When It Comes To An Agreement, What Is “Market”?

Here’s yet another Ruminations blog posting without a conclusion. We call that Ruminating. Almost all of our readers operate within a contractarian society. Yes, our agreements are governed by a set of laws, but not like a lot of other places. There is a saying that in the United States, “everything which is not prohibited is allowed,” while in Germany, “everything which is not allowed is prohibited.” Freedom of contract is great, but how should it work in practice?

We’ve observed that, for the most part, agreements, such as leases and purchase contracts, verbose and comprehensive (and those two are not inextricably entwined) as they most often are, really recite the reasonable expectations of the parties. And, those reasonable expectations are based on what each party thinks is “market” or “fair.” Yes, each side sees industry wide or local customs and practices through a biased (and wishful) set of eyes, but there are remarkably few places where their expectations are truly divergent. Ruminations feels comfortable in writing that because market expectations also include business terms known to be “open for discussion, ones that could go either way.”

Here’s an illustration, one that is simple and short. The retail leasing community expects that tenants will reimburse their landlords for a proportionate share of certain operating costs (from “dollar one”), often (wrongly) called the “triple net” approach. One can expect that’s what a lease will say even if the subject was never discussed. In contrast, the office community expects that tenants will pay a proportionate share of the amount by which operating expenses exceed those in a base year. In the end, each tenant’s total lease costs will be the same (because the base year operating expenses are embedded in the office tenant’s base rent), but the expectations in the two marketplaces are different.

With those thoughts behind us, let’s talk about the responsibility for maintaining, repairing, and replacing heating, ventilating, and air conditioning (HVAC) equipment. This isn’t to suggest a fixed rule, but only is intended to illustrate today’s premise.

In the retail situation, who, landlord or tenant, should be responsible for each of those three activities when it comes to the HVAC equipment that serves just the leased space? We think the market always expects that normal maintenance such as filter changes, belt changes, and lubrication falls on the tenant and that tenants are expected to engage a professional service company for that work. So, that’s not going to be grist for our mill today, leaving the issues of repair and replacement.

What does the market, informed by industry practices and (to a lesser extent) local custom, think about who should be responsible for repairs? That’s a tougher question for a few reasons. For one, there is an expectation that the HVAC equipment should be in good condition at the outset of the lease and not need repairs, certainly not for some period of time – like a year (or more). Yet, landlord form leases overlook this “less than nuance” and posit that the tenant be responsible for repairs from “day one.”

Why should a tenant be responsible at all for repairs to a dedicated HVAC system? Does a tenant “break” it through normal use? [After all, a tenant will be responsible for things its breaks through misuse.] Perhaps one can think of most repairs as resulting from the tenant’s “consumption” of the HVAC system’s components, much like the tenant being expected to repair a failing fluorescent light fixture. But, there are at least two issues with that. One is that there must be a threshold between a repair and a replacement. Most repairs are actually replacements of minor components. At what point does minor morph into major? The other issue is that HVAC systems include passive components such as ducts or controls. Those don’t wear out, they aren’t “consumed,” they break on their own. What is the theory behind making a tenant responsible for their repair?

The market knows about the first issue – minor versus major – and it addresses it by introducing a spending test. For example, tenants are expected to spend up to $X for a single repair or, in the alternative, to spend up to $Y in any given year before the landlord writes a check for the excess. The thresholds aren’t precisely defined in the market or custom, but each recognizes that smaller spaces equate with lower thresholds and so on.

We’ve left the hardest for last – replacement. Does anyone think it to be “fair” to impose the replacement obligation on a tenant with a one year lease? We think not. Rhetorically, why is that?

Why stop at one year? How about two years? Anyone for “five”? STOP. Most of us have seen landlord-created leases calling for a five year tenant to replace the HVAC equipment. Shouldn’t a tenant be entitled to an HVAC system that doesn’t need replacement within the first five years?

So, the question becomes: “Is the length of the lease term a critical factor in determining the responsibility for HVAC equipment replacement?” Is the HVAC system on par with a light switch (where the market expects the tenant to make replacements)? Ruminations doesn’t think so. We think the market, in the case or “ordinary” retail leases, seeks to be fair and that, in fairness, capital items such as major HVAC components should be a landlord’s responsibility. That’s the way most major leases handle the issue. Why should a low bargaining power tenant not have the same outcome? Well, that’s the point we started with: perhaps the marketplace’s expectations override the “fairness” approach, not because the marketplace doesn’t seek to be fair, but because the course of history just turned out that way.

What do you think the market place “says” and what do you think the marketplace “ought to say”?