Imagine buying a chain of 50 restaurants, only to find out that 10 of the leases have expired or the option notice date has passed. Even worse, the landlord already agreed to place another tenant in the space. You just made a significant investment and now you may potentially lose a large percentage of your anticipated income stream as well as part of your investment from the acquisition as a result of not completing your due diligence.
Acquiring a new group of retail stores or restaurants can be an exciting and lucrative business venture. However, it is crucial to pay close attention to the leases associated with the properties during the due diligence process, as they can impact the outcomes of the acquisition. This article will discuss the key factors that a potential acquirer should look for in commercial leases during such an acquisition process.
Before we begin, it is essential to remember that every transaction is unique, and the specific circumstances may require additional considerations or professional advice. If you work in commercial real estate or are involved in an acquisition, it’s crucial to consult with experienced professionals such as real estate attorneys, brokers, and other industry experts to ensure that you are well-informed and able to make the best decisions for your specific situation.
Why Due Diligence Matters in Lease Acquisitions
Here are a few examples of complications that can arise as a result of not completing due diligence prior to a lease acquisition:
Increased Base Rent
In the excitement to sell their business to a large corporation, a seller failed to exercise their renewal option on time, resulting in the buyer having to engage in a difficult negotiation to keep the space in a major city’s medical district. Unfortunately, as a result of missing the renewal notice date, the base rent was increased from $40.00 per square foot up to $85.00 per square foot.
Reduced Profits
One buyer found out after the fact that there was a verbal agreement in place between the seller and the landlord where the seller was paying a significantly higher rent than what was documented in the lease. The landlord then expected the buyer to honor the verbal agreement they had with the seller. This significantly reduced the anticipated profits of the buyer and resulted in difficult negotiations with the landlord which ultimately led to the threat of legal action.
6 Key Factors to Consider During the Acquisition Process
Confirmation of Key Lease Dates
One of the first things a potential acquirer should do when reviewing commercial leases is to confirm the key lease dates to ensure the lease is still active. These dates include the commencement date, expiration date, and renewal options notice dates. Understanding these dates is essential for planning the transition and future operations of the acquired business.
In addition, the acquirer should check whether the lease terms align with the intended duration of the acquisition, and that it is long enough to see a return on investment. If a lease is set to expire soon after the acquisition, it may be necessary to have the seller negotiate an extension or find an alternate location, which can be time-consuming and costly. Or the extension of the lease could be completed via the assignment document. This can, however, result in delays to the acquisition closing date, due to complications that arise when negotiating lease terms.
Request Estoppels
One proven way to ensure that you have documentation of the lease term dates and that the lease is still indeed active and in effect is to request the seller complete estoppels with all of the landlords. An estoppel certificate can be used to confirm lease details, such as critical dates, renewal options, and any outstanding balances. When reviewing estoppels, it is a good idea to look for any conflicting info that may be present in the lease files.
Compile a Comprehensive Set of Lease Documents (with no gaps)
Another important aspect to consider is the completeness of lease documentation. A comprehensive set of lease documents should include the original lease agreement, any amendments or addendums, and any related documentation such as estoppel certificates, subleases, or guarantees.
Gaps in documentation can lead to misunderstandings or disputes between the landlord and the new tenant (the acquirer) and may result in unexpected liabilities or obligations. It may also be very difficult to obtain all the respective lease files after an acquisition has closed. Therefore, it is essential to ensure that all documentation is complete and accurate before proceeding with the acquisition.
If there are gaps, the acquirer should request the missing documents from the seller or landlord as part of the due diligence process. For example, if you have a lease and Amendment 5 but nothing else, you need to find amendments 1-4 before you agree to anything. Otherwise you have no idea what exactly is included in those missing documents.
Consequences of Assigning the Lease to Someone Else
During an acquisition, the existing tenant’s lease is often assigned to the new tenant (the acquirer). It is crucial to understand the consequences of this assignment, as it may affect important lease provisions. For example, the assignment of the lease may void renewal options or exclusive use protections, which can significantly impact the long-term viability of the business.
To avoid any surprises, the acquirer should thoroughly review the lease assignment provisions and consult with a real estate attorney to understand the implications. This language is often complex and may require an attorney review.
Future Renewal Options with Defined Rents
Renewal options are an essential aspect of commercial leases, as they provide the tenant with the opportunity to extend the lease term beyond the initial expiration date. When acquiring a chain of retail stores or restaurants, it is crucial to understand if there are any future renewal options in the leases and whether the rents for these options are defined.
Having renewal options with defined rents provides the acquirer with more predictability and control over future occupancy costs. In contrast, leases without renewal options or with uncertain future rents may expose the business to significant rent increases or force the acquirer to search for alternative locations upon lease expiration. To mitigate such risks, the acquirer should prioritize leases with favorable renewal options and clearly defined rents.
One area in particular to review during your due diligence is whether any lease provisions are affected by the assignment. If necessary, the acquirer may need to negotiate with the landlord to ensure that essential lease provisions are preserved during the assignment process. It is common to potentially forfeit any future renewal options if the terms of potential assignments are not followed correctly.
Other Terms or Conditions That Make it Difficult to Operate Out of the Space
Lastly, the potential acquirer should carefully review the lease terms and conditions to identify any provisions that could make it difficult to operate out of the space. Some examples include restrictive use clauses, which limit the types of businesses that can operate in the premises, or exclusivity clauses that prevent the tenant from opening a similar business within a specified radius of the leased property.
Additionally, the acquirer should be aware of any significant maintenance or repair obligations, as these can result in substantial expenses and disrupt operations. If the lease includes onerous terms or conditions that could negatively impact the acquired business, it may be necessary to renegotiate these provisions with the landlord or consider alternative locations. It is always recommended to visit the site and inspect the property in advance of the acquisition. Do not be afraid to ask for copies of HVAC maintenance reports, as unexpected HVAC expenses can be a very unpleasant expense.
In conclusion, a thorough examination of commercial leases is necessary during the due diligence process of a potential acquisition. At a minimum, acquirers should review key lease dates, confirm comprehensive documentation, assess lease assignment consequences, evaluate future renewal options, and scrutinize restrictive terms. Meticulously addressing these factors can help acquirers more confidently navigate the acquisition process and mitigate risks.
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