Canada: Vacant Space on Closing: Head Leases and Vacancy Agreements

Here is the scenario. A developer wants to sell a strip mall that has just been completed but is only partially leased. Your company wants to purchase the asset and the only way it can get the deal is if it agrees to a purchase price which takes into account the income from the property as if it were fully leased. The seller will agree to provide a head lease with respect to the remaining unleased space.

This short article outlines some of the issues that arise when a buyer is requested to accept a head lease with respect to such unleased space.

Nature of Relationship

The problem with a lease is that it was developed to govern the relationship between an owner of a property and the user of a property. Where the seller, as tenant, has no interest in occupying the property but only has an interest in reducing its exposure to pay the rent and other costs as a tenant under the head lease, the concept of a lease does not fit the situation appropriately.

Bankruptcy

If a tenant goes bankrupt, the trustee in bankruptcy has the option to terminate (disclaim) the lease, thereby extinguishing all obligations of the tenant thereunder. It would seem clear that any trustee in bankruptcy would quickly disclaim or terminate any head lease as all it creates are responsibilities to the bankrupt tenant without giving it any benefits, which in a 'real lease' would normally be the occupation of the premises for the business of the tenant.

Landlord Remedies

The normal remedies a landlord has if the tenant does not fulfill its obligations are termination, suing on the covenant, or distraint. As the tenant under the head lease has no improvements, inventory or other assets in the premises, there is nothing to distrain against. The landlord wants the tenant under the head lease to continue to pay and, other than terminating, the only way it can practically enforce that is through bringing an action on the covenant each month to receive the rent owed.

Vacancy Agreement

To deal with the problems inherent in the lease relationship, the practice has arisen whereby an agreement (which is not a lease) is entered into pursuant to which the seller agrees to pay to the buyer amounts that are equivalent to rent while the lease-up process by the buyer or seller continues. If these payments are also due in monthly increments, there is still the same issue of having to sue each time that a payment is missed. However, provisions can be added to call for an acceleration of the total of all payments should the amounts not be paid when due and, accordingly, make them all due and payable on default. As with a lease, the issue of the strength of the covenant of the vendor party which enters into the payment agreement still needs to be considered. Sometimes, the covenant can be buttressed by a holdback or other security such as a letter of credit.

Lease-Up Process

The question of whether the seller or the buyer will be principally in charge of leasing the vacant space is dealt with in the head lease or the vacancy agreement. Under a head lease, it is usual for the tenant/seller to continue to be responsible for the vacant space and then sublease the space to actual users. The trouble with this arrangement is that the seller only has an incentive to lease-up the space so that its obligations under the head lease are mitigated. Accordingly, it has no real interest in the long-term viability of the tenant, the tenant mix, or other issues that are of interest to most normal landlords. Usually minimum leasing guidelines are agreed to such as the minimum length of the term (often five years), that the covenant and use are acceptable to the buyer and that there are no unusual provisions in the lease, such as termination or downsizing rights.

Of course, from the buyer's perspective, it would like to control the leasing and, hence, the concept of the head lease whereby the seller may sublease is not its preferred course. Rather, the buyer would like to enter directly into leases with the tenants of the unleased space and this can also be achieved by having the head lease partially surrendered with respect to the newly leased areas. Issues that arise include at what point the seller/tenant under the head lease is relieved from its obligations. Does that occur when the new lease is signed up or, alternatively, when the new tenant is in possession or when the tenant is paying rent? Also, is the seller/tenant under the head lease still responsible should a new tenant of the unleased space default?

Leasing Costs

It is important to understand the competing interests of the seller and the buyer in structuring leasing costs. In theory, only the seller or the party bearing the costs of leasing the unleased space has an interest in keeping them low. The buyer wishes to maximize the base rent. However, the net effective rent payable by the tenant is made up of the base rent less the cost of achieving the base rent including leasing commissions, tenant inducements (such as prior lease takeover costs, landlord's work and contributions to tenants' work) as well as free rent or reduced rent periods. Since the cost of leasing and the base rent together determine the net effective rent, it is important to ensure that guidelines on these leasing costs appropriately reflect the form of lease (presumably fully net), the types of leasing costs and by whom they will be payable.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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