The location of a dental practice’s office is a significant factor in its long-term success and among its most important assets. Consequently, a dentist’s office lease is perhaps the most important contract that will be executed pertaining to his or her practice. As leases generally have lengthy terms, you get one chance to negotiate an office lease that you will have to live with for a long period of time. In order to obtain satisfactory business terms, it is important that you secure the assistance of an experienced commercial real estate agent who specializes in office and/or retail leasing and knows the specific market you have targeted. Likewise, you should have an attorney who specializes in commercial real estate review your lease to make sure you are receiving the full benefit of the agreed upon business deal, and to negotiate the important legal provisions throughout the lease document.
It is very important that a dentist, acting through his or her professional corporation, limited liability company or other practice entity, not make the mistake of signing a landlord’s lease without attorney input, notwithstanding assurances that it is a “standard” lease. Landlords are in the business of leasing space, and their leases (especially those of large, institutional landlords) are meticulously drafted to protect their interests, often at the expense of the tenant’s reasonable business expectations. One should assume that a landlord’s lease form favors the landlord heavily and most likely includes onerous legal provisions which could become a huge problem for the tenant at some point during the lease term. This article highlights six of the most frequent lease provisions which favor the landlord in rather extreme fashion, but these are by no means the only pitfalls to be avoided.
1. The Landlord’s Right to Relocate: A relocation provision gives the landlord the unilateral right to require a tenant to move to other premises within an office building or shopping center. A landlord might exercise this relocation right in order to accommodate an existing tenant or prospect requiring a large amount of space. The relevant language will usually require the landlord to pay or reimburse the tenant for all moving expenses and incidental costs. However, this does not compensate the tenant for the temporary shutdown of its practice or the continuing disruption after the move is completed. Perhaps more fundamentally, the tenant wanted the space it leased and made a long-term commitment to the landlord in order to secure that very space. The landlord should not be able to unilaterally change the business deal struck by the parties by moving the tenant to new space which might have poorer visibility, access and/or other characteristics. From a tenant’s perspective, a relocation right in favor of a landlord is a recipe for potential disaster.
2. The Arbitrary Refusal to Consent to an Assignment or Subletting: A tenant may want to sublet space within its office to another dentist or complementary business or professional. A dental practice may want to assign its lease altogether to a third party, most frequently when the practice is being sold. The landlord needs the right to approve any such subletting or assignment in order to protect its legitimate business interests. The landlord needs to know who will be occupying its property, and needs to ensure that the proposed assignee or subtenant has a good business reputation and the financial means to honor its obligations. However, the landlord should not be able to withhold its approval arbitrarily or in an effort to extract additional financial consideration from the tenant. Additionally, a tenant would like to be released from obligations under the lease which arise after assignment, particularly where the assignee, i.e. the practice purchaser, has financial strength equal to or greater than the original tenant. A properly drafted landlord approval provision will fairly protect the interests of both the landlord and the tenant.
3. The Recapture Right: The recapture right is a particularly onerous provision sometimes included with the lease clause dealing with the landlord’s right to approve a proposed sublease or lease assignment by the tenant. Upon receipt of a tenant’s request for approval, the landlord may circumvent the approval process by terminating the lease and thereby “recapturing” the leased premises. Needless to say, this is fundamentally unfair and places the tenant at great risk. Instead of simply being denied landlord’s approval of a sublease or lease assignment, the tenant can lose its entire interest in the premises. No tenant should agree to the inclusion of a recapture right in any lease.
4. The Overbroad Indemnification Provision: Generally speaking, an indemnification provision allocates certain risks and potential costs to one party to a business transaction. Office leases frequently include landlord friendly indemnification provisions which make the tenant liable for an assortment of potential injuries to persons or property losses. A dental practice is in possession and control of its office and can protect against claims resulting from incidents occurring within such premises by ensuring a safe working and treatment environment. Consequently, a tenant will generally be willing to indemnify its landlord should the landlord get sued for events or circumstances occurring within the tenant’s office, unless caused by the landlord (which would be unusual). However, a tenant should not indemnify a landlord for any injuries or property losses which occur in common areas or otherwise outside of its leased premises, unless resulting directly from the tenant’s negligent actions or wrongful conduct. Indemnification clauses are complicated and confusing to read so it is very important to have your legal counsel review and negotiate them.
5. The Renewal Option that Really Isn’t: As your practice grows, a substantial part of the value of your practice—what accountants term “business goodwill”—is tied to your office location. Consequently, your broker will know when negotiating the business terms of your new lease how important it is to obtain one or more renewal option terms so that you will have the ability to remain in your office after the termination of the initial term.
Let’s say that after extensive negotiations your prospective landlord agrees to grant you one or more renewal option terms. Success! But wait. When you receive the initial draft of the lease, you discover that the rent during the option term(s) will be the “fair market rent” as determined by the landlord when you exercise the option, and that the option will terminate if you disagree with the landlord’s determination. Basically, you have the right to continue leasing the premises at a rental rate determined by landlord or agreed upon by the parties. While this contractual right is better than nothing, it does not satisfactorily protect your interests.
Instead, you should seek a renewal option with a specified, predetermined rental rate for each year of the renewal term(s). This can be done with annual base rent escalation at a specified percentage (2.5% to 3% is common currently). Obtaining a renewal option with fixed future rental rates allows you to secure the right to continue occupying your office without having to engage in new negotiations with your landlord, while placing a cap upon your future rental rate. If the specified rental rate ends up being higher than the market rate, you can always elect not to exercise the renewal option and seek to negotiate a new lease with your landlord.
6. The Expansive CAM Charge: Leases for space within multi-occupant office buildings and shopping centers usually provide for the tenant to pay a prorated share (typically based upon the ratio of the square footage of the premises to the square footage of all tenant space within the office building or shopping center) of landlord’s real estate taxes, insurance premiums and common area maintenance expenses, commonly termed “CAM charges”. CAM charges include a broad array of expenses relating to the operation of the common areas of the office or retail development, from electricity and other utility costs to expenses for restriping parking areas. CAM charges may also include management fees, whether the property is managed by the landlord (or any affiliate) or by an unrelated third party, and administrative charges. An expansive CAM charge provision may saddle the tenant with a prorated share of expenses which do not relate to maintenance, but rather are capital in nature. These include costs associated with the replacement of a roof or the construction of a parking deck.
In negotiating your lease, it is important to try to cap annual increases in the CAM charges. A tenant should also resist language which allows a landlord to collect for management fees and administrative charges, and all management fees should be required to be commercially competitive in the immediate real estate market which includes the subject property. Additionally, capital costs should be specifically excepted from the definition of CAM charges if possible. At a minimum, each capital cost should be amortized over the usable life of the associated improvement, and the tenant should only have to pay a prorated portion of the amortized cost for each lease year. Lastly, the tenant should insist upon a right to audit the landlord’s records regarding CAM charges to ensure that there has been no overcharging, whether intentional or due to error.
In summary, commercial leases are complicated business contracts that are extremely important to the success of a dental practice. You will have to live with your lease for many years, so it is important to have it handled properly on the front end. Negotiating and finalizing a commercial lease with an experienced landlord’s agent is clearly not something to attempt on your own (the saying “lambs to the slaughter” comes to mind). You need an experienced office and/or retail broker and commercial real estate attorney on your team.
by Andrew P. Kaiser, Esq.