November 27, 2017
What due diligence steps should a tenant undertake with respect to a commercial property before signing a lease?
Due diligence customary in a commercial real property purchase
Step back and consider for a moment that when we buy a piece of real property — for our home or for our business — it is prudent and customary by both the buyer and the lender to conduct due diligence investigations of the property:
- physical inspections of the structure and mechanical systems,
- environmental, and
- checks of governmental records for notices of liens for violations, zoning, traffic engineering, etc.
The list can seem endless.
Isn’t a commercial lease low-risk for the tenant?
But when simply signing a lease for a term of years, why should the tenant be concerned with these things? After all, his upfront cash may not be significant (relative to a purchase) and if things don’t work out, the tenant can just leave, right?
Well, sometimes that is the case. The cost and time needed for due diligence would outweigh the risk the tenant is undertaking by simply signing the lease and moving in. If so, then by all means, proceed.
But, wait, consider this!
But consider these countervailing factors:
- Tenant is spending significant monies on tenant buildout costs.
- Tenant is spending significant monies to move, including moving of furniture, fixtures and equipment, the installation of computer and phone systems, and printing of letterhead, envelopes and business cards.
- The disruption of your business arising from a move (and if things don’t work out a second move).
- The image you are building at the new location. What will be lost if a second move is necessary? Think of a restaurant or bar, retail store, or bank branch. The location is intricately tied to a business’s identity in the mind of the consumer. It may not be easy to just pick up and move.
The reality is that if the tenant does not undertake the kinds of due diligence implemented for a property purchase, he could “lose” the property in many of the same ways as in a purchase — i.e., he could lose the out-of-pocket costs associated with the activities noted above and have the inconvenience and loss to reputation by relocating to a second location.
The types of risk potentially borne by a tenant that due diligence could avoid
Indeed, in certain circumstances the tenant could be obligated to pay rent throughout the lease term, but the property cannot be occupied for its intended purpose. (Consider a situation where the property cannot be occupied but where the landlord does not appear technically in default of his obligations under the lease.)
- When signing a significant lease for property, a title examination, possibly a survey, and assuring lender buy-in of the lease can be absolutely critical.
- If, for example, the landlord has a mortgage against the property, and the mortgage is in default, that lender legally can extinguish a later–signed lease concurrent with the foreclosure.
- To avoid this risk, one asks a landlord to execute a subordination, non–disturbance and attornment agreement agreeing that so long as tenant makes prompt and full payment of rent (to the landlord or– when in default of the mortgage — to the lender), the lender or a successor buyer will honor the lease.
- A tenant’s policy of title insurance can be issued, transferring that risk to a title insurer.
- If the property does not comply with the regulatory requirements, zoning for example, of the jurisdiction in which the property is located, the tenant could be required to make extensive property modifications or to move.
- If the property has environmental problems, the cost of compliance — in an unlimited manner — could be transferred to the tenant.
- If the property has structural problems or the HVAC system is old and inoperable, depending on the lease language (shifting repairs and replacement of the HVAC to the tenant), the burden of fixing the problem could fall to the tenant.
Many times tenants will assume these risks in smaller leases. Negotiating with the landlord’s lender and conducting full-scale inspections and other due diligence may just not be practical.
But a tenant in a commercial setting should carefully consider the risk-benefit to foregoing certain due diligence steps to prudently protect their investment in their new premises.