Hug-Gate and Net Leases
There are certain things that just should not happen.
As a general rule, for example, middle aged guys should give up the “high five” and “bro hug”, with the rare exception being a celebration after putting together a truly fine boilerplate lease provision.
If you are a middle aged Governor of New Jersey with Presidential ambitions, it should be illegal for you to high five or bro hug under any circumstances.
You may have seen the priceless and now viral Chris Christie embrace of the Dallas Cowboys owner, Jerry Jones, during the Cowboy’s playoff win over Detroit.
It really was more of an aborted high five that morphed into an awkward bear hug/man snuggle. I have to admit that I am partial to his lucky orange sweater, but then again I am colorblind and fashion challenged.
Poor Governor Christie got lambasted on Twitter and other social media for being a Cowboys fan, and not a quiet one either, whooping it up with Jones in his private box.
Many of the Governor’s constituents expect him to be a New Jersey Giants or Philadelphia Eagles fan and were none too happy with his apparent disloyalty. At least he is safe in that New Jersey does not have a professional basketball team, but then again, neither do we in New York.
As you might expect, there are also certain things that just should not happen in commercial leasing.
For example, when a tenant negotiates a net lease, it should not end up with space lease limitations.
We recently represented a sophisticated client on a commercial sale with a regional purchaser which involved a leaseback by our client under a long term net lease.
The purchaser/landlord was not familiar with net leasing and a great deal of negotiation and educating was required to obtain certain essential rights and flexibility that are customary under a net lease.
A net lease, or “triple net lease”, is generally a long-term lease where the tenant controls the building and is responsible for paying the operating expenses, taxes and insurance as if it were the owner.
A ground lease is a type of net lease, although it often involves the lease of land by a developer who intends to construct a building on the land (rather than utilize an existing building) and, since the costs of construction will likely greatly exceed the value of the land, requires a long term to allow the tenant to recover its investment.
The many differences between a net (or ground) lease and a typical space lease are beyond the scope of one newsletter (even one as thorough and intellectually stellar as ours), so today we are focusing on the casualty or damage and destruction provisions in a typical net lease.
Unlike a space lease, the tenant under a net lease generally bears all risk of loss due to fire or other casualty. In fact, this is true even to the extent that after a casualty the rent is not abated and the tenant must continue to perform all of its obligations under the lease.
Accordingly, with this greater responsibility the tenant will require greater rights and flexibility.
Make sure to cover the following eight points in your net lease casualty provision:
- Your leasehold mortgagee comes first. The leasehold mortgagee is the driver behind a net or ground lease transaction, and as part of making your lease “financeable”, you must allow your present (and potential future) leasehold mortgagee to control the insurance proceeds through the leasehold mortgage provisions. The fee mortgagee and landlord are (relative) stepchilds in this transaction.
- Allow flexibility in building. You should be able to determine whether to restore or rebuild and whether or not to recreate the damaged building, as long as the value of the resulting improvement is not less than that of the building immediately prior to the casualty and such improvement is in compliance with applicable laws.
- Address control of the insurance proceeds. Subject to the terms of the leasehold mortgage, your landlord will look to maintain some level of control of the insurance proceeds, perhaps as a co-trustee. A common compromise is to provide for a third-party institutional lender “Depository” to hold and disburse insurance proceeds.
- Give yourself time to complete the building process. Your landlord may demand the right to use the insurance proceeds to restore if you do not do so expeditiously, but you must take into account unavoidable delays and the time to adjust insurance claims and obtain insurance proceeds.
- Specify conditions for disbursement. Clearly state conditions for release of the proceeds similar to disbursement requirements for a tenant improvement allowance (e.g., delivery of plans, retainage, certifications that work is completed, lien waivers, etc.).
- Allow flexibility for smaller casualties. For smaller restoration projects under an agreed upon dollar amount (increasing over time based on the CPI), you should have the flexibility to restore without the need for a Depository or disbursement conditions.
- Address shortfalls in insurance proceeds. If the reasonable cost of restoration (based on an independent determination) exceeds the available insurance proceeds, expect that your lender and/or landlord will require a cash deposit or some other security to cover the difference.
- Provide an option to terminate. Endeavor to obtain an option, subject to the terms of the leasehold mortgage, to terminate the lease in certain specified circumstances, e.g. (a) if the damage exceeds a certain percentage (40%, 50%) of the replacement cost of the improvements and/or (b) during the last few years of the term when rebuilding would not make much economic sense.
○ In the event of such termination, the insurance proceeds should be applied first to pay back your leasehold mortgagee.
○ Thereafter, your landlord will likely look for some of the proceeds but this is negotiable. Such amount could run from the replacement cost of the building if it was not constructed by you to (particularly with respect to a termination during the last few years of the term) the present value of the remaining rent less the fair market rental value.
○ You should expect to have to cover the deductible on your insurance policy.
○ At your landlord’s option, you may also be required to demolish the improvements.
Cover these essential points in your net lease casualty provision and Governor Christie might be tempted to come over and give you a high five (perhaps even a hug or a snuggle).