Top 10 Ways to Limit Liability in a Commercial Lease

By Forrest Blake, Senior Vice President of SVN Commercial – Phone 310-850-2381 – CalBRE Lic # 01054174

This subject creates anxiety for many Partners. Landlords on most long-term multi-million dollar commercial leases require personal guarantees from professional services firms. When a firm’s cash flow goes negative or the partners split up and the leased space is no longer affordable or needed, under a lease default situation the landlord is going to want a personal guarantee of payment under the terms of the lease.

The landlord, in an attempt to mitigate their damages, does have the right to require a personal guarantee. Once a judgment is established, the landlord will chase down any cash or assets the partners own.

Brobeck, Phleger & Harrison was one notable firm who got caught with a guarantee issue. In February of 2007, four years after Brobeck went bankrupt, Kilroy Realty sued 220 former partners in San Diego Superior Court for $3.8 million in unpaid rent. They were able to settle the case, but each defendant had to pay a share of the liability. (1)

How does a firm limit this liability? It starts with the lease negotiations. This applies to both new space and renewals. With everything from rent to guarantees on the negotiating table, this is the time to create the best scenario as a tenant.

Here are 10 strategies.

1. Minimize the tenant improvement costs

With new energy conservation regulations “Title 24” construction costs for tenant improvements have escalated. To do a complete remodel for a traditional professional services firm, costs are in the range of $100 to $125 per usable square foot of space. The portion of tenant improvements paid for by the landlord is going to be guaranteed by the tenant. A firm can limit the costs of improvements to their space by taking on an existing professional services firm’s space, thereby lowering the potential exposure of the guarantee.

2. Don’t guarantee the entire lease obligation

Most lease terms are for more than 5 years. If the monthly rent is $50,000 plus increases, the total lease consideration would be over $6 million on a 120 month lease. Although this is the tenant’s obligation under the lease contract, the dollar sum doesn’t represent the out of pocket expense for the landlord. The landlord has the upfront costs of the tenant improvements, brokerage fees and any free rent provided to the tenant. This usually represents about 30% of the total lease obligation. This could be negotiated as the amount to be guaranteed by the tenant. For example, negotiate a 5% or 10% over the actual cost of the landlord’s exposure, but certainly not 100%

3. Annual reduction of the guaranteed amount

If a firm signed a 72-month lease, the obligation reduces by 1/72 every time a monthly rent payment is made. Wouldn’t it then make sense to also reduce the guarantee by the equivalent amount? To a tenant it certainly does. A landlord, typically, adjusts the guarantee annually versus monthly. This can be negotiated.

4. Termination right

If a firm requires a longer-term lease, having a termination clause after 5 or 7 years, providing an “out” of a lease, could be a real benefit. The formula for a termination is very similar to what is discussed above in point number 2. If a landlord is not willing to limit the tenant’s liability, a counteroffer could be a right to terminate the lease.

5. Removal of partners upon resignation or retirement

Having this provision in the lease would make partners leaving the firm much more comfortable. It is important to note, the liability would shift to the remaining partners.

6. Buy insurance

In case there is a death or disability, purchase an insurance policy to pay off the portion of the guarantee that is left by a deceased or disabled partner. The proceeds from the insurance could be placed into an account to be used in the event of a default. Depending on the policy, at the end of the lease term, the remaining partners could receive a distribution of these funds.

7. Separate individual partner liability not joint and severable

Landlords clearly do not like this provision, because it makes it more difficult for the landlord to recover any damages.

8. Posting a letter of credit for a portion or the entire guarantee

A letter of credit could be the perfect solution for a firm who does not want to assume any personal guarantees. The bank extending the credit may require the firm to have deposits exceeding the letter of credit amount. This could present a challenge.

9. Short-term lease

The shorter term of a lease, the smaller the liability. Guarantees are based on the out of pocket expenses of the landlord and total lease obligation.  Reduce the lease obligation and reduce the guarantee.

10. Negotiate when there is a default

Since most of the assets of a firm are in the partner’s name, as is the revenue they generate, a landlord understands that if the firm is not making money neither are the partners. When in default, time to negotiate with the landlord.

I hope you enjoyed the article. Please reach out with any commercial real estate questions.

Forrest Blake | Senior Vice President

SVN | Commercial – DTLA

800 South Figueroa Street, Suite 925, Los Angeles, CA 90017

Phone 213.618.4196 | Mobile 310.850.2381

forrest.blake@svn.com | www.svn.com

CalDRE# 01054174

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