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Reviewing Leases on Income Producing Properties

When acquiring an investment property, a thorough review of lease agreements is required to determine the appropriate valuation of the property.  The value of the investment property is directly linked to the amount of rental income, the term, the quality of the tenants, the enforceability of the lease, and any issues that may interfere with the landlord’s ability to collect rent.

Quality of the Tenant
Assessing the stability of the tenant is a critical consideration. In the commercial context, large shopping malls and plazas typically have a number of store-fronts with a diversified tenant base, where the rental income is split between a number of units. In such a case, where one tenant’s lease expires and does not renew, or where one business shuts down, the overall impact on the profitability and value of the property will ideally be negligible. However, where an Anchor Tenant occupies a large portion of the property square foot, the success or failure of this particular tenant has large implications on the value of the property. If the Anchor Tenant does not renew its lease at expiry or the business ultimately fails, large amounts of square footage can be left vacant and difficult to fill with new occupants. This is more common as e-commerce is reducing the square footage commanded by traditional bricks-and-mortar retailers.

Duration of Term
A purchaser of an investment property has to understand the terms of the leases and any options to extend or renew the lease terms. The lease terms are key considerations in determining the length and extent of the rental income stream. The terms of potential lease renewals should be considered and the rental basis (i.e., whether fair market rent at the time of renewal or inflation-adjusted escalators or other means of determining the rent at the renewal period).  If the intention is to develop the property, long lease terms (without demolition clauses) will have an impact on a purchaser’s ability to do so. Specific consideration must be given to demolition clauses to understand the basis this can be done and the notice or time frame required to be given to the tenant.

Use & Exclusivity
Commercial leases will specify the permitted uses of the premises.  Use provisions restrict the tenant’s flexibility in its operations and ensure that a landlord stays onside other leases which restrict what the landlord can and cannot permit at the property. This is particularly relevant in medical office properties where tenants request that direct competitors cannot operate in certain proximity around their practice. All restrictive covenants in the lease should be identified to ensure existing and prospective tenants are in compliance.

Tenant Inducements
For new tenants, landlords will often grant rent-free periods or grant allowances to improve the property for tenants permitted use.

Triple Net Leases – Q & A

As a real estate lawyer handling commercial leasing disputes and a commercial property manager, I am commonly involved with payment disputes between Landlords and Tenants, often resulting from ambiguity in the terms of a Lease Agreement.  In this article, I will provide some initial definitions to differentiate between a Gross Lease and Net Lease and thereafter I will discuss some specific challenges, and means to remedying such challenges, pertaining to the most common lease in the commercial property context – the Triple Net Lease.

Gross Lease: A gross lease is where the tenant pays the landlord a flat monthly rental amount, which is determined upon signing of the Lease Agreement, and the landlord pays all expenses related to property ownership (i.e., property taxes, maintenance, utilities, and insurance).  Gross leases are more common in residential leasing (i.e., apartment) transactions. The monthly rental payment in a gross lease is typically higher than in a net lease scenario.

Net Lease: In a net lease, a tenant is required to pay, in addition to the monthly fixed rental payments, a contribution towards the landlord’s property taxes, insurance, maintenance, repairs, utilities, etc. In such cases, the Lease Agreement stipulates that the tenant is to pay the landlord a Base Rent and an Additional Rent (amounts which are typically based on a dollar value per square foot of rentable space). Where property taxes, maintenance, and insurance are all paid by the tenant, the lease is typically referred to as a “triple net lease,” in which case the Landlord receives the funds “net,” after the expenses passed through to the tenant are paid.  Net leases are most common in a commercial property context.

Net Leases – What is Additional Rent?

As mentioned, in a triple net lease the tenant is required to pay Base Rent (i.e., the cost of renting the premises) plus an Additional Rent (i.e. to defray the landlord’s property-related expenses). In commercial properties where multiple tenants lease divisible units of a larger building, a triple net lease will include a provision allowing the landlord to charge its tenants for their respective contributions (usually on a proportionate share basis of the ratio that the rentable area of the particular tenant’s premises bears to the total rentable area of the commercial property).

The operating costs (i.e., the expenses incurred by the Landlord in owning, operating, insuring, repairing, and managing the property) are shared between the tenants based on their proportionate share of the property.

Calculating Additional Rent

Triple net leases typically provide the landlord with the right to estimate, in advance, the amount a commercial tenant will pay in respect of operating costs on an annual basis. At year-end, the total amount paid by the tenant to the landlord on account of operating expenses is compared to the actual amount of operating expenses incurred by the landlord during that period.  At this point, these amounts are to reconciled between the landlord and tenant within a period of time (typically 30- 60- or 90 days following year-end) to ensure that the tenant is credited for any overpayment of Additional Rent or the tenant pays the landlord for any underpayment.

In the multi-tenant scenario, the Landlord is required to determine the proportionate share of operating expenses applicable to each tenant, and reconcile their Additional Rent payments accordingly.

Operating Cost Statements

Operating cost statements are financial disclosures provided by landlords’ to tenants to support their claim for Additional Rent. Such statements will itemize total maintenance and repair bills paid during the relevant time period, property tax installments, insurance premiums, and variable utility payments. Landlords have a common law obligation to produce an operating cost statement to its tenants, irrespective of the terms of the Lease Agreement. As such, tenants have the right to inspect the landlord’s claims for Additional Rent and can request books and records, and supporting invoices, to substantiate such claims.

In 1877352 Ontario Inc. v. 699147 Ontario Inc.the Court indicated: “the duty of the Landlord to perform its obligations under the Lease is served by requesting it to deliver all documents that are the basis for the annual adjustment.  It is commercially reasonable to imply a term into the Lease that requires the Landlord to deliver with its annual adjustment for Additional Rent a copy of all the documents such as tax bills, insurance premiums, property management invoices, which support the amounts claimed.” 

In 2373322 Ontario Inc. v. Nolisthe tenant was obligated under the lease to make Additional Rent payments in monthly installments with the landlord at least once a year to provide an operating statement as required to accurately calculate the amounts payable in respect of Additional Rent. The Landlord provided one operating statement in 2016 to substantiate the expenses incurred from 2013 to 2016. The Court concluded that the failure of the landlord to deliver the operating statement does not relieve the tenant from the obligation to pay Additional Rent once the statement is provided. In this case, the Court permitted the Landlord to recover its proportionate share of expenses notwithstanding its late deliver of the statements.

Avoiding Disputes in a Commercial Lease

In order to avoid Additional Rent disputes, it is imperative that the Landlord provide the Tenant with an operating statement shortly after year-end. If the Tenant requests supporting documentation, the Landlord should deliver the same in order to substantiate its Additional Rent reconciliations. In the subsequent years, the Additional Rent estimate is based on the actual amount of expenses incurred by the Landlord in the previous years. If you are a Landlord, it is imperative that you comply with these obligations in order to properly administer a Triple Net Lease; otherwise, a tenant may have the right to hold-back Additional Rent Payments claimed.  As such, a professional accountant and lawyer with experience handling these matters can save both parties from substantial costs in the event of a dispute.

In a legal and property management capacity, we have been involved in a number of disputes between commercial landlords and tenants related to cost allocations. In many cases, disputes arise around repair and maintenance obligations and the parties respective payment obligations under the lease (a topic we will delve into further in a later blog post).  For the purposes of this discussion, it is imperative that the reader understands the characteristics of a gross vs. net lease, and the obligations of landlords and tenants in both scenarios.  For further questions about commercial lease disputes or other real estate-related matters, feel free to contact Goldstein Law at 647-838-6740.