Stan Mullin specializes in the sales and leasing of industrial land and buildings in southern Orange County, California. His areas of expertise include: entitlement, contract language, construction schedules, development, assessment district and community facility district bond financing.  

Tenants Rights in a Lease

Author: Stan Mullin, CCIM, SIOR

In this article we have taken four topics, common to commercial real estate leases and briefly described either a) the rights that a tenant typically has in relation to the landlord or b) provisions you might attempt to have included in a lease when you are representing a tenant. Because this synopsis cannot address the intricacies of any specific transaction and landlord/tenant law varies from state to state, we recommend that you consult with local legal counsel who specializes in real estate law before making a binding commitment.

1. Offset Rights - If a landlord fails to perform his obligations pursuant to the lease, can the tenant perform the obligations and deduct any cost incurred from rent due under the lease? The ability, perceived or real, for the tenant to utilize “self help” under these circumstance is one of the greatest threats to a landlord, and even if the tenant does not have the contractual or legal right to self help, the landlord may well find it difficult to convince a judge of the merit of his case against the tenant if the landlord has not complied with his obligations under the lease.

Unlike some types of contract law, which allow a party to a contract to withhold performance of its obligations after the other party has breached the contract, most states require the parties to a lease to continue to perform their obligations, even when the other party is in default or breach. While many states have adopted laws which allow residential tenants certain self help rights, those rights have not generally been extended to commercial tenants. If commercial tenants are not provided with these rights, what can they do if their landlord does not fulfill his obligations? In some states, the courts have ruled that if the landlord is not performing his obligations under the lease, that he has constructively evicted the tenant. This allows the tenant to be relieved from the lease and move elsewhere. If the tenant stays in possession, however, he must pay rent. This does not, therefore, provide much assistance to those tenants for whom it would be impractical or expensive to move to an alternate building.

If the state in which the property you are dealing with does not allow self help, you may wish to suggest that the proposed lease be modified so as to provide that the tenant has the right to fulfill the landlord’s obligations if they are not met within an agreed upon time frame after appropriated notice and then deduct the cost thereof from future rent. You might also wish to suggest that the lease specifically state that the tenant’s obligation to pay rent is a covenant dependent upon the landlord’s performance of its obligations.

2. Capital Expenditures - Sometimes, near the end of the lease term, a landlord may notify the tenant that he plans to make certain major repairs to the property and/or replace certain portions of the capital improvements, e.g. the roof. While leases often require the landlord to maintain the roof, building exterior, parking lot and common areas, sometimes what is characterized as a routine replacement or maintenance is a thinly veiled excuse to renovate the property, at the tenant’s expense, so as to make the building attractive to prospective tenants after the existing term expires. Landlord’s that have re-roofed, re-painted the building, re-surfaced the parking lot, or renovated the landscaping and subsequently billed the departing tenant for the cost, have motivated the revision of many leases around the country during the last few years. A tenant’s advisor can help mitigate and/or prevent this type of problem by including language in the lease which requires the landlord to allocate the obligation to pay for these types of expenses over the expected useful life of such upgrades. If a new roof has a useful life of 20 years and two years remain on the term, the tenant should only be obligated to pay, in equal installments, along with base rent, 10% of the cost of the roof during the last 24 months of the term. You may, therefore, wish to include language similar to the following in your lease: “……the cost thereof shall be prorated between the Parties and Tenant shall only be obligated to pay, each month during the remainder of the term of this lease, on the date on which Base Rent is due, an amount equal to the product of multiplying the cost of such replacement by a fraction, the numerator of which is one, and the denominator of which is the number of months of the useful life of such replacement, as such useful life is specified pursuant to Federal income tax regulations or guidelines for depreciation thereof (including interest on the unamortized balance as is then commercially reasonable in the judgment of Landlord’s accountants), with Tenant reserving the right to prepay its obligation at any time.”

But what if the capital expenditure is government mandated? If such a capital expenditure is mandated by a governmental agency as a result of tenant’s specific use of the property, typically the entire cost is borne by the tenant (you can always attempt to have the landlord pay for the share of the cost that is equal to the percentage of the improvement that is likely to have reversionary value to the landlord). If, on the other hand, the subject capital expenditure is required at the building regardless of use, such as natural hazard mitigation (i.e. seismic modifications), energy efficiency, etc., the cost burden should be shared between the landlord and the tenant based upon the remaining term of the lease and other similar factors. A lease provision which splits the cost in the same fashion as suggested in the paragraph above is a good alternative. If these expenditures are mandated near the end of the term, the landlord should have the right to terminate the agreement if the cost is too burdensome and the tenant should have the right to a) terminate the lease if the landlord does not pay his share or b) pay for landlord’s share and offset that cost against rent due. A similar approach can be used with other cost sharing issues such as the remediation of environmental contamination that is not caused by either party or damage due to natural hazards (i.e. ice storms, earthquakes, wind, etc.)

3. Right of 1st Refusal - Many tenants will want the right to either acquire the property or take additional space during the term of the lease. As a rule, the first rights of refusal benefit only the tenant as they limit the landlord’s ability to sell the property or lease portions of the property. Often, however, such concessions are granted by the landlord in order to entice a tenant into entering into a given lease. Care should be taken to draft any such provisions carefully so as to eliminate any future misunderstandings. The tenant should attempt to obtain an “ongoing” right of first refusal which will provide the alternative throughout the term. If the right is “one time” the tenant may face an opportunity to purchase or expand early in the term when he or she is still getting established in the property and may not have the need for additional space or the cash available for the purchase. If the tenant is limited to the one occasion, it defeats the intended purpose of the right. As long as any first right provisions typically require the tenant to pay a fair market rental or price, the landlord/seller should not be unduly harmed by providing a continuing right through-out the term.

In addition, it is important to clearly specify who may exercise these rights - especially with regard to first rights of refusal to purchase. For example, the principals in the tenant company may wish to exercise the right to purchase in their own name rather than have the tenant make such a purchase. In appropriate circumstances, one might also wish to address how these rights are to be treated if the tenant’s partnership is dissolved or if married tenants are later divorced.

Where a right to purchase is being granted, the landlord typically must fully negotiate the terms to a sale, then provide notice of the terms to the tenant, provide a period for the tenant to match those terms (typically 1-3 weeks). If the tenant does not respond within the allotted period, the landlord may proceed with the initial sale and the tenant’s right to purchase is extinguished. Where a right to expand is granted, the landlord be required to notify the tenant at least 30 days in advance of the pending availability of the subject space.

4. Subordination, Non Disturbance and Attornment Agreements - If a tenant is making substantial tenant improvement to the space or the building is uniquely suited to the tenant’s use, the tenant should request a subordination, non disturbance and attornment from the landlord’s lender so the tenant’s lease will not be voided in the event of the foreclosure on the property. On occasion request and receive a Subordination, Non Disturbance and Attornment agreement from the landlord’s lender, in the hope that the tenant’s lease will not be voided in the event of foreclosure on the property. Each state differs in it’s handling of this issue, and this area of the law is far too complex for this article. By way of illustration, however, California uses a “race notice” system which establishes priorities between interests in real estate. Typically, the party which records its interest first takes priority over later attaching interests. In this system, the foreclosure of a senior deed of trust can terminate junior interests (i.e. a lease agreement) in the property. 

Is a lease automatically extinguished when a) the lease is executed after the deed of trust was recorded against the property (which is typical with property encumbered with a loan), and b) the deed of trust was subsequently foreclosed upon by the property’s lender? Can the purchaser at the foreclosure sale void the lease even if the tenant is in full compliance? 

In California, a 1997 decision in the case of Miscione v. Barton Development Company held that the lease was not extinguished because the lease contained an attornment provision (a provision wherein the tenant agrees to recognize a buyer at a foreclosure sale as landlord) the court found that the buyer at the foreclosure sale could elect to either void the lease, since there was no subordination agreement, or agree to recognize the lease and have the tenant attorn to it under the provisions of the attornment provision. Since the buyer had accepted rent from the tenant, the court held that the buyer had recognized the lease notwithstanding the priority of the deed of trust.

Please contact the authors if you would like suggested language to address some of the topics addressed in this article.

Stan Mullin is a Senior Vice President in the Newport Beach, California office of Grubb & Ellis with a focus on corporate real estate. You can learn more about his firm at www.grubb-ellis.com.

Richard L. Riemer is a real estate attorney in private practice in Santa Ana, California and is the attorney for the Forms Committee of the American Industrial Real Estate Association.