Commercial Leasing In Mixed-Use Condo Projects

Mixed-use residential condominium projects create a number of issues for commercial landlords and tenants that should be addressed early in the leasing process.  

Mixed-use projects are becoming more common as urban infill increases. While all mixed-use projects create a number of issues for commercial landlords and tenants that are absent from comparable single-use projects, these issues are particularly pronounced in mixed-use residential condominium projects.  

The structure of a condominium project tends to decentralize the typical landlord-tenant relationship because the project will ultimately be controlled by an association acting through a board of unit owners. A tenant is unable to look directly to the landlord, who may simply be one owner of many, to perform customary "landlord" functions such as operating, maintaining, and insuring the building and common areas.

As a condominium unit owner, the landlord's interest will be subject to various governing documents. Any lease will need to be consistent with these documents and require the tenant's compliance with applicable restrictions. Lease provisions that parties are accustomed to negotiating at length, such as rights related to use and access, insurance requirements, operating expenses, maintenance obligations, and procedures following casualty events, to name a few, will largely be dictated by the project's governing documents.

To add to this already difficult framework, the nature of the users' interests are fundamentally different and often at odds. On one end of the spectrum are residential homeowners, directly involved in the association and highly invested in the operation of the project. On the other end are commercial tenants who must look to an absentee landlord to ensure their rights are enforced and protected. Commercial units also typically form only a small part of an overall project, putting commercial owners and their tenants at risk of being marginalized by the majority residential owners.

Review The Governing Documents Early

Given the potential for conflict, commercial landlords and tenants should review the project's governing documents as early as possible. These documents include the declaration of covenants, conditions and restrictions, condominium plan, association articles of incorporation, bylaws and budget, and applicable rules and regulations, such as architectural standards. The governing documents in larger projects may also include documents related to a master association, and separate reciprocal easements and cost sharing agreements.

The landlord may be unable to obtain amendments to the governing documents in an existing project, and a tenant or potential purchaser should see the review as part of its early feasibility analysis. A tenant may request revisions to the proposed governing documents if the project is still being developed, and a landlord/developer should generally accommodate reasonable requests and proactively include protections for the commercial uses because a commercial unit may have little value if its use is overly restricted or its share of expenses too burdensome.

Ensure These Critical Issues Are Addressed

Commercial landlords and tenants should ensure the following issues are adequately addressed (at a minimum) when reviewing the governing documents: 

Protection of Minority Interest –

Protections should be included to ensure the commercial owner's interests are not easily overridden or interfered with by the residential majority. This can be done, for example, by requiring a commercial owner's approval for matters material to the commercial unit, and by excluding the commercial unit from, or providing alternative standards for, certain rules and regulations, such as architectural review requirements.

Restrictions on Use –

Restrictions on use, whether blanket restrictions on nuisance activities or specific restrictions on access, hours of operation, noise levels, and the like, are commonly included in governing documents and should be reasonable. Ideally, they would include broad exceptions for contemplated commercial uses, particularly with respect to operating hours, outdoor music and noise, and common odors.

Operational Obligations –

The governing documents should clearly indicate the extent of the association's obligations to insure and maintain the project and comply with applicable laws, such as accessibility requirements, so that the parties can clearly allocate any remaining obligations in the lease.

Appurtenant Rights –

In addition to clearly describing the commercial unit, the governing documents should grant the commercial owner and its tenant the right to use others areas necessary for the tenant's operation, such as parking, outdoor patios, trash enclosures, roof access, and shared signage.

Operating Expenses –

The operating expenses that landlords and tenants customarily negotiate in a lease will instead largely be incurred by the association and passed through to unit owners in the form of assessments. These assessments should be reasonably allocated. Commercial owners should not be required to contribute to facilities used exclusively by residential owners, and vice versa. To the extent facilities are shared, the allocation of costs should generally be based on rates of consumption or use, rather than a unit's pro rata share of the overall project.

This article originally appeared in the Western Real Estate Business magazine. 

photo credit: neighborhoodcentermixedusehousing (31) via photopin (license)

Leasing Basics - Assignments, Subleasing, and Transfers, Part 3 – Grounds for Denial

This is Part 3 of the basic series I've been doing on assignments, subleasing and other transfers in commercial leases. As covered in Part 2, commercial leases commonly require a landlord’s consent to any assignment, sublease or other transfer of the lease, and often the parties will go one step further and include a negotiated list of grounds which the parties agree will give the landlord a reasonable basis for denying its consent to a transfer.

These grounds vary from lease to lease and may be property specific but typically relate to the transferee’s financial condition and background, the proposed use of the premises, and sometimes the terms of the transfer itself. 

Below is a list of several common grounds for denial, grouped roughly by whether they relate to the transferee, the transferee's use, or the terms of the transfer. For most, the landlord's perspective is self-explanatory, so often only the tenant's countering perspective is noted.

In addition to understanding the concepts behind these grounds for denial, you should also note how they are drafted in the lease. Often the concept itself is just fine, but it is drafted in a way that's too vague or subjective to provide a workable standard. In that case, instead of fighting about whether the provision should stay or go, see whether a revision might make the issue come across more clearly and objectively.    

Grounds For Denial Related to the Transferee:

1. The Transferee's creditworthiness, character or business reputation is unsatisfactory.

Tenant's Perspective: Generally acceptable. You'll see these phrased in all sorts of ways, and again, it's important that the standard be objective. What's "unsatisfactory"? A more objective standard would be that the transferee's credit and reputation are comparable to that of tenant and existing tenants in project, or even similar projects in the vicinity if the project happens to be quite small..

2. The transferee's financial condition or stability is insufficient to support its obligations under the lease or would increase the risk of default.

Tenant's Perspective: Also generally acceptable, and again, these come in all shapes and sizes. A common variation is a net worth test, requiring the transferee not to have a net worth less than the tenant. That may be fine; however, if the tenant has a net worth higher than necessary to service its obligations under the lease, this standard may be too restrictive. A strong tenant may also ask that this condition not apply to subleases (because the tenant and guarantors are still directly liable and often in possession) and, for any other transfer, take into account the continuing liability of the tenant or guarantors -- the argument being that often the landlord has less additional risk because the original parties are still on the hook.

3. The transferee is a current tenant in the project or a prospective tenant that landlord has negotiated with.

Tenant's Perspective: Generally unacceptable. Other tenants in the project or tenants a landlord has solicited are ideal transferees because they are already in, or interested in, the project. A strong tenant would delete this entirely. A tenant with less negotiating power would request exceptions (e.g., existing adjacent tenants). A tenant may also ask what the landlord's concern is and then address that concern.  For example, if a landlord is concerned about tenant mix and diversity, agreeing on not transferring to certain existing tenants.

4. The transferee is a governmental agency or instrumentality. 

Landlord's perspective: This is not always self-explanatory, so here is a bit of landlord's perspective: Like it or not, government uses often include denser, lower quality uses with a multitude of visitors that impact the common areas, conflict with other uses, and make the building generally less prestigious. Something I often see is a group of people lined up around a building waiting to get into the social security administration office. Most landlords (and their other tenants) don't want that. 

Tenant's Perspective: Often unacceptable. Most tenants would argue (and stronger tenants often successfully) that the landlord's concerns are legitimate but covered by other factors relating to the use (like those below) and that government agencies are often made up of professionals not working with the public. If the landlord is unwilling to delete the condition altogether, a tenant may fall back to condition the restriction on there being no government use then in the project.

Grounds For Denial Related to the Transferee's Use:

1. The transferee's use is different from the permitted use in the lease.

Tenant's Perspective: Generally acceptable; however, if the permitted use is narrow, which will more often be the case in a retail lease, then a tenant many ask for the right to request a change in use subject to reasonable conditions, which may be listed in the transfer provisions themselves (i.e., the other conditions appearing below), or in the use provision.   

2. The transferee's use would increase use of common area.

Tenant's Perspective: Generally acceptable with some revisions. The concept behind this ground is fine; however, to ensure it is not used to bar any sublease (which often results in additional uses and thus additional use of the common area), a tenant might ask to require that any increase in use be materialand incompatible or disproportionate to the use by other tenants in the project.      

3. The transferee's use is adverse to or would interfere, conflict, or compete with use of landlord or existing tenants.

Tenant's Perspective: Generally acceptable in a retail setting; however, if this shows up in a general office lease, a tenant may request that it be deleted or inquire into what the landlord's concern is. For example, a condition on not interfering with other tenants is hard to object to, but what does competition mean in an office setting?  

4. The transferee's use would violate an agreement the landlord is a party to or that affects the project.

Tenant's Perspective: Generally acceptable. This often arises in retail leases where a landlord has granted exclusives to other tenants or the project is subject to CC&Rs.

5. The transferee's use would be less prestigious or otherwise inconsistent with character and quality of project. 

Tenant's Perspective: Generally unacceptable. The concept here is fine, but as expressed, it's too vague and subjective. If many of the other grounds above have been included, a tenant might reasonably argue that the landlord's concerns are covered. But if a landlord still wants a catchall provision, a better one would be that the use will not be inconsistent or incompatible with the project and the existing uses in the project. (But again -- this point may already be covered by other grounds).

6. The transferee will pay less percentage rent (i.e., its gross sales will be lower).

Tenant's Perspective: Generally acceptable in a retail setting, for obvious reasons. If the landlord negotiated base rent and percentage rent based on the tenant’s business and projected gross sales, that is the economic deal. That said, a careful tenant may ask to exclude any reduction in percentage not caused by the transfer (e.g., due to general economic conditions vs. a change in use or trade name). And if a tenant felt that it needed more wiggle room, it might request that the condition instead be based on the projected aggregate of base rent and percentage rent, since a reduction in percentage rent can be offset by increasing the base rent. 

Grounds For Denial Related to the Transfer Itself:

1. The transfer is of less of less than the entire premises or term. 

Tenant's Perspective: Generally unacceptable. This would prohibit most subleases, and unless the landlord is agreeing to recognize a sublease if the tenant defaults, the other conditions adequately cover any concerns a landlord may have.  

2. The transfer will result in alterations.   

Tenant's Perspective: Often unacceptable. Many subleases require alterations. A tenant may want to soften this, for example by providing that the transfer will not result in any alterations reasonably objectionable to the landlord (so that the fact that there will be alterations is not itself automatically a ground for denial) or even exclude alterations resulting from demising walls or other customary alterations made in connection with a sublease.

3. The transferee will pay less rent than the rent quoted by the landlord in the project.

Tenant's Perspective: Generally unacceptable. Subleases will always been discounted because, recall from Part 1, there is no direct relationship with landlord, and unless a landlord agrees to recognize a sublease, a subtenant gets wiped out if the tenant's lease is terminated. Additionally, there is little need to push a tenant to get the best deal it can on a transfer because most leases provide that the tenant will keep all or a portion of any rent in excess of that due under the lease, and even if there is no excess rent, the tenant will of course be trying to minimize its downside, that is, the difference between the rent it pays under the lease and the rent it gets under a sublease.    

Landlord's Perspective: That said, a landlord may have a legitimate basis this condition, particularly if the tenant was given a below market deal with material concessions.  In that case, a landlord does not want a tenant competing with it as it tries to lease up the building. If this is the case, a tenant may need to scale back from deleting the provision agree that it will apply until the building is leases or during an initial term or negotiate for a lower percentage of the rent quoted by the landlord.

4. The tenant is in default at the time it requests a transfer.

Tenant's Perspective: Generally unacceptable. This is a sort of gotcha that stronger tenants object to (and that landlord's do not need to feel guilty about deleting). If the tenant is in default, the landlord has its remedies under the lease, e.g., send a notice and demand cure, and if there is no cure, evict; however, if the landlord has decided to forbear (a typical example is when a tenant finds itself in trouble and is paying rent, but not all rent), that decision should not cut off the tenant's lifeline, which is a sublease, assignment or other transfer. The landlord should be covered by all of the other grounds discussed above.

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AIR Form Comparison: The only ground for denial expressly listed in the AIR forms is that the landlord may deny any proposed assignment or subletting if the tenant is in default at the time consent is requested. This of course is the ground discussed immediately above. As for the lack of other grounds for denial in the AIR forms, as covered in part 2, including a list of grounds for denial in a lease is not required, but for larger leases has become fairly standard and may benefit both parties by providing a framework for proposed transfers. 

Leasing Basics – Assignments, Subleasing, and Transfers, Part 2, Defining and Conditioning a Tenant’s Right to Transfer

This is Part 2 of the basic series on assignments, subleasing and other transfers. Part 1 covered the difference between assignments, subleases and other transfers, and provided a short summary of California law. This post covers how transfers are defined and conditioned from the perspectives of a landlord and a tenant, how AIR forms cover these issues, and a few thoughts on how to prioritize negotiation.  

Why Are Transfer Provisions so Critical?

If you are a landlord, these provisions are your way of ensuring that you maintain control over your property. As covered in Part 1, if a lease is silent on transfers, the tenant has the right to freely sublease, assign or transfer its interest in the lease. And, to the extent a lease does restrict transfers, a court will read those restrictions narrowly and in favor of permitting transfers. For this reason, landlords need to clearly restrict all possible transfers and then carveout specific exceptions for the types of transfers they are willing to accept.        

If you are a tenant, these provisions are just as critical. I don’t know who said it first, but a general rule in business, especially in the business of real estate, is to always know what your exit plan is. If you are a tenant, your exit plan is the transfer. Tenants often need to expand, downsize, move, close or sell their businesses during the term of a lease, and there is a chance you will too. When you sign a lease for 5 - 10 years and commit to paying hundreds of thousands, and often millions, of dollars in rent and other expenses, you have to take the time to get these provisions right.

Negotiate Accordingly to Your Business Plan and Manage Risk

Before discussing the issues a landlord and tenant often negotiate, I need to add a sort of disclaimer that applies to this post and every post to follow: I may list a lot of issues but not all of them will be important for a specific transaction. Many landlord forms do not cover all the landlord issues identified here, and many tenants will not convince their landlords to make changes to cover all the tenant issues identified. And that is OK. An easy way to kill a deal, or at least waste a lot of money on attorneys, is for either party to make an issue out of everything regardless of how small the impact or likelihood.

                             Mind Tools Risk Impact/Probability Chart

Anytime you are working through a lease, or any other agreement for that matter, remember to (1) negotiate according to your business plan, that is, know what issues are important based on your specific business, what it is doing now and what it may be doing in 5-10 years, and (2) think about other issues from a risk management perspective, that is, prioritize issues based on what might happen, how often it might happen, and what the impact will be. This chart from Mind Tools is a good reminder. 

I’ll add to this by saying that generally you should also factor in the size of the deal and its relative importance, to you and to the other party you are negotiating with. You start with the high impact, high probability issues, and as the size or importance of the deal grows, you generally move down the scale. A lease of 1,000 square feet for 3 years cannot be negotiated the same way as a lease of 20,000 square feet for 10 years. And it goes both ways – if you are a tenant don’t ask for low priority things that don’t matter, and if you are a landlord and your tenant asks for low priority things that don’t matter, don’t be afraid to say yes to keep thinks moving.  

AIR Commercial Real Estate Association Leasing Forms

For each of these posts, I’ll briefly compare the issues identified with how those issues are covered in the AIR Commercial Real Estate Association leasing forms widely used in California. There are primarily three types of AIR forms, an office lease, a shopping center lease, and an industrial/commercial lease, and these forms come in variations – single tenant or multi-tenant, and net or gross. My comparisons will mostly be based on the multi-tenant net versions of the office, shopping center, and industrial/commercial leases. 

The comparisons are not meant to bless or condemn the AIR forms, but since the goal of this site is to be a resource, and many of you use AIR forms, this is an easy way to flag potential issues you may want to consider as a landlord or tenant. Remember, because the AIR forms are designed to cover as many transactions as possible, they are by nature generic and will often need to be revised by the parties to fit the transaction, sometimes slightly, sometimes so much that it's easier to start with another form.

A Landlord's and Tenant's Fundamental Perspective 

Let’s start with the fundamentals from a landlord’s and tenant’s perspective. If you add your own hotbutton issues to this list and keep it in mind when reading through the transfer provisions in a lease, the rest will largely be common sense.     

Landlord:

• Control. Wants to control its property and vet and approve any new party or entity in the same way it did with the original tenant. In short, a landlord doesn't want someone in its building or center it would not have originally leased to.
   
• Risk. Wants to minimize changes to the extent possible. The landlord got comfortable with and underwrote a specific set of facts that made up the deal – the principals or management of tenant, the tenant’s business, the guarantors, the tenant’s assets, etc. Whenever possible, a landlord will be looking to minimize, approve, or at least have notice of any changes to those facts because they may increase the landlord's risk.
   
• Value. Wants to recover increases in value, avoid any disruption of cash flow, and ensure the space stays marketable and the tenant mix appropriate (which is always important but can be critical for a retail property).

Tenant:

• Freedom. Wants to ensure restrictions on transfers will not unreasonably constrain internal operations –for example, entity structuring, routine transfers among affiliates, subleasing or sharing space with affiliates. 
   
• Exit. Wants reasonable assignment and transfer rights as an exit – for example, the right to assign the lease to a third party or to sell its business.
   
• Growth/Contraction. Wants to be able to sublease to expand or contract space as needed.
   
• Third Parties. May need the right to encumber, pledge or assign the lease in connection with financing, franchise agreements, or partnership agreements (remember to negotiate according to your business plan).   

How a Landlord and Tenant Define Transfers 

Landlords Broadly Define – A landlord should define transfers broadly to cover every possible transfer and then carveout specific exceptions for transfers that are permitted or permitted subject to the landlord’s consent. Accordingly, restrictions on transfers should be written to apply to everything – not only to assignments and subleases – but also licenses, space sharing and occupancy agreements, encumbrances, pledges, and transfers of the ownership, control, or assets of the tenant, all whether voluntary, involuntary or by operation of law (see Part 1 for why this is important).

Tenants Carveout Exceptions – A tenant will generally accept the landlord’s broad definition of transfers but will want to carveout exceptions for “permitted transfers”. Typically these include (1) changes in ownership or control resulting from internal organizational changes and restructuring, (2) assignments or subleases to affiliates, and (3) sharing space with affiliates, clients, customers, and contractors. A tenant may also negotiate a relaxed standard for the sale of its business (especially for larger companies acquired as a going concern where the specific management or personnel of tenant is not material to the landlord).

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AIR Form Comparison:  For the landlord, while the AIR forms broadly define transfers, they could be broader still and include (1) involuntary transfers (courts distinguish between transfers “by operation of law” which are covered by the AIR forms vs. “involuntary” which are not), and (2) licenses or other space sharing or occupancy agreements. If maintaining current ownership is important, the change of control provisions could also be broader and include involuntary or voluntary transfers, and the transfer, pledge or encumbrance of ownership interests in the tenant (think death, bankruptcy, and mezzanine debt).

For a tenant, none of the typical carveouts for permitted transfers are included in the AIR forms, other than a reference to allowing vendors to use “a deminimis” portion of the premises, for what that’s worth. A tenant also needs to determine whether the restrictions on transferring voting interest or assets are acceptable. Is a restriction on transferring 25% of the voting interest or reducing the tenant’s net worth by 25% acceptable? Often these thresholds are revised up to 50% as a matter of course. But there’s more to consider: What’s “voting control”? For an LLC or LLP, does this include transfers where the manager/GP maintain control? For a corporation, is this the board or shareholders? If the board, a tenant with regular changes in the board would violate this provision repeatedly without even thinking about it. And what about transfers of assets? At minimum this should exclude transfers made in the ordinary course of business; however, for particular tenants, the provision may need to be deleted altogether.

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How a Tenant's Right to Transfer is Conditioned 

With few exceptions, every lease form will require that a tenant obtain the landlord’s consent before transferring the lease (other than for the permitted transfers noted above).

The landlord's consent will generally be conditioned in two ways: First, there will be an express standard saying the landlord's consent will be reasonable or that the landlord's consent will be in its sole discretion. (And remember from Part 1, in California, if the lease is silent on the standard, then the landlord's consent must be reasonable). Second, there will be a list of conditions or grounds for denial that the parties agree will give the landlord a reasonable basis for denying a transfer.

What Standard Should Apply to a Landlord's Consent?  –  Reasonable or Sole Discretion? 

If a lease requires a landlord's consent, should that consent be reasonable or in the landlord’s sole discretion, and does it matter? Many practitioners, and I'm among them, believe the landlord's consent should always be reasonable. There are a couple reasons for this:

First, in California, most landlords want to preserve their remedy under Civil Code 1951.4 to keep a lease in place after a tenant's default, and the landlord only has that remedy if the conditions to transfers are reasonable. (See Part 1 for more detail)

Second, when the parties list out conditions to a transfer, they are really already moving beyond the "sole discretion" standard and agreeing that if those conditions are met a transfer will go through. I know I know, the lease will never say that, but that is clearly the implication, and unless a landlord has a very good reason, if a tenant doesn't hit any of the triggers for denial, it's implied that the transfer will be approved. 

Third, and most importantly, a sole discretion standard doesn't have much benefit. Although using a sole discretion standard means you don't have to be reasonable, it doesn't get you out of your obligation to act in good faith, which is a standard read into all contracts by courts in California and the majority of other states. And the line between the standards that apply when someone is supposed to act reasonably versus "just" in good faith is murky. Simply put, a sole discretion standard gives the landlord a little protection from a court second-guessing its decisions, but not much.

Most tenants request that the landlord agree to act reasonably (this avoids the hassle of potentially litigating the extent to which the landlord's sole discretion allows it to act unreasonably), and most landlords readily agree to the tenant's request.  

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AIR Form Comparison: The AIR forms require a landlord’s consent but are silent on the standard that applies, so the landlord’s consent must be reasonable under the Civil Code.

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Grounds for Denial – Should a Lease List These Out?

In addition to requiring that a landlord consent to any transfer, most commercial leases these days also include a negotiated list of grounds for denial, or sometimes conditions to approval, that apply to any transfer proposed by a tenant. More often than not, these are written as grounds for denial, e.g., if X is true, then the landlord can reasonably withhold its consent. I'll say "grounds for denial" to be consistent, but note that these could also be written as conditions to approval, e.g., if X, Y and Z are true, then landlord will not unreasonably withhold its consent.

Should a lease list out the grounds for which a landlord may reasonably deny a proposed transfer? For most leases, the answer is yes. It’s not required. (And as noted below, the AIR forms don’t list these out.) Simply stating that the landlord's consent is required gives the landlord the right to withhold its consent if there is a reasonable (read justifiable or legitimate) basis for doing so. However, listing out grounds for denial, which the parties agree are reasonable, shifts the burden of proof to the tenant and makes it harder for the tenant to later argue that any of these grounds are no longer reasonable. For this reason, most landlord forms do include a list.

For a tenant, it's less important that a list be included, but on balance, it’s still preferable. The reason for this is that, although the list is not exclusive, in the same way that it’s harder for a tenant to challenge a denied transfer based on a listed ground for denial, it is also harder for a landlord to deny a transfer based on a ground not listed. If a lease simply requires a landlord's reasonable consent, a landlord has a lot of leeway to make up arguments for why a transfer is not reasonable. But if a lease lists out specific grounds, it’s implied that if none of these triggers are hit, a landlord will consent to the transfer. Putting in the list also gives the tenant a chance to negotiate these points with the landlord upfront, while the tenant still has leverage.    

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AIR For Comparison: The AIR forms do not include a list of grounds for denial. The only express condition, other than the landlord’s consent, is that the tenant not be in default.

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That's it for Part 2. To keep the posts from getting too long and to make it easier to find posts in the future, I'll be splitting these up. Part 3 will follow this post and cover the various grounds for denial that are most frequently seen in a lease. As you'll see, the list is surprising long.