CHICAGO-Net-lease investors would be well served to focus on more than a deal's economic factors when drafting a new net lease. Experienced outside counsel and expertise at this key moment can ensure long-term protection of an asset's value.
The art of creating a fundamentally sound net lease, after a tentative agreement is reached between a landlord and tenant, is a frequently overlooked skill among the real estate investment community. Too often, new leases include potential pitfalls, which while seemingly insignificant when the lease is executed, could have disastrous long-term consequences for landlords. The impact of lease deficiencies can range from severely compromising the sale value of a property, to making refinancing impossible, or allowing a tenant to reduce his rent arbitrarily or even terminate a lease early.
When drafting a new lease, landlords often overlook the fact that long-term goals and strategies for property may change during the term of the lease. Initially landlords may intend to hold a property indefinitely, but circumstances may change, necessitating sale or refinancing. If landlords do not plan for potential changes in strategy, lease deficiencies may leave them unprepared for a new course of action. It's critical for landlords to draft leases that provide for any contingency they may experience during their ownership of a property.
Some of the most commonly overlooked lease provisions that could lead to challenging scenarios include: assignment language, financial reporting provisions, landlord expense obligations and co-tenancy provisions. While it's impossible to address each potential issue individually, the following example illustrates one possible pitfall.
In 2008, a midwestern shopping center landlord agreed to a ground lease with a major national bank for an out-parcel of one of its grocery-anchored centers. Satisfied that they were long-term holders of the center, and that the bank would invest more than $2 million in improvements and pay a good rent, the landlord did not spend a great deal time negotiating various smaller provisions of the lease. One of those provisions was an assignment clause that allowed the tenant to assign the lease to another tenant as long as the assignee had a net worth in excess of $100 million.
During the tumultuous financial crisis, the landlord decided to pursue a sale of the ground lease to free up capital. However, investors were concerned the assignment provision could lead to a significant downgrade of the credit behind the lease. To insulate themselves from the perceived risk, investors priced the asset's capitalization rate 100 basis points higher than similar assets in the market. Ultimately, the lease deficiency cost the landlord more than $500,000 in total sale value. The landlord could have easily avoided the lease issue when the lease was drafted.
For landlords, potential pitfalls posed by various lease provisions may be difficult to catch and correct. Often the experience of third party advisors, such as experienced real estate attorneys, investment sales brokers and mortgage specialists, can be invaluable in these matters. These professionals have extensive experience and knowledge of net lease provisions and potential hazards they could contain. Many net-lease tenants have standard lease forms that they utilize, which these professionals have worked with intimately, and can help navigate the nuances of the document. Seeking out their counsel and advice during the lease negotiation process can avoid pitfalls and pay real dividends in the long-run.
Brad Feller is an associate director in the Chicago office of Stan Johnson Co. He can be reached at [email protected]. The views expressed in this column are the author's own.
Want to continue reading?
Become a Free ALM Digital Reader.
Once you are an ALM Digital Member, you’ll receive:
- Breaking commercial real estate news and analysis, on-site and via our newsletters and custom alerts
- Educational webcasts, white papers, and ebooks from industry thought leaders
- Critical coverage of the property casualty insurance and financial advisory markets on our other ALM sites, PropertyCasualty360 and ThinkAdvisor
Already have an account? Sign In Now
*May exclude premium content© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.
