The value of income-producing properties, such as office towers and shopping centres, can often be distilled down to the income derived from the property's existing leases. As such, it is absolutely vital to analyze and confirm that the expected income from a property is actually supported by the terms of the leases. Set out below are some lease due diligence considerations that will assist a purchaser in ensuring that it will be able to realize the income stream that it bargained for. For a more general overview of lease due diligence issues (monetary and non-monetary), see our November 2012 article: Conducting Leasing Due Diligence? Watch for These Nine Lease Provisions.
Leases should be reviewed to confirm that the basic/net rent set out under the lease, including the date and applicable rate of any step-ups (increases), matches that set out in the rent roll, confidential information memorandum (CIM) and other income documentation that the purchaser may be relying on in establishing the value of the property. Based on our experience, discrepancies are very common.
Cross-Check with Actual Payments
The rent set out under the lease should also be compared against a tenant's actual payments. This will help flush out, among other things, whether a tenant is enjoying the benefit of any undocumented rent reduction. At law, a purchaser of a property may be barred from enforcing contracted rental rates where the vendor had orally agreed to reduce a tenant's rent or acquiesced over time through historical acceptance of a lower rental.
The provisions in a lease regarding the size and measurement of the leased premises should be reviewed against the information contained in the income documentation upon which the purchaser is relying. Vendors should also be asked for any area certificates in their possession or control in order to ensure that the certified area, as well as the measurement standard employed, is in accordance with the lease. This due diligence exercise will help avoid unexpected rent reductions due to the size of a tenant's leased premises being smaller than previously thought.
Where tenants are to pay operating costs, realty taxes or other costs on a proportionate share basis, the definition of "proportionate share" should be closely examined in each lease. In particular, the purchaser should ensure that the denominator of the proportionate share fraction excludes any rentable areas whose taxes, maintenance and insurance (TMI) contributions are capped or limited in some manner so as not to permit a full recovery. Without these exclusions, the purchaser may have to cover any TMI shortfalls out of its own pocket thereby diminishing a property's net income. The denominator, as defined in the lease, should also be examined in order to ascertain whether it reflects the sum of the rentable areas actually used to calculate the rent of each tenant of the property. In some cases, particularly for office properties, the denominator is defined as being the rentable area of the entire property calculated in accordance with the Building Owners and Managers Association or some other measurement standard. However, this could lead to a recovery shortfall where the rentable area of one or more premises on the property has been capped or reduced in some manner. For example, where the landlord has capped the gross-up used to calculate rentable areas (a very common occurrence where the gross-up would otherwise be a very large number) but the denominator contemplated in its leases does not adjust for same (but, rather, contemplates full rentable area calculations for all premises), a shortfall may occur.
A purchaser should review the realty tax recovery provisions in a lease to ensure they permit a full recovery of taxes from the tenant. Less than full recovery may occur where a lease stipulates that the tenant is not to contribute towards realty taxes reasonably attributable to parking, storage and other similar facilities. In retail leases, it is customary to find anchor or major tenant leases which contemplate recoveries based upon separate assessment information or prevailing property tax valuation methodologies. As noted above, where other tenants of the same property are to pay realty taxes on a proportionate share basis, a purchaser should ensure that the calculation of the denominator of the proportionate share fraction permits the landlord to exclude these major or anchor tenants, otherwise a shortfall may occur if the amounts payable by the major or anchor tenant are less than the amounts payable had proportionate share calculations been used.
The operating cost provisions should be closely scrutinized to determine whether they result in a recovery shortfall. Leases with fixed common area maintenance payments, or capped annual increases, could result in shortfalls for landlords. In a retail context, shortfalls often result where a tenant is only required to contribute to exterior common area costs, whereas other tenants are to pay for interior and exterior costs. Of course, the operating cost inclusions and exclusions expressly described in each lease should also be reviewed to ensure they do not result in any material recovery gaps. They should also be reviewed to confirm the management or administration fee, if any, properly payable under the lease.
Options to Renew/Extend
Options to renew/extend contained in a lease should be closely examined to ensure that the rent payable during the option term(s) is acceptable to the purchaser. Options with pre-set rental rates or capped increases could be problematic for a purchaser, particularly where the rates or caps result in a below-market rent. Where option period rent is expressed to be based on some form of fair market rate, the provision should still be closely examined to determine whether the definition of "fair market" contemplates rates for improved or unimproved premises and to ensure it is otherwise acceptable. The existence of any options to renew/extend should also trigger an investigation by the purchaser as to whether any broker commissions would be payable upon exercise of the option by the tenant. Having to pay a commission without recovery in the determined fair market rent will obviously eat into the property's income.
Leases should also be reviewed to bring to light any unaccounted for future payments or credits for which the purchaser may be liable. These include deposits which are to be returned or credited to the tenant at a later date, yet-to-be-paid allowances/inducements and unexpired rent-free periods. A purchaser should also be cognizant of whether a lease requires the tenant to remove improvements and restore the leased premises back to base-building condition at the end of the term. If the lease does not contain such a requirement, the purchaser may be stuck with the costs of paying for its own removal and restoration and lost rent during such period, with the result that the property's net income will be negatively affected. A purchaser should also be aware of what improvements and equipment a tenant is permitted to remove at the end of the term (e.g., generators, supplemental heating/cooling equipment, racking and electrical upgrades). Where such improvements are integral to the functionality or value of the leased premises, the purchaser may find itself out-of-pocket as it will be responsible for replacing the item(s) removed by the tenant.
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.