Commercial leases are generally much longer than a typical residential lease. The tenant is making a much larger financial commitment. In fact, the financial commitment is so large that new accounting rules were put in place to make sure that financial reporting by public companies reflected this commitment. For details see this NY Times article: http://www.nytimes.com/2010/06/23/realestate/commercial/23fasb.html?_r=0
For people new to commercial leases, it is important to understand the consequences of not meeting this obligation, or in other words, defaulting on the lease. The exact consequences will depend on the terms of the lease, local law, and common business practices in your community. That is one reason why it is so important to review your lease terms with an attorney before signing. And, if you think you may default, you should review the possible consequences with your attorney again.
I’ll cover two scenarios that I’ve seen expressed in commercial leases. One is more common than the other.
Can I get out of my lease without defaulting?
There are ways of avoiding default when you either can’t, or don’t want, to continue paying your lease through the end of the term. The two primary options are subletting or assigning the lease. In both cases, you find another tenant to pay some or all of the lease.
When subletting, you continue paying your lease to your landlord, but you lease the space to a new tenant, who pays you. Most leases will only allow this with the landlord’s permission. It is possible to make a profit doing this if the rent you charge is higher than the rent you pay. Your lease may or may not allow you to pocket the difference.
When assigning the lease, you find a tenant to take your place in the lease and they become the new tenant, accepting the original terms of the lease and paying the full rent. This is most common when selling a business that occupies leased space. In most cases the landlord will ask that you remain secondarily responsible for paying the lease if the new tenant defaults.
In both cases, there will likely be some charge by the landlord to cover their time and expense in reviewing and approving the arrangement.
Scenario 1
Now, what happens when you default instead of finding a new tenant? Most often we see a lease that describes the tenant and landlord responsibilities like this: The tenant is responsible for the payments for the remaining term of the lease, but the landlord is required to try and find a replacement tenant. Once the landlord finds a new tenant, then they deduct the income from the new tenant, over the course of the remaining original lease, from the amount owed by the original tenant. The landlord is allowed to deduct the costs of acquiring the new tenant, such as commissions or Tenant Improvement costs, or repair costs from damage caused by the original tenant, from the new tenant income, before subtracting it from the amount owed before totalling the number. (Or, I look at it as they can add the cost to the amount owed).
The ‘math’ looks like this:
Amount owed on remaining lease
-Amount that will obtained from replacement lease (rent)
+Cost of obtaining the replacement lease (commissions, TIs, etc.)
—————————————————————————-
Amount defaulting tenant owes
The logic here is straightforward. The landlord would have received x amount of dollars if tenant did not default. They have a right to collect the money. This is offset by their ability to collect from a new tenant (its not fair if they collect from both). However, there is an expense associated with obtaining that new tenant, so its considered fair for them to deduct that expense from the amount recovered (or in my math, add it to the amount owed… equivalent math).
On a 10 year lease where the tenant pays $40,000 a year, if the tenant defaults in year 5, there is 5 years, or $200,000 remaining on the lease
If the landlord is able to get a new tenant at the 12 month mark, and gets them at a lower rent of $40,000 per year, then they will obtain $160,000 on the replacement.
If the landlord has to pay $5000 in commissions, and provide $15,000 in TIs to get that replacement tenant the math would be like this:
$200,000 owed
-$160,000 replacement
+ $20,000 in leasing costs
—————————–
$60,000 owed by defaulting tenant
Scenario 2
The other way I’ve seen this done is for the landlord to say that the defaulting tenant owes the amount of the remaining lease, plus any ‘unamortized’ lease up costs from their lease, less the amount received from a new lease. This concept of “unamortized costs” is a bit of a misnomer, as the costs are fully amortized for tax purposes in year one. But, most landlords view it as an expense recovered over the term of the lease. That is why most landlords are willing to do expense TIs for longer leases vs. shorter leases. For a 10 year lease, with $20,000 in lease up costs , the landlord would figure those costs are $2000 per year.
If the tenant stays the whole, term they’ve recovered all of their costs. If they leave in year 5, there is $10,000 in costs they have not recovered.
I think leases end up with this scenario through negotiations. In scenario 1, the tenant may feel they are at the landlords mercy during default and they have no control over the amount of TI allowance or commision the landlord pays out at the time of that new lease. So, with this scenario, the amount they owe is more directly associated with their own lease. The math looks like this:
Amount owed on remaining lease
-Amount that will be obtained from replacement lease
-Unamortized lease up costs for your lease (TIs/Commissions)
—————————————————————————
Amount defaulting tenant owes
So, using the same example from above (and assuming an original $20,000 in lease up costs), we get:
$200,000 owed
-$160,000 replacement
+$10,000 in unamortized expenses
——————————————–
$50,000 owed by defaulting tenant
Capping the default amount
These numbers can look pretty scary. And, most landlords will require a personal gurantee of the lease by the business owner, so the protection of an LLC or Corporation does not protect the owner from the debt. As a result, most tenants will want to try and negotiate some cap to the total default amount. In many cases, this amount will vary over the term of the lease, with a higher cap earlier in the lease than later. For example, in a 10 year, lease the landlord may ask for a guarantee of the first 2 or 3 years of the lease, and then after than ask for a guarantee of only up to 1 year. This is a point of negotiation. The landlord would always want a guarantee of the full lease. Its up to the tenant to ask for a cap on the guarantee.
I hope this was helpful and if you need help negotiating your next lease, please contact us.