Retail landlords must consider a host of factors when they craft and negotiate letters of intent today.
Cox, Castle & Nicholson LLP Partner Dan Villalpando shares a few insights that touch on the importance of LOIs from a leasing perspective.
The Q&A below examines, among other things, how LOIs can impact rent collection, address charges beyond rent and concerns pertaining to the proposed use of a retail space, and how LOIs can help ensure retailers are open, operating and contribute to a shopping center’s appeal to consumers.
Q: What is a letter of intent in a leasing context and why is it important to a landlord?
A: When landlords and/or their brokers are close to finalizing the terms of a retail lease with a potential tenant, the parties typically document the “key” terms in a letter of intent (LOI). As many in the industry are aware, there has been much written about the enforceability of LOIs and the language that should be included to ensure that LOIs are non-binding on the parties, and that no agreement is formed until a lease is fully executed (more on that later). However, it is also important for landlords and their brokers to focus on several issues when negotiating LOIs to help “flesh out” provisions of importance to Landlords that can be critical when it comes time to prepare the applicable lease document.
Q: Perhaps the issue nearest and dearest to a landlord’s heart in a retail lease is the receipt of rent. What are the key considerations when addressing rent commencement in an LOI?
A: It is important for the landlord to clearly define in the LOI the date upon which the tenant will be expected to commence the payment of rent. Typically, a landlord will want rent to start upon the earlier of: (1) a certain number of days (the so called “build out period”) following delivery of the premises to tenant, and (2) the date tenant opens for business from the premises. However, tenants with some leverage may not want to agree to start paying rent until they have received (for example) the permits necessary to build out their space and/or to operate their business. This creates the potential for a floating rent commencement date that is entirely under the tenant’s control and that may never occur (if, for example, the tenant is unable to obtain its permits for whatever reason). In that case, the landlord will be stuck in the unenviable position of having a binding contract with the tenant (who may never start paying rent) while being unable to negotiate a lease for the premises with another tenant. Therefore, landlords should be leery of including the requirement that the tenant obtains its permits as a component of rent commencement without (i) an outside date by which such permits must be available for pick up (after which the landlord should have the right to unilaterally terminate the lease and get the space back), or (ii) an express requirement that the Tenant apply for the permits by a certain date and diligently pursue them.
Q: Other than base rent, what other charges might a landlord expect to charge in a retail lease, and how should those be addressed in the LOI?
A: Many retail leases are “triple net” in nature, meaning that, in addition to rent, the tenant is obligated to pay its pro rata share of taxes, insurance and common area costs. Again, since the payment to landlord of these charges is a critical component in any lease, the Landlord should be mindful of referencing in the LOI certain charges it expects to receive, especially when dealing with more sophisticated Tenants. For example, will the landlord be charging an administration or supervision fee in connection with overseeing the maintenance of the common areas in the shopping center and, if so, how will that fee be calculated? In addition, if a landlord expects to be able to pass through the cost of capital repairs and/or replacements, it may make sense to reference those costs in the LOI to avoid drawn out discussions during lease negotiation. Moreover, if a landlord is requested by a tenant to include in the LOI the amounts of “triple net” charges that will be payable by the tenant in, for example, the first year of the term, the landlord should make it abundantly clear that it is including such numbers as estimates only, and that the tenant will be obligated to pay its actual pro rata share of such costs, regardless of what they end up being. This will potentially help the landlord avoid any arguments by the tenant that the numbers provided in the LOI were intended to be “caps” on such costs, instead of merely estimates.
Q: With regard to the proposed use of the tenant’s premises in a retail lease, what concerns does a landlord have and how can they be addressed in the LOI?
A: Retail landlords typically have a vested interest in the “tenant mix” at their shopping centers, and the LOI is usually the first opportunity for the landlord to try to “pin down” the tenant to a specific use. Landlords should try to make it clear in their LOIs that the permitted use of the tenant is limited to the specific items listed (i.e., “for the retail sale of video games, video game related hardware and directly related accessories”) and for “no other use or purpose whatsoever,” unless the circumstances dictate otherwise. In addition, Landlords may want to provide that the permitted use is subject to existing recorded documents (e.g., CC&Rs and REAs), as well as then-existing exclusives and prohibited uses affecting the shopping center. This provides landlords with some protection against the overlap of uses, as well as potential violations of existing exclusives and prohibited uses. It also accelerates a discussion with the tenant regarding the existence of documents of record and other use restrictions affecting the shopping center that may be binding on the tenant, and that a more sophisticated tenant will want to understand prior to executing a lease.
Q: There are few things that make a shopping center less desirable to shoppers than a bunch of empty stores. What provisions should a landlord include in its LOIs to make sure that its tenants are open and operating?
A: An important consideration for retail landlords in the LOI phase is ensuring that the tenant is required to: (1) open from the premises by a date certain, and (2) remain open and operating in the shopping center for the entire term of the lease. Most tenants will agree to open for at least one day within a certain number of days following rent commencement, and the landlord should make sure that such an opening covenant in included in the LOI. In addition, although most leases require tenants to pay rent and “triple net” charges even if they decide to close their doors to the public, the landlord will, at a minimum, want the ability to put the tenant in default if the tenant stops operating from the premises. Another alternative that can be negotiated in the LOI stage is a “recapture right” which allows the landlord to terminate the lease upon notice to the tenant (without putting the tenant in default) if the tenant fails to operate for a continuous period of time (e.g., 60-90 days). A tenant might be amenable to a “recapture right” in the event it shutters its doors; if a tenant does close for business, it is presumably because sales are poor and the tenant has little interest in continuing to operate from the shopping center, let alone paying rent and “triple net” charges in connection with a closed store. If the parties do not spend at least some time addressing the issues of opening and continuous operation in the LOI stage, they may be setting themselves up for a battle as to whether there was any intent for these concepts to be a part of the applicable lease.
Q: Are there certain conditions to the effectiveness of a lease that are crucial to the landlord and should, therefore, be addressed in the LOI?
A: Yes, there are. For example, if the landlord is negotiating a lease for property which it does not yet own or control, it should make it clear in the LOI that a condition to the effectiveness of the lease is its acquisition of the property, usually by a date certain. Similarly, if the landlord is required to obtain any permits or approvals in connection with the tenant’s build-out or operation from the premises which it may be uncertain it will receive, it should probably reference in the LOI that the landlord obtaining the permits is a condition to the effectiveness of the lease. Including such provisions in the LOI also serves to highlight them for the drafter of the lease, further ensuring that such important concepts are not missed when it comes time to prepare the lease itself.
Q: You mentioned earlier some important language that should be included in LOIs to ensure that LOIs are “non-binding” on the parties. Can you elaborate?
A: Most leasing professionals are familiar with the language usually found at the end of an LOI which provides that the LOI is not a binding contract and that it simply provides a basis for the preparation of a lease agreement. In addition, the language typically states that no binding agreement between the parties exists until a lease is fully executed and delivered. Such language is certainly important to protect the general intent of the parties when negotiating an LOI. However, as discussed above, in addition to this protective language, there are also several issues that Landlords and their brokers should consider in the LOI stage. Dealing with them in the LOI will likely help streamline lease discussions and potentially avoid any surprises between the parties that could derail negotiations.
Dan Villalpando is a partner at Cox, Castle & Nicholson LLP who brings more than 25 years of specialized experience in commercial development and leasing. Developers and property owners look to Villalpando for counsel on all aspects of shopping center development, including the acquisition and disposition of commercial real estate and the negotiation and drafting of development agreements, reciprocal easement agreements and leases with almost every national and regional retailer.