New York City is a fascinating and dynamic retail market. It is also one of the most competitive and challenging markets, requiring a careful and methodical approach to leasing to avoid potential commercial and legal pitfalls that can be costly to tenants. This article will focus on some commercial and legal considerations retailers should address at the outset of their negotiations to ensure that they obtain a lease that is comprehensive and properly protects their interests.
The Retail Team
At the outset of each lease transaction a retailer should select a team of professional consultants, including a real estate broker, attorney, architect, engineer, general contractor and other consultants to assist in negotiating the terms of the lease. It is very important to work with only one real estate broker in searching for the right store location to avoid potential commercial and legal problems. Engaging more than one broker to act on behalf of a retail tenant can result in the loss of a lease transaction when multiple brokers submit simultaneous lease offers for a space on behalf of one retailer and a dispute arises as to which broker is the procuring broker entitled to the payment of a brokerage commission. New York City landlords customarily pay one real estate brokerage commission in connection with a commercial lease transaction, which is normally split between the landlord’s and tenant’s brokers. Consequently, upon selection of a broker it is advisable for a retailer to obtain a letter from the broker confirming that it will look solely and exclusively to the landlord for the payment of any lease commissions on the transaction.
Once a retail location is selected, inspections and due diligence investigations should be conducted on the premises by the tenant’s professional consultants to verify use, condition and feasibility of establishing a retail store, including structural, mechanical, and environmental inspections. Conducting these investigations early on in the negotiations will avoid potential problems and misunderstandings that may arise at a later date when a comprehensive lease agreement is prepared and negotiated. It is also advisable to carefully review the results of the due diligence investigations with your attorney and other professional consultants to determine any special tenant requirements (i.e., electrical, heating, air conditioning, etc.) and if any additional concessions from the landlord need to be obtained such as the landlord performing certain construction and renovations to ready the premises for the retailer’s occupancy.
Typically, a term sheet is used to memorialize the basic financial and commercial terms of the lease transaction, which are then incorporated into the actual lease agreement prepared by landlord’s counsel. While many commercial tenants rely almost exclusively upon their real estate broker to negotiate the term sheet, it is advisable to include your attorney in these negotiations to ensure that key lease provisions are addressed, negotiated and included in the text of the term sheet. If a desired term does not appear on the term sheet, it may be very difficult to include it in the text of the actual lease. Below are several key points that require special attention during negotiation of the term sheet and the lease:
- Term. Most retail leases in New York City are for a five- or ten-year term. Careful thought should be given to negotiating and including a lease renewal option exercisable by the tenant, which could result in future savings for the retailer in times of inflation.
- Premises. New York City landlords generally use the term “rentable square footage” in establishing the amount of space a tenant is leasing. However, the landlord’s determination of rentable square footage can be arbitrary and may include space that is neither usable nor includable in the premises, such as columns, elevator banks, janitor’s closets, lobbies, stairways, etc. In most instances, rentable square footage is less than the “usable square footage” of the premises. The difference between “rentable square footage” and “usable square footage” is commonly referred to as the “loss factor.” Typically, the loss factor in New York City office leases is between 20 percent and 40 percent and in retail leases it is 10 percent or less. Consequently, a lease provision indicating 2,000 rentable square feet of retail space may mean that the tenant is only getting 1,800 square feet of useable square feet, depending upon the loss factor. Since the profitability of a retail store may be adversely affected by the loss factor, retailers should pay careful attention to determining the loss factor as soon as possible during the due diligence investigations in connection with their decision to lease a particular location.
Rent. The rent payable under a commercial lease normally consists of fixed rent and additional rent.
- Fixed Rent. Frequently calculated as a certain dollar amount per “rentable square foot” of the premises, payable monthly, and may include electrical charges. In certain instances it may be advantageous for a retailer to submeter the electricity and pay charges directly to the local utility.
- Additional Rent. Most leases contain provisions requiring tenants to pay additional rent in the form of real estate tax and operating expense escalators to cover the costs of yearly increases in real estate taxes and operating expenses for the building. These lease escalators normally require the payment of tenant’s proportionate share (e.g., the ratio that the rentable square footage of the premises bears to the total rentable square footage of the building) of the difference between actual real estate taxes and operating expenses incurred by the landlord during each lease year and the amount of real estate taxes and operating expenses incurred by the landlord during an agreed-upon “base year.” For example, if real estate taxes for a building are $100,000 during the base year and are $110,000 during a subsequent lease year, a tenant who occupies 25 percent of the building would be required to pay its proportionate share of the increase in real estate taxes over the base year, or $2,500 (i.e., 25 percent x ($110,000 - $100,000). A tenant can realize substantial savings over the life of a lease by negotiating and obtaining the most current base year for the calculation of real estate tax and operating expense escalators, since these costs historically increase each year in New York City.
- Free Rent/Rent Abatement. The amount of any free rent, rent abatements or other contributions by the landlord is negotiable between the parties. If a free rent period is negotiated, it should commence from the date the landlord completes its work and delivers possession of the premises to the tenant. A landlord may agree to reimburse the tenant for the costs of the tenant’s build-out of the premises in lieu of granting the tenant free rent under the lease. It may be preferable for a tenant to receive the landlord’s contribution by way of a reduction in the monthly rent in lieu of a lump-sum cash payment to avoid the negative impact of a bankruptcy filing by the landlord.
- Security Deposit. Depending upon the financial solvency of the prospective tenant, the amount of any security deposit may be six months or more of fixed rent. In some instances, landlords will require both a security deposit and a corporate guarantee of the lease. A tenant should try to obtain the landlord’s agreement to reduce or “burn down” the amount of the original security deposit after a certain period of time has passed and provided the tenant has met all of its obligations under the lease.
- Use. Prospective tenants are well-advised to investigate and determine the permissible uses of a space under local zoning ordinances and the Certificate of Occupancy for the building where the store is located prior to proceeding with full-scale lease negotiations. If the retail store is located in a cooperative or condominium building in New York City, the tenant’s intended uses under the lease must be permissible not only under the Certificate of Occupancy for the building but also under the by-laws and other regulating documents of the co-operative or condominium. Further, written approval or the waiver of any first right of refusal by a cooperative or condominium board of managers is often required for the making of the lease.
- Tenant’s Alterations. Most retail leases provide that the tenant will accept the store premises in its current “as is” condition and, unless there is a special agreement with the landlord as part of the lease negotiations, landlords will not do any work to ready the premises for a retailer’s occupancy. Consideration should be given to preparing and submitting full construction plans and drawings, including signage and storefront designs, to the landlord for prior approval and incorporation into the lease. This will eliminate uncertainty at a later date as to whether or not the landlord will approve the tenant’s storefront design and plans for the construction of the retail store. If the space lies within an Historic District or is in a landmark building, any alterations affecting the exterior of the building will need to be approved by the landlord and the New York City Landmarks Preservation Committee. Further, if the space is located in a cooperative or condominium building, the co-op or condominium board will also need to approve any proposed alterations.
- Sublet and Assignment. Landlords generally will not permit tenants to assign or sublet their store premises without the prior written consent and approval of the landlord. To ensure that a landlord’s consent will not be arbitrarily withheld, the lease should contain a provision stating that the landlord will not unreasonably withhold, delay or condition its consent to any subletting or assignment. Many New York City leases contain recapture provisions granting the landlord the right to terminate a lease if the tenant gives notice of its desire to sublet all or a portion of the premises or to assign the lease. If the landlord exercises its recapture right within the time period specified in the lease, the lease will terminate and the tenant will lose its leasehold premises. If the landlord does not exercise its recapture right, the landlord may either grant or withhold its consent to the subletting or assignment.
These are some of the key issues to consider when negotiating and entering into retail store leases in New York City. Careful attention to these and other lease issues will help avoid costly and time consuming errors and ensure the successful operation of your retail store.