Legal Considerations for Commercial Leases
So, you have found the right commercial property for your business or the right tenant for your commercial property. Before you sign on the proverbial dotted line, there are quite a number of issues to be considered and negotiated. While the potential list of details to be addressed before signing will vary widely from one lease to the next, and can be nearly inexhaustible in more complex transactions, the following considerations are common to nearly all commercial leases in Pennsylvania.
Duration of Lease
While both landlords and tenants alike tend to prefer longer leases of three to five years or more in order to ensure the continuity of business or rent receipts, longer leases can work as double-edged swords. A landlord is generally able to evict a tenant who is not paying the agreed rental, regardless of the stated duration of the lease. In cases where the landlord has entered into a long-term lease based upon underestimates of future increases in rental values, the landlord may face a greater risk with a tenant who is paying his rent on time. In such a case, a landlord could end up locked into a lease with a tenant who has a legal right to continue renting for less than fair rental value.
For tenants in Pennsylvania , there are greater risks. Most landlords will require the personal guarantees of business owners (and often their spouses as well) before leasing commercial space to fledgling corporations or newly formed limited liability companies. Thus, in dealing with his landlord, the new business owner will generally operate without the limited liability protection he might otherwise enjoy in running a business through a corporation or limited liability company. If we consider this reality of commercial leases in combination with the additional reality that small start-up businesses have a high failure rate, we arrive at the further reality that many commercial leases will last longer than the businesses that sign on to them. When this happens, the small business owner can wind up owing rental payments to the landlord long after the business has ceased occupancy of the building. The tenant of a small business under a long-term lease runs an even greater risk because unless the lease contains a specific requirement that the landlord make affirmative efforts to re-let the premises after the tenant defaults (a rarity in commercial leases), a commercial landlord is generally under no such duty. Instead, the landlord can usually invoke the acceleration clause of the typical commercial lease to sue both the tenant and the tenant’s guarantors for the entire unpaid rental owing for the full remainder of the lease term.
For these reasons, a potential tenant with the market leverage to do so is often better off negotiating a long-term lease with a business-failure escape clause, or else a short-term lease with a series of renewal options. The alternative may be a long-term lease that out-lives the tenant’s business.
When both landlord and tenant do agree to a lease of longer than two years, the landlord will generally want to make sure that the lease provides for rental increases to keep pace with changing rental values. There are essentially two ways of addressing this issue.
First, the landlord can assume that rental values will increase by a certain percentage each year, and, on the basis of that assumption, specify in the lease the actual dollar amount of the rent for each year of the lease and for each year of any option or renewal term. The fundamental advantage of this approach is certainty as to what one’s rental obligation or entitlement will be from one year to the next.
In the alternative, the landlord can avoid making such assumptions by relying instead upon some independent index to establish the rate of rental adjustments for future years. One of the indices commonly used for this purpose is the CPI-U (Consumer Price Index-All Urban Consumers), as compiled by the federal Bureau of Labor Statistics. The CPI-U was established upon a 1982 base, or starting point, of 100. As of December 2004 the index had risen to 190.3. As of December 2005, the index stood at 196.8. Typically, a lease indexed to the CPI-U or similar index will provide for annual percentage rent increases equal to the percentage change in the index over the previous year. Notice that the typical commercial lease will call for rent increases pegged to the change in the index, but will generally provide for no change in rent whatsoever if the index declines. Prospective tenants rarely have the market power to negotiate index-based rent decreases.
It is the exception, rather than the rule, when a tenant finds a rental facility ideally suited to the tenant’s commercial needs, without any need for further alteration or improvement. Particularly when the property has been sitting vacant for an extended period of time, the tenant may be able to persuade the landlord to perform and pay for some or all of the fit-ups or improvements appropriate to the tenant’s proposed use. This will more likely be the case for simple fit-ups, such as a typical retail space might require, as opposed to the more costly fit-ups often required for new restaurant uses and other uses requiring extensive equipment or regulatory compliance. But even beyond the question of what improvements or fit-ups the landlord is willing to pay for in order to induce the tenant to sign on to a lease, there is also the question of what later alterations or improvements the tenant is allowed to make. Most leases will provide limits on a tenant’s ability to make alterations or improvements to a commercial space without the prior written approval of the landlord. If the tenant requires particular alterations or improvements, the tenant will be best served to address the tenant’s particular alteration and improvement needs in the body of the lease before it becomes an obstacle after the lease is signed.
Confession of Judgment
Most commercial leases contain clauses providing for confession of judgment, and most tenants have absolutely no idea what these clauses mean. A relic from the dark ages of Pennsylvania Common Law, “confession of judgment” is a legal device by which a creditor (typically a landlord) can obtain immediate judgment against an allegedly defaulting tenant without the necessity of proving a default at a hearing.
This remarkable result is achieved by means of a boilerplate clause by which the tenant agrees that the landlord’s attorney will serve as the tenant’s attorney for the limited purpose of “confessing” to the court that the tenant has defaulted on the lease. With the tenant having thus presumably confessed to being liable to the landlord, no hearing is necessary, and there is no obstacle to the court entering judgment in favor of the landlord for possession of the property and for whatever amount the landlord claims to be due from the tenant. Once judgment has been confessed, it is the burden of the tenant, rather than the landlord, to go into court and affirmatively allege a reason why the confessed judgment should be opened or stricken from the record. While the Pennsylvania Supreme Court has drastically limited the use of confession of judgment over the years, particularly in consumer contracts and residential leases, confession of judgment still has some remaining vitality in the area of commercial leases.
A commercial landlord will generally wish to include clauses for confession of judgment for possession of real estate and for money damages as a matter of course in each and every commercial lease. A tenant with the market leverage to do so will generally wish to negotiate a removal of confession of judgment clauses.
Zoning and Regulatory Compliance
Not all commercial properties are zoned for all commercial uses. Some commercial properties are zoned for office or retail uses, while others are zoned for more intensive commercial and industrial uses. While it is generally preferable for the tenant to have the landlord commit to a property’s zoning within the body of the commercial lease, this is no substitute for the tenant conducting an independent investigation of a property’s zoning before signing on to the commercial lease. A tenant who signs on to such a lease without first conducting such an investigation does so at his or her own risk.
Regulatory compliance requirements should likewise be considered by both landlord and tenant before entering into any particular commercial lease. Before they commit to the bottom line, both parties need to know what improvements or repairs will be required to bring a building into compliance with labor and industry standards. Further, environmental concerns can create both enormous complications and enormous potential liabilities for both landlord and tenant alike. Although this is a subject for another, much longer article unto itself, it can be said as a general proposition that a tenant faces potential environmental clean-up liability if later environmental testing reveals soil contamination for which the tenant might have been responsible. Further, if a tenant causes an environmental contamination and thereafter vacates the property, the landlord or any subsequent owner of the property will generally be viewed as the primarily responsible party from which the federal Environmental Protection Agency or the Pennsylvania Department of Environmental Protection will seek clean-up costs.
A commercial lease can be complex terrain. Landlords and tenants alike are well advised not to negotiate such terrain without the advice of legal counsel. Experienced counsel can help smooth the journey.
The attorneys of Wolf, Baldwin & Associates, P.C. have counseled numerous clients, both landlords and tenants, on the establishment of commercial leases. Click here to contact us and schedule an appointment today.