Many contracts and leases leave the parties to determine a future purchase price or rent between themselves as set by the then “Fair Market Value” (FMV). The crafty draftsperson will often try to sneak in language “as determined by seller (or landlord)”. But smart buyers and tenants won’t stand for that unilateral determination. A more concrete method of determining the FMV needs to be added to the document to set the future purchase price, option price or renewal rent. FMV is then usually determined by an appraisal. Sometimes the seller or landlord will obtain the initial appraisal, with the buyer/tenant having the right to challenge the initial appraisal by obtaining its own appraisal. If the 2 appraisals don’t agree, the appraisers choose a 3rd appraiser whose appraisal would then be binding. This process can be time consuming and costly. Other times, the buyer and seller or landlord and tenant agree in advance as to who the appraiser will be and jointly pay for the appraisal prior to the time the purchase price, option price or rent is to be set. The appraiser’s determination of FMV would be binding and the purchase price or rent is set based on such determination.

It is important to understand what you are getting when you add this appraisal language to a contract or lease. Otherwise, when the time comes, the appraisal you obtain might not fit your needs and the FMV could cause you to overpay, as tenant or buyer, or receive, as seller or landlord, less than FMV.

The Uniform Standards of Professional Appraisal Practice, as developed by the
Appraisal Standards Board of the Appraisal Foundation, has 3 approaches in determining a property’s value:

  1. Cost Approach: Under this approach, a property’s value is determined by adding the estimated value of the land to the current cost of construction of the replacement for the improvements on the land and subtracting depreciation (land value + construction cost – depreciation). The appraiser must obtain cost estimates from builders and contractors. Appraisers must do research as to depreciation. Land value is established separately.
  2. Sales Comparison Approach: this approach is useful when several similar properties have sold or are for sale in the subject market. The value of the subject property is determined by comparing comparable sale and a price range is given.
  3. Income Capitalization Approach: Value under this approach is reached as the present value of future benefits of property ownership. There are 2 methods, direct capitalization and yield capitalization. Direct capitalization is the relationship between 1 year’s income and the value of the property that equals a cap rate or income multiplier. Yield capitalization is the relationship between several years of stabilized income and a reversionary value at the end of a defined term.

 

Most appraisals determine value using at least 2 of the methods. Income producing property will almost always use an Income Capitalization Approach. Where 2 of the approaches conclude virtually the same value, it is safe to assume that the appraisal is fairly accurate. However, it is important to review the appraiser’s assumption. How old are the comps used? What is the supply of like properties currently for sale? What is the absorption rate? What are area cap rates? What is the condition of the subject property and what was the condition of the comps? What is the vacancy rate and what vacancy rates were used? There are many other assumptions to consider that could affect the appraiser’s conclusions as to FMV.

At contract/lease drafting time, sellers and landlords want as much flexibility as possible to raise the purchase price or rent in the future. At this point, FMV is a very loose term. Buyers and tenants want caps. Efforts to cap an increase are sometimes futile, especially following a lengthy initial lease term with small rent increases. That is why it is essential that the parties work to ensure that FMV actually be fair at the adjustment time.

Usually, it is a good thing when an anchor tenant decides that it is time for a massive renovation that requires Landlord to totally renovate and redesign the shopping center. It should mean a good face lift and upgrades for the local tenants. However, there will be some challenges and pain suffered along the way, particularly if the tenant does not have protections built into its lease up front, but also if the tenant doesn’t seek and obtain protections prior to the commencement of construction.

This scenario is playing out for a local restaurant client of mine. The restaurant, a popular deli located in a Publix anchored shopping center is suffering through Landlord’s renovations of the Publix and the shopping center. To call the work “renovations” is an understatement as Publix, like it so often does with its older, smaller stores, is in the process of a total rebuild. Only the exterior walls remain. The interior has been totally gutted and the roof above the store is gone. Like so many old Publix centers, Publix sits in the middle of the shopping center, with small, local retail, including my restaurant, on either side. From the street, it looks as if Publix is not just closed, but demolished. Therefore, it looks as if the entire shopping center will also be demolished.

During the demolition work, the contractors have cut water, gas and electric lines multiple times causing my client to close down for several days. The client has suffered lost revenue and expenses including paid wages for closed days to employees, not to mention spoiled food and other lost expenses. Vibrations from construction activities, unclean work site (such as nails in the parking lot), unsafe sidewalks and no signage, have also adversely affected business. The client has contacted the Landlord through the property manager and so far, the property manager has deferred to the general contractor, arguing that all cuts in utility services are general contractor’s liability.

Client contacted me for help. The first thing to look to is the lease. The lease should have protections for disruption of utilities and services caused by Landlord, in this case through its contractors. It should have provisions regarding construction and renovation of the shopping center, maintenance of the common areas, access to the shopping center and Tenant’s premises, quiet enjoyment. signage and multiple other like provisions. Needless to say, I have seen better leases than this one.

The next question is whether Landlord approached Tenant prior to construction started. Landlord should have discussed its plans with all of the tenants and the accommodations Landlord would make to minimize disruption to each of the tenants’ businesses. Tenants could then outline their concerns so that Landlord could adjust. Expectations could be set and met. In this case, despite the fact that everyone knew Publix’ plans, work just started without any converations.

Now, here we are with loss of business damages to the client. This is a good reminder as to why it is important to consult with an attorney prior to signing any document. A properly drafted lease probably would not have stopped this Landlord from doing thing that disrupted Tenant’s business. But it sure would have given Tenant leverage and remedies when things got bad.

Paul Newman uttered that famous line as Cool Hand Luke at the end of the 1967 classic, mocking the prison warden just before he is killed after his escape from jail. I often think about this quote when I am working out disagreements between parties. How often are these disagreements between contracting parties caused by a simple lack of communication? More often than the clients would like to admit, for sure.

We have been working on a problem for a tenant client with his commercial lease. He has been experiencing roof leaks for almost the entire time he has been in the building. Many of the air conditioning units have failed and the property manager has been non-responsive. There have been other smaller issues that have become bigger issues because of the lack of attention to the on-going roof and HVAC issues.

After numerous complaints following major afternoon thunderstorms, a roof contractor was finally dispatched. Some patch work was done, but the problem has never been totally resolved. Some of the HVAC units have been replaced while others have continued to deteriorate and ultimately failed. And, it appears, that the way the units are mounted on the roof have caused many of the leaks. The AC contractor and the roof contractor agree on this, yet the property manager has not authorized either to fix the problem.

Getting no satisfaction from the property manager, we made demand on the Landlord. Landlord made its own demands due to the smaller lease issues. It became apparent through this exchange of demands and subsequent conversations with Landlord’s attorney that Landlord was missing key information and, perhaps, so was Tenant. Landlord was not aware of the number of times Tenant had complained about the leaky roof or that the AC and roof contractors had agreed that the installation of the HVAC units were causing some of the leaks. Nor was Landlord aware that Tenant was fulfilling its own obligations under the lease to keep the HVAC units in good repair up to a maximum dollar limit. Tenant was unaware of the efforts Landlord was taking to resolve other issues Tenant had raised. Neither party was communicating with the other directly. Nor was either party giving the other complete information of the various issues and resolutions. Part of the problem was that the property manager, the go between, was withholding information. We aren’t exactly sure why. Perhaps property manager was protecting itself and its contract. Or maybe the property manager is just not competent. Regardless, the lack of communication has caused Tenant and Landlord to posture to the point of dueling demand letters with threats of litigation seeking damages and potential injunctive relief.

This is not the result either party wants. But, when it’s raining in your offices and you don’t feel as if you are getting the attention you require, I suppose it is hard to keep a level head. We are hopeful that the lines of communication are being restored and repairs will begin promptly. After all, it didn’t end well for Cool Hand Luke.

Sophisticated commercial tenants generally understand that the cost of leasing space is not limited to rent. Most retail and higher end office spaces are net leases and therefore, include a separate charge for Common Area Maintenance and Operating Expenses (CAM). CAM charges are the charges that the landlord incurs for running the common areas of the building, such as utilities, maintenance, taxes, insurance, security and the roof and structure. Depending on the tenant’s size and financial strength, care should be given to negotiating what is included in the definition of CAM and what is specifically excluded. I’ve written on this topic before (see post HERE).

Another factor in negotiating CAM from the tenant’s perspective is limiting the increase from year to year. Again, there are tools to help limit tenant’s exposure to significant increases to CAM charges (discussed in my previous post and also HERE). But once the CAM provisions have been negotiated and included in the lease, tenants can’t forget about them. If they do, tenants could be faced with improper CAM increases or charges.

In my practice, I am asked what to do about large CAM increases all the time. When I have been the one to have negotiated the lease, the process is usually simple and the same. There are 2 questions of concern. First is the reconciliation of the prior year’s CAM. That occurs because landlord has underestimated the actual operating costs for the building for the prior year and tenant is required to “true-up”. The second is the new charge for the coming year. If landlord under budgeted for the prior year, the new charge should factor in the short-fall plus a percentage increase for the coming year so that the tenant will not suffer sticker shock.

The review process is not complicated in a properly drafted and negotiated lease. Within a certain number of days following the end of the calendar year, the landlord should provide an operating statement showing the reconciliation including the original budget and the actual budget. The tenant will have a period of time to object and, if desired, audit landlord’s records to determine accuracy. If tenant’s audit finds a discrepancy over an agreed percentage, landlord pays the cost of the audit and sometimes, a penalty to tenant. If tenant still owes, tenant pays. Tenant also has the right to review the proposed budget. If there was an audit, the audit should give the tenant some insight as to the accuracy of the new budget.

If landlord fails to timely deliver the reconciliation, landlord waives its right to collect any shortfall. CAM, however, should be adjusted up or down, at any time during a calendar year. While tenants might look at this provision as giving a landlord too much discretion, it is better to make incremental changes during the year than to be faced with a large reconciliation at year end which must be paid in lump sum on 15 days’ notice. And, because tenant should have the right to audit, the payments can be recovered if found to be improper.

Sometimes, actually, often, I get leases that I did not review or negotiate. New clients or even existing clients who didn’t think they needed me or my partners to handle what they considered to be a “simple lease”. Recently, a firm client, who signed a lease before we represented him, was presented with a very large reconciliation. It came at the start of the 3rd calendar year of the lease. This was the first time the client had ever received a reconciliation. He should have received 2 reconciliations previously but apparently, the property manager “forgot” to send the prior reconciliations. As a result, there had never before been a true-up. In addition, the property manager had, for the prior 2 years not increased CAM because he “forgot” to bill the client. Now, the client had a large reconciliation and a large increase. The client had never questioned the property manager, but why would he? His rent increases were small and the CAM wasn’t changing. On the other hand, now he faces a very large bill.

How can the client be certain that the property manager isn’t attempting to recoup the lost CAM going back to the first year? The issue is sloppy record keeping.   By not presenting timely reconciliation statements, the lease provides that the true-up is waived for those first 2 years. Therefore, the landlord is only entitled to catch up for last year. But the sloppy property manager never even prepared a budget those first 2 years so there is no documentation to prove that the client underpaid last year or to prove that the reconciliation is only for last year and not a recovery of all lost CAM. The best that property manager and landlord can do is show us tax and insurance bills over the life of the lease to prove that non-controllable expenses.

In hindsight, I have explained to the client, the lease requires that the landlord provide a budget by December 1 of each year. That budget is to include a CAM estimate for the coming year. The estimate should prepare the client for what is to come in the reconciliation statement. Although these are landlord’s obligations, if the tenant does not keep its eyes open and be aware, a big surprise will come at some point. That surprise is likely to turn into a costly fight.

A Right of First Refusal (ROFR) is the right to match an offer to purchase a seller’s property. ROFRs can be found in different types of documents relating to both real and personal property. Often, they are contained in leases, giving the tenant a ROFR to purchase the leasehold property. They are also used in shareholder, partnership and operating agreements giving “partners” the ROFR to purchase each other’s interest in the entity.

ROFRs often have a chilling effect on a seller’s ability to sell property, particularly real estate. Potential buyers won’t put forth much time, effort or due diligence in looking at a property knowing that an offer could be matched and the property sold to the holder of the ROFR. If a property is very desirable, a potential buyer might have to overpay in order to discourage the ROFR holder from exercising.

Generally, ROFRs require that the holders close on the same terms as set forth in the offer. Therefore, if a seller receives an all cash, no-contingency deal, the holder would have to close without financing and with no contingencies. Sometimes this will also work to the potential buyer’s advantage. While the price might be attractive to the ROFR holder, the terms of the offer might make it difficult, if not impossible for the ROFR holder to close.

Usually, the event that triggers the ROFR is a “bona fide, 3rd party offer” duly accepted by the seller. What constitutes a bona fide 3rd party offer? The easy, legal answer is an offer made by an unrelated 3rd party purchaser who purchases the property for valuable consideration that is inducement for the entering into a contract without fraud or deception.

I recently had a tenant ask me to analyze a situation relating to a ROFR. The tenant had completed its 10 year initial lease term and the 1st year of its 5 year renewal term. There were 4 years remaining on the lease. The landlord had received an unsolicited offer to sell the building from an unrelated 3rd party. Though the landlord had not intended to sell, landlord was inclined to accept and forwarded the offer on to tenant with a note saying that landlord would pass on the offer if tenant would agree to purchase the property at the end of the lease term for a price that was $200,000 less than the current offer.

Needless to say, the tenant was confused. To make it more confusing, the offer was full of contingencies. The first major contingency was that the buyer had to get 3 adjacent properties under contract and then simultaneously close with this property. So, the contract was intended to be a property assemblage and this was the 1st of 4 parcels that the buyer had made an offer on. The other major contingency was re-zoning and site plan of the assembled property. However, the contract did not describe the intended use or the required approvals. My primary question was whether we even had a bona fide contract that triggered the ROFR.

The biggest problem was that tenant’s ROFR required that tenant respond in 15 days and close within 45 days thereafter. Given that the buyer’s contingencies had not yet been satisfied and that there was no possible way that they could be satisfied before tenant would be obligated to exercise the ROFR and then close, the contract was not yet ripe and therefore, not a bona fide contract for which tenant’s ROFR had been triggered. Until the buyer satisfied or waived the contingencies, the buyer had not obligation to close and therefore, the buyer was not a bona fide purchaser.

Further, landlord’s action in advising the tenant that it would reject the offer and enter into a different purchase agreement with tenant indicated that landlord had not accepted the contract and was using it as a method to force tenant to purchase the property using the ROFR. Landlord wanted the best of both worlds – 4 more years of cash flow via rent, and a guaranteed buy out at the end of the term. Landlord could not get either of these through the contingent offer but had to accept the offer when tenant rejected the offer and put landlord on notice that the offer was not bona fide. This could come down to a shoving match if and when the proposed buyer satisfies its contingencies and attempts to close.

Lesson learned? Make sure you understand the triggering event of the ROFR before signing a lease whether you are the landlord or the tenant. Any ambiguity in an offer can be exploited and delay the exit strategy for one side or the other.

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