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Mergers and acquisition real estate due diligence – or pay your dues

When companies acquire or merge with other competing or complementary firms, real estate is, as a part of the transaction, generally a small overall concern. However, we frequently see major risk being absorbed by the acquiring firm with potential for a very negative surprise down the road.

Here’s the error: Due diligence of the real estate is often relegated to their investment advisory firm and/or an M&A legal team to simply provide a cursory review of the legal terms of leased real estate without much attention to the business terms.

It becomes especially onerous when the selling principals have an ownership interest in the real estate and have either leased it back to their corporations, or will remain the owners of the property and lease it to the acquiring firm.  Realize that any lease developed by principals for leaseback to their own corporations, while perhaps near “arms length” rental rates, generally places as much operating risk as possible onto the corporation tenant.  They are often intentionally structured with maintenance and compliance requirements (replacement of roof or structural members, ADA or fire code improvements, environmental remediation) without ANY representation or warranties from the Landlord to the Tenant.

Certainly if it’s your corporation you can do whatever you want, but no intelligent or well-advised tenant would accept those terms in a market-competitive situation.  Except when they are doing an acquisition, that is.

Once, we saw a lease that required the Tenant to pay a net rent equal to the Landlord’s mortgage payment and, in the event that the Landlord refinanced the property, the Tenant would be responsible for the adjusted payment and all closing costs related to the refinancing.

This gave the Landlord the ability to pull out as much equity as any lender would provide, at will and upon any terms or amortization schedule that they desired, and the Tenant was obligated to pay the cost.  Unfortunately for our client, we were hired AFTER they had acquired the firm that was the Tenant from the former owner Landlord – and that is exactly what he had done.

It can be nearly as bad when the company is acquiring the business but not the real estate and doing a leaseback of the principal’s building.  Inevitably, the seller’s attorney wants to prove themselves clever enough to insert equally risk-shifting strategies into the new lease document.  Don’t allow it.

Here are three ways to protect yourself:  

  1. Every lease on acquisition property should be treated with the same process that is applied to any new corporate lease.
  2. Make it clear from the earliest acquisition discussions that all leases from the target’s principals will be on your own fair and balanced standard lease form.
  3. If they already have leased the property back to their corporations, require that lease be terminated at closing and the new one take effect.  Their attorneys will fight it of course, so make this a deal-killer absolute up front in the negotiations. It will prevent unreasonable risk being shifted to your firm.
commercial lease commencement dates

Commercial Lease Commencement Dates

A typical commercial office or industrial lease states something to the effect that the “The Commencement Date of the Lease shall be the later of X date or the date that the Landlord delivers the Premises to the Tenant.”  (Note:  If it says the “earlier of X date ….”, your landlord is really giving you a raw deal.)

This Commencement Date language protects you in case the Landlord is late in completing construction and you don’t get possession when planned.  Right?  Wrong.  Here’s why:

Suppose that you are planning to take possession of a property on or before June 1st and your existing lease expires May 31st.  As is not unusual in commercial real estate lease transactions, getting the construction completed on time is a push but appears not unrealistic.

A week or two before June 1st, the Landlord informs you that the space will be delivered June 5th.  Your new rent will be prorated so that you don’t pay for June 1 – 4.  That’s fair, isn’t it?  Probably not.

You will be forced into a holdover position in your existing space.  If your lease is silent on the subject, most States provide that a landlord can charge double rent during a holdover period.  Many commercial leases address this issue and specify some increased rent penalty from between 125% (if you negotiated it up front) to 200%.  In addition, since rent is paid monthly, you are obligated to pay for the entire month – there is almost NEVER a provision for a daily prorated  holdover rent.  Further, you may be liable for other costs incurred by the landlord.

If he has leased the space and plans to commence build out for a new tenant, you’ll likely get charged for the overtime incurred to get them back on schedule.  If you are delayed long enough for his prospective new tenant to bail, you may get sued for the entire value of the failed lease.  Meanwhile, your new landlord’s liability is limited to compensating you by not charging for the four days of rent that you didn’t have use of the premises.  Ouch.

So how do you protect yourself?  The lease should state that “the Commencement Date will be later of June 1st (in this example) or the first of the month following delivery of the Premises by the Landlord with substantial completion and and a Certificate of Occupancy.  In the event that the Commencement Date is other than June 1st, the Landlord will pay $X for each month or each partial month of delay.”

The $X should equal the new rent plus your holdover penalty, and should include any damages charged by the existing landlord if the tenant is liable for such costs.

In addition, you should state that, in the event that the lease has not commenced by X date, the tenant may terminate the agreement on X days notice.  You can’t wait around forever.

commercial lease demising

Commercial Lease Provisions: Tape on the Floor

Here’s a simple technique that has saved several dozen of our clients literally millions of dollars in lease costs, and is very applicable to the changes happening in today’s market. We call it the Tape on the Floor Option.

Many years ago, a utility client asked our firm to help them secure 25,000 SQFT of Class A office space. After some discussion, they revealed that they’d only have about a dozen employees to start although expected to ramp up to about 60 people within 18 months.

We located a building that had four vacant floors of about 25,000 SQFT each and made the landlord the following offer: The landlord would agree to have an entire floor painted and carpeted, and my client would lease just 5,000 SQFT with an option to take additional space at the same rent and a first right of refusal if the landlord found another user for the balance. Further, rather than put up a demising wall, we simply put tape on the floor with the understanding that should the landlord discover that we were occupying beyond the taped boundary, they could charge my client for the entire floor.

Once the lease was signed, we met with the landlord’s rep and explained the growth plans of this VC-backed company and convinced him that it was in both parties’ interest for him to focus his attention on filling the other floors first, since my client was likely to grow into the rest of the floor. In fact, every 2-3 months, we ended up going back to the landlord and moving the tape to capture another few thousand feet to accommodate a few more rows of cubicles. Eventually they did take the entire floor and ultimately we ripped up that lease and executed another for two floors in a different building owned by that landlord.

Here’s the point: This particular client was prepared to take and pay for 25,000SQFT from day one. If the landlord had approached them the day after the lease was signed with another tenant who wanted the remaining space, they would have almost certainly exercised their refusal option and paid the full rent. However, that never happened. Instead, the landlord focused on leasing the other floors, and my client avoided paying full price for the space for well over a year – and earned a six-figure savings in rent.

Here’s why I’m telling you this now: 1) It helps to have a flexible landlord with a fair amount of vacancy to make this idea work well, and many landlords are starting to fit that profile nicely, 2) You might be looking for ways to contract or minimize expenses with the thought that your business will rebound to previous levels when the economy turns, and 3) This is a perfect maneuver for companies that are able to downsize although would like to stay in their existing space and plan/expect/hope to restore themselves later.

This solution works equally well for office or industrial users. Why not ask your landlord to put the “tape on the floor” and negotiate a lesser rent? Rather than have your space cut down in size, agree to wait until they have another user before the demising wall goes up. Which may be never.

operating expense pass through

Operating Expense Pass Throughs – Protecting Yourself

I’m not crazy about condominiums.  Here’s why:  Other people (the condo association – which is often controlled by a very small group of individuals) get to vote on how to spend your money.  Some of those choices may not add value for you or to your property.  Operating expenses on leased commercial property work the same way.  The management company, which is the property ownership or someone under their direct control, gets to decide what expenses get passed through to the property tenants.  So what expenses do they pass through?  Every single one that they can possibly get away with.  There are only two methods of protection for tenants, and I’d estimate that more than half of all leases don’t fully take advantage of them.

Protection #1:  Operating Expense Exclusions.

Most commercial leases say something to the effect that the landlord may pass through all expenses (or the expenses over a base year) related to the ownership, maintenance, and operation of the project.  As long as these expenses are market competitive, that’s fair or at least customary, right?  Wrong.  The landlord should only be passing through the costs of maintenance and operation, not ownership.  Ownership could include costs of refinancing, marketing the property for sale or lease, legal costs related to the ownership structure, accounting fees for ownership tax returns – even income tax.  Taxes are a cost of ownership.  My point is, you need to exclude those costs and any other costs with specific language because the landlord’s thirty or fifty page document (or more, I’ve completed leases of more than a hundred pages and the landlord’s attorney didn’t have a single word in there by mistake) allows everything including their Christmas party, executive meetings in Las Vegas, and hiring family members to provide management or lawn service.  You need to have a long list of what is NOT allowable, and argue to get them into every lease.  You won’t always succeed on every item, though you should always try.

Protection #2: Auditing.

You need to audit the Operating Expense Reconciliation that you receive from your landlord annually.  Why?  Because if you have used Protection #1 to modify your lease in any way, you can bet that whomever actually does the bookkeeping has never bothered to read the changes that you made to the provision.  My firm has seen landlords ignore negotiated caps or limits included in the lease and include capital improvement costs, expenses directly for the benefit of a another tenant, costs related to code issues that existed before the tenant’s lease commenced, and costs for services that were not competitively bid and significantly out of line with the market.  If you don’t have the time, expertise, or resources to audit the reconciliations yourself, hire an outside firm on a contingent basis. Most importantly, do it in the first year of your lease, so that you 1) put the landlord on notice that you are the “auditing type” – most tenants are not – and will nail them on any inappropriate charges and 2) identify any issues early in the relationship, since most leases prevent you from challenging expenses or auditing prior years after a certain period – some as short as 30 days after receipt of the reconciliation.

A recent trend that we’re seeing is the inclusion of six-figure executive salaries(with titles such as Asset Manager or Director of Properties) usually split between several properties.  As the economy puts the pinch on commercial landlords, they are allocating as much of their overhead as possible to their portfolio’s operating expenses.  If you are lucky, you’ll have inserted language into the original lease that prohibits salaries above a property manager.  And if you’re smart, you’ll audit the operating expense reconciliation to enforce your rights.  When it comes to pass-through expense, Less is most certainly More.

Interview with Eric Berson – Avocat Group CEO

You’ve negotiated commercial leases from New York and Washington D.C. to Beijing and Moscow. What has that taught you?

EB – Negotiating an office lease is like playing chess for money. Very significant amounts of money. However, unlike chess, you cannot study and learn the moves from the masters in a book or from a computer. Certainly laws vary between municipalities, although so do customs and customary lease terms. Something learned in Abu Dhabi might spark an idea for a transaction in Chicago, or vice versa. The only way to learn is through personal experience and direct involvement, and this cumulative global experience expands the solutions available.

Are there mistakes that you commonly see being made by firms leasing space?

EB – Of course. Real estate is a relationship business, primarily because it is business that requires a very high level of trust. People tend to trust the people that they know, and they should of course, but that can also cause them to be blind to recognizing competency and seeking out the highest level of expertise. For example, we often see law firms that will choose a real estate representative based on that firm sending business to the firm. So in exchange for some nominal amount of legal work that primarily benefits a few real estate partners, the entire firm might suffer six or seven figure missteps in their lease strategy.

Well, yes, that certainly could be painful. Anything else?

EB – Most firms generally do not allow enough time for planning and wait for an event, such as an expiration or need to expand, before developing a strategic plan. The real estate strategic plan should be ongoing. It should start at the beginning of a lease term, so that it can be tweaked and refined over time, and the tenant can properly position themselves with the landlord and in the market. The best time to start is not a year before the expiration.

Your website has a “Canon of Ethics” that discusses conflicts of interest. Should that be a concern?

EB – There are only two types of representation: No Conflict and Not Quite No Conflict. Which do you think is best? I’m an attorney, and each state Bar where I’m admitted has a set of rules of professional conduct that says to effect, that “a firm will not represent a client if their responsibilities to that client might be adversely affected by their responsibilities to another client”. Unfortunately, the commercial real estate industry does not hold itself to such standards and client firms tend to therefore overlook the issue. The simple fact is, a real estate company cannot represent both tenants and landlords, because the other party represents prospective business to their firm, and that can cause unfavorable judgement or pressure on the part of the representing firm. The full service firms try to explain this away by saying that they manage it, but they cannot manage both the interests of individuals in their firms and of their stockholders to maximize profit.

Your client list includes some of the largest law firms in the world and presumably some of the smartest attorneys. Does that make it more difficult for you to represent them?

EB – On the contrary, the smartest attorneys are the easiest to work with because they understand that it takes intelligence combined with experience focused in a very specialized area to create excellence. Whether hiring an attorney or a real estate advisor, or both, you have to decide whose brain power and personal experience you want working for you.

Two ways to protect yourself on operating expense pass-throughs

I’m not crazy about condominiums.  Here’s why:

Other people (the condo association – which is often controlled by a very small group of individuals) get to vote on how to spend your money.  Some of those choices may not add value for you or to your property.

Operating expenses on leased commercial property work the same way. The management company, which is the property ownership or someone under their direct control, gets to decide what expenses get passed through to the property tenants.

So what expenses do they pass through?  Every single one that they can possibly get away with.  There are only two methods of protection for tenants, and I’d estimate that more than half of all leases don’t fully take advantage of them.

Protection #1:  Operating Expense Exclusions
Most commercial leases say something to the effect that the landlord may pass through all expenses (or the expenses over a base year) related to the ownership, maintenance, and operation of the project.  As long as these expenses are market competitive, that’s fair or at least customary, right?  Wrong.

The landlord should only be passing through the costs of maintenance and operation, not ownership.  Ownership could include costs of refinancing, marketing the property for sale or lease, legal costs related to the ownership structure, accounting fees for ownership tax returns – even income tax.  Taxes are a cost of ownership.

My point is, you need to exclude those costs and any other costs with specific language because the landlord’s thirty or fifty page document (or more, I’ve completed leases of more than a hundred pages and the landlord’s attorney didn’t have a single word in there by mistake) allows everything including their Christmas party, executive meetings in Las Vegas, and hiring family members to provide management or lawn service.  You need to have a long list of what is NOT allowable, and argue to get them into every lease.  You won’t always succeed on every item, though you should always try.

Protection #2: Auditing
You need to audit the Operating Expense Reconciliation that you receive from your landlord annually.  Why?  Because if you have used Protection #1 to modify your lease in any way, you can bet that whomever actually does the bookkeeping has never bothered to read the changes that you made to the provision.

My firm has seen landlords ignore negotiated caps or limits included in the lease and include capital improvement costs, expenses directly for the benefit of a another tenant, costs related to code issues that existed before the tenant’s lease commenced, and costs for services that were not competitively bid and significantly out of line with the market.

If you don’t have the time, expertise, or resources to audit the reconciliations yourself, hire an outside firm on a contingent basis. Most importantly, do it in the first year of your lease, so that you:

  1. Put the landlord on notice that you are the “auditing type” – most tenants are not – and will nail them on any inappropriate charges.
  2. Identify any issues early in the relationship, since most leases prevent you from challenging expenses or auditing prior years after a certain period – some as short as 30 days after receipt of the reconciliation.

A recent trend that we’re seeing is the inclusion of six-figure executive salaries (with titles such as Asset Manager or Director of Properties) usually split between several properties.  As the economy puts the pinch on commercial landlords, they are allocating as much of their overhead as possible to their portfolio’s operating expenses.

If you are lucky, you’ll have inserted language into the original lease that prohibits salaries above a property manager.  And if you’re smart, you’ll audit the operating expense reconciliation to enforce your rights.  When it comes to pass-through expenses, Less is most certainly More.

Are you paying for imaginary space?

If you go into the grocer and purchase, for example, three pounds of salmon, you can be relatively certain that you now possess three pounds of salmon.  However, if you lease 30,000 SQFT of space in an office building, can you be relatively certain that you possess 30,000 SQFT?  Absolutely not.

Here’s why:
To start, there is the concept of “rentable” and “usable” space.  In summary, “usable space” is the space actually contained within your walls, and “rentable space” is the same number plus your proportionate share of all common elements such as elevator lobbies, bathrooms, fire stairs, and mechanical rooms.  If you lease half of a floor, the rentable calculation would apportion half of those elements for your use and add that amount to your usable calculation.

The American National Standards Industry (ANSI) has created very detailed specifications on how to create accurate measurements.  For example, dimensions are taken from the interior of glass windows to the mid-point of the wall for any walls shared in common with other tenants, etc.  This standard has been adopted by The Building Owners and Managers Association (BOMA) and some landlords agree to adopt these standards.  Fair enough.

But there is another scenario which can cost you thousands, perhaps even tens or hundreds of thousands of dollars over the term of your occupancy:  Phantom Space.  This is when either the usable or the rentable numbers or both are inflated above the actual or proper numbers.  Sometimes this occurs because the Landlord or their representatives choose to ignore the ANSI/BOMA standards in favor of their own.  These may be based on a measurement of the landlord’s choosing (the drip line of the roof for example) or could be, well, anything that they decide which may or may not be based on a real metric.  Illegal?  No, because all aspects of a lease are negotiable – including the basis for measurement – and the landlords that do this almost certainly have very smart attorneys who put language in the lease that will indemnify them and prevent recalculation to any reality-based standards.

Do you think this is a low risk concern?  A May, 2014 article in the Wall Street Journal details how the MetLife Building has somehow grown from it’s original 2.4M SQFT in 1979 to 3M SQFT today.  Indeed, NYC is notorious for floor measurements that have in some cases exceeded the outside measurement of the actual building.  Many real estate firms, including one quoted in the article that purports to represent tenants, turn a blind eye to the practice and shrug it off with the attitude, “It’s an important enough market that they (the Landlords) can make their own rules”.

How do you protect yourself?  Take these precautions:

1. Insist that measurements and rentable adjustments be done in accordance with ANSI/BOMA standards.  Note that The International Property Measurement Standards Coalition mentioned in the article is working towards a global standards, although it will likely be years before it is adopted in any significant way – and more likely never by unscrupulous landlords.

2. Hire your own architect, rather than relying on the Landlord’s architect.  The architect, like most professionals, has a fiduciary responsibility to their client.  Make sure that you have someone on whom you can rely for accurate and honest representations.

3. Include language in the Lease document that affirms measurement to to ANSI standards and allows for adjustment if a discrepancy is discovered.

4. Be certain that you have a tenant representative that insists on the items above, manages the transaction to meet ANSI compliance, and will not passively accept the non-conforming measurements of unscrupulous landlords.

When it comes to Phantom Space, Less is More.