Canada: Conducting Leasing Due Diligence? Watch for These Nine Lease Provisions

A purchaser of income-earning commercial real property must take steps to confirm the integrity and enforceability of the property's leases. Below is a brief explanation of nine aspects of leases that should be reviewed by the purchaser or its legal advisers during the due diligence period.

1. Completeness of Lease Documentation

A review of the lease documentation received from the vendor often reveals that there are missing pages and unsigned or missing amendments and extension agreements. Since the purchaser needs an accurate understanding of the documents forming the entire lease, the vendor should be asked to explain any gaps in the documents and provide any missing items. The information contained in estoppel certificates, which tenants will be asked to sign to confirm financial and other terms of their leases, should match the information contained in the leases. If the purchaser waits until after the due diligence date or the closing date to investigate gaps or discrepancies in lease documentation that were apparent at an early stage, it will likely be too late to do anything about it.

2. Outstanding Tenant Inducements

Unexpired free rent and rent abatement periods, payment of leasehold improvement allowances and completion of outstanding landlord's work, if not performed by the closing date, can all affect the purchaser's return from the transaction. If not adjusted for on closing, the purchaser may be responsible for discharging any such outstanding obligations out of its own pocket. Accordingly, outstanding tenant inducements should be identified, confirmed in estoppel certificates and, if appropriate, adjusted for on closing so that the purchaser is not left with unexpected post-closing financial obligations to tenants for which it has not been compensated.

3. Operating Costs

Since a landlord's ability to recover operating costs from tenants in a timely manner is critical, of utmost importance is a careful review of the definition of operating costs to confirm there are no unusual deductions or exclusions. Particularly important is the ability of the landlord to recover costs of capital repairs and replacements. Also, if an administration or management fee is chargeable to tenants, it is often calculated as a percentage of some measure of operating costs, meaning that if the definition of operating costs is restrictive, the same will apply to the landlord's entitlement to collect a management fee on the costs of any carve-outs.

4. Exclusive Use Provisions

Most prevalent in the retail context, anchor and other tenants with a large degree of bargaining power are sometimes able to negotiate restrictive covenants from the landlord that premises in the project will not be leased to tenants engaging in competitive businesses. These restrictions frequently list prohibited business activities generally and sometimes the business names of prohibited competitors. With many retailers looking to broaden their lines of business beyond traditional areas to gain competitive advantage, purchasers disregarding exclusive use restrictive covenants in leases take unnecessary risk. All restrictive covenants in each lease should be identified and a canvass of each tenant's business activities at the property undertaken to ensure there are no conflicts. Sometimes these restrictive covenants are so broad that they affect lands that may not even be owned by the landlord, making enforcement difficult unless the restriction is registered on title to those other lands. The identification of restrictive covenants will also shed light on what future leasing opportunities are possible and which will not be permitted, having regard to existing restrictive covenants.

5. Signage and Parking Rights

Tenants may be granted the right to use a specified number of parking spaces (sometimes reserved), often on the basis of a ratio of a number of parking spaces per square feet of rented space. Similarly, the landlord may provide one or more tenants with the right to install signage on the face of the building or on podium signage. Important in both the multi-tenant retail and office context, the purchaser should verify that there are no inconsistencies in any of the existing rights that have been granted and confirm that there is sufficient space to accommodate all of the parking and signage entitlements. This confirmation process will also be of benefit to the purchaser in identifying limits on its ability to grant other signage and parking rights to tenants in the future.

6. Tenant Options to Purchase

A tenant is sometimes provided with a right in its lease to purchase the property in which its leased space is located. For example, if the landlord has entered into an agreement to sell the property to a third party purchaser, the tenant may have been granted a right of first refusal to purchase the property on the same terms as those upon which the property has been offered to the third party. Sometimes the landlord even has to offer to sell the property to the tenant before offering it to a third party. These rights must be identified during the due diligence period and evidence of waiver by the tenant delivered to the purchaser. Even if waived by the tenant for the transaction at hand, the purchaser will want to take a hard look at the terms of the tenant rights to determine the extent to which the ongoing rights will affect the future marketability of the property and any impact on the purchase price that might be offered by a future purchaser.

7. "Go-Dark" and Recapture Provisions

The leases should be reviewed to see whether or not they allow tenants to cease operating from the premises (even if they continue to pay rent and abide by all other terms of the lease). In a retail setting, "dark" premises reflect poorly on the project as a vibrant operating location. Where a tenant has the right to go-dark, the lease should be reviewed to ensure that the landlord is able to terminate (recapture). This ability to recapture vacant space will allow the landlord to control re-leasing of the premise.

8. "Make-Good" Provisions

A purchaser will also want to determine what the leases require each tenant to do at the end of the term of the lease with respect to returning the premises to base building condition. Removal of a tenant's leasehold improvements can be a costly proposition for a landlord, especially where complex cabling or interior walls and staircases have been installed. On the other hand, if a tenant (with or without the landlord's financial assistance) has expended significant resources in rendering premises operational, the landlord might wish to limit the tenant's ability to remove leasehold improvements without the landlord's consent, as the premises could be in a more "ready" form for a succeeding tenancy. Ideally, through the lease, the landlord will exert some measure of control over the tenant in this area.

9. Early Termination Rights

Some tenants are able to negotiate early termination rights. If exercised, the purchaser's income stream may be adversely affected. Accordingly, early termination rights should be identified and a purchaser should satisfy itself that it remains comfortable proceeding with the transaction in light of the termination right.

Though the foregoing is not by any means an exhaustive list of the matters that a prospective purchaser should review when conducting leasing due diligence, it is a useful reminder of some of the typical "hot button" issues which every purchaser should consider.

Once the lease-related due diligence is complete, it is critically important to share this due diligence with the people conducting other aspects of the real property due diligence. It is important that the various components of real estate due diligence typically undertaken as part of a transaction not be viewed as independent processes but as intertwined. For example, if the lease review discloses that a particular tenant is entitled to multiple access points to and from the property, it must be confirmed with those conducting title-related due diligence that such points of access exist without any obstruction. If this is not done, a purchaser will miss the opportunity to request the seller to correct the problem at the seller's expense. There are other similar areas of overlap arising out of lease reviews which, if not addressed, could lead to difficulties later for the purchaser.

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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