the amortized cost of the unit over the term of the lease. Ambiguity can cause unexpected expenses down the road.
6) What is a Standard Deposit Amount?
The agreement will spell out the deposit amount, and who is responsible for holding it in trust for (landlord's lawyer, tenant's lawyer, or real estate agent's office).
In most cases, deposits are refundable up until the time that any conditions have been satisfied within the agreement. There are, however, extenuating circumstances that go beyond the scope of this article.
In short, there are three scenarios for which a deposit is released from a trust account.
(i) both parties agree to terminate the agreement and the funds are released;
(ii) the deal has closed, and the deposit is applied per the language in the agreement;
(iii) there is a dispute which requires court appointed direction for its release.
Generally, the deposit represents the first and last months rent. In other words, a portion of the deposit is applied against the first month’s rent, and the last month’s rent, respectively, as they fall due. Additional security deposits may be added to offset any perceived risks to the landlord, as previously mentioned.
7) What is a Tenant Improvement Allowance?
If there is work to be completed within a unit, a tenant may request a leasehold improvement allowance. This represents a sum of money the landlord is willing to spend towards the tenant’s renovations. This can be an effective way for the tenant to gain access to capital and amortize the cost into their lease rate. This amount will factor in an interest rate that the landlord is comfortable lending on – similar to a bank.
There is added risk to the landlord in lending money up front to the tenant. Should the tenant default, the landlord may be left without repayment. Even if the renovations have been completed prior to a default the value add of the improvements may not offset the amount the landlord is out of pocket. This is a good example of when a landlord may request a personal indemnification to offset any financial risk.
8) Condition Precedent vs. Condition Subsequent
The distinction between a condition precedent and condition subsequent is an important one. In a lease agreement, a condition precedent requires a party to notify the other of their intention to waive or satisfy their conditions. If they don’t notify the other party within a pre-determined timeline the offer is null and void.
In the case of a condition subsequent, the initial party is not required to notify the other of their intention to satisfy their conditions. By not providing notice otherwise, the conditions are deemed to have been satisfied and the agreement remains in full force. It is possible in this scenario to inadvertently waive or satisfy one’s conditions simply by ignoring the deadline for expiry.
9) Exclusive Use Clauses
Exclusive use clauses are predominately found in retail leases. A tenant may offer a particular service, or product and if a competing business were permitted to operate within the plaza it would be detrimental to their business. Landlords need to balance accommodating such requests, with restricting possible future leases.
The more specific the wording used, the better. For example, a tenant may request exclusivity on the sale of food within a plaza. Narrowing the scope down to include a specific type of food (eg. pizza) allows the Landlord to lease space in the plaza to another restaurant not serving pizza.
10) Lease Renewals and Arbitration
The agreement will specifically state if a tenant has the right to renew the terms of the lease beyond the expiration of the initial term. The language should state the duration of the renewal, and number of options the tenant may have to exercise said renewal(s). Generally, the terms of the original agreement remain unchanged, save for the rental rate, which is based on the Market Rental Rate at the time a renewal option is exercised.
In the event that the parties to an agreement can’t agree on what Market Rent should be, the process may move to arbitration. This process varies, but typically it involves each side electing their own arbitrator, from which a third (neutral) arbitrator is appointed. The respective sides make their case for Market Rent and the appointed arbitrator makes a decision, which both landlord and tenant must adhere to. Most disputes will not go to arbitration. However, the system is put into place to protect each party with a fair process for establishing market rent.
These are just a few areas that can create issues within the leasing process. Having an experienced representative advocating on your behalf is an important step towards ensuring your goals are properly communicated.