Property acquisitions require a comprehensive approach to existing-lease due diligence.
by Crystal Lofing
Although commercial real estate investors often look at capitalization rates and replacement costs when considering an acquisition, the primary income stream — and therefore the primary pricing mechanism — is rent and operating expense recoveries paid by tenants. Comprehensive lease due diligence relating to the income stream or net operating income of a building is critical when acquiring a commercial property. In addition, a myriad of other lease provisions may have a material economic impact on the NOI.
Prior to undertaking lease due diligence, the buyer and its legal team should tailor the scope of the lease review to the size and type of the transaction and property. Considerations to review include financing, state-specific provisions, and buyer-specific considerations, such as risk tolerance, as well as corporate, tax, and accounting issues.
Significant Lease Provisions
In addition to identifying basic lease terms such as fixed rent, expense stops, and base years, and reviewing any specific, transaction–driven terms, such as subordination provisions in the context of a corresponding acquisition loan, there are certain lease provisions that should be identified and analyzed as part of every lease review due to their potential economic significance and ongoing property management implications. These provisions include rights to purchase or expand into other space at the property; lease term renewal, termination, and reduction rights; tenant obligations to reimburse landlord for capital expenditure costs; and state-specific issues, such as the presence of any Proposition 13 property tax protection in California leases.
In analyzing the above provisions, the event or date that triggers any expansion, purchase, renewal, or termination rights and the date by which such rights must be irrevocably exercised should be identified, as it assists the buyer in tracking future lease obligations and accordingly minimizes the risk of a future buyer default. It also alerts the buyer, particularly with respect to first refusal rights of tenants to expand their premises or purchase the property, and to any potential adverse side effects regarding its ability to lease or sell the property. For example, as a result of the waiting period imposed in connection with first refusal rights, a buyer, as owner, could experience a potential reduction in the pool of tenants or buyers and a corresponding reduction in the rent or purchase price that would be gained by a more competitive process.
Any potential economic impact on the rental stream should be analyzed as well. For example, an expansion, renewal, or purchase right may have an unfavorable rent or purchase price calculation. Depending on the circumstances, the impact could result from a deficient or discounted fair market formula or a dispute resolution process that favors the tenant. An expansion or renewal right also may require the landlord to provide certain tenant concessions, such as a construction build-out period.
A termination right that does not trigger a corresponding termination fee should be identified, as well as any deficiencies in the termination fee itself. For example, the termination fee may not contain a component attributable to downtime costs. A lease review also should identify if a tenant is not obligated to reimburse the landlord for market capital expenditure costs, such as operating expense-reducing costs or those required by law.
Any property tax protection granted to the tenant also should be described, together with any landlord rights to buy back the protection or reduce the protection over the lease term. For example, in California, full Proposition 13 protection prevents the buyer from receiving reimbursement for the applicable tenant's share of property taxes equal to the difference between the property taxes based on the current owner's purchase price (plus 2 percent annual increases) and the property taxes based on the purchase price to be paid by the buyer.
Additional Provisions
Additional lease provisions often are identified and analyzed by a buyer's legal team during the lease review process. Particularly for economically significant leases, these include the following plus other out-of-the-ordinary lease provisions that may have a material economic or accounting impact on the buyer:
unusual rent abatement or offset rights, including self-help rights;
significant restrictions on operating expense recoveries, such as an annual cap on increases in operating expenses;
audit rights, including a cut-off period to object to operating expenses or landlord obligation to pay for an audit;
security deposit or letter of credit provisions, including any burn-down or restrictions on application;
environmental representations and warranties or environmental indemnities made by the landlord;
pro-tenant landlord default provisions, such as offsets or an express right to terminate following a default by landlord; and
in-term lease concessions, such as a refurbishment allowance, or the ability of a tenant to convert an improvement allowance into a credit against rent.
These lease provisions are a starting point in determining the scope of the legal review of the lease component of an acquisition. They can be supplemented as appropriate by additional transaction-, state-, property-, and buyer-specific considerations.
Crystal Lofing is a real estate attorney in the Century City, Calif., office of Allen Matkins Leck Gamble Mallory & Natsis, a real estate, land use, and environmental law firm. Contact her at clofing@allenmatkins.com.
