August 31, 2018

Avoiding Unexpected Costs in Lease Agreements

by Stephen Tanner, Ice Miller LLP

Although many aspects of life are shifting online, most businesses still need to secure sufficient office space for their employees, warehouse space for their product or retail space for their customers. Oftentimes, that occupancy arrangement comes in the form of leasing space from a landlord.

Leases are typically referred to as being either "gross" or "net." A gross lease will typically require a tenant to pay a flat amount of rent each month, while a net lease will typically require a tenant to pay a flat base rent amount each month together with a variable amount of additional rent to reimburse the landlord for the costs of operating and maintaining the property. While a gross lease can provide cost certainty to a tenant, landlords typically prefer net leases because it provides greater income certainty to the landlord.

Net leases are fairly common, and it is commercially reasonable to enter into net leases, but there are a number of provisions that should be reviewed carefully, as many provisions could significantly increase leasing costs above budgeted levels.

A lease should clearly describe the costs that are passed through to the tenant and the costs that are borne by the landlord. It should also state which party will be responsible for performing various maintenance, repair and replacement obligations.

A tenant can gain additional cost certainty by negotiating into the lease a cap on annual increases in operating expenses. When negotiating a cap on operating expenses, the parties should consider whether the cap will be cumulative, where the maximum charge for operating expenses increases by the full amount of the cap each year (even if the actual operating expenses were lower than the cap), or non-cumulative, where the maximum charge for operating expenses in any given year can only be higher than the prior year operating expenses by the amount of the cap.

Capital repairs and replacements are another potentially significant cost item that should be addressed in the lease. The lease should state which capital repairs and replacements will be made at the landlord's cost and which will be passed through to the tenant. It is common for capital repair or replacement costs passed through to the tenant to be amortized over the useful life of that repair or replacement, so that only a fraction of the cost is passed through to the tenant each year. Without such a provision, an unsuspecting tenant may get stuck paying for the landlord's new roof over the course of a single year. This is especially problematic if the tenant only has a short lease term remaining, as it will have paid the entire cost for a benefit it will never realize.

Leases are complex documents. It can be tempting to gloss over the substance of the lease once the basic economic terms have been agreed to in a letter of intent. However, it is in the best interest of both the landlord and tenant to ensure the lease accurately reflects their expectations, as that document will guide their relationship for years to come.