Assigning a Lease – Does the Landlord Really Own the Property?

Print
Print Friendly

“You can’t freely assign your lease because I own the property. I’m in the real estate business. You aren’t. No one is going to make a profit from the real estate business but me.”

What a refrain. You can’t have been in the lease-making business very long if you haven’t heard this from a landlord or said this to a tenant. The problem is that there is no basis behind such a statement.

A lease gives a tenant the right to exclusive possession of real property provided the tenant pays the rent and abides by the contractual provisions of its lease. Thus, while the landlord owns the real property (assuming it is, as in the most common situation, the fee owner), its tenant also owns a real property interest. Yes, when a landlord leases property, it CONVEYS real property to its tenant – the leasehold interest. That is also an ownership interest. And, just as a landlord, absent a contractual limitation, can freely sell its property (subject to the lease), a tenant can freely sell its own property interest, i.e., it can assign its lease.

The common law understood this basic real property principle. So, at common law, tenants could freely assign their leases. It is only the “contract” side of a lease that serves to impair this right.

Once a landlord has “sold” the right to use premises for a period of time, at a set price, it can’t reasonably claim the right to “resell” the same space while its tenant is there. That right belongs to the tenant and any profit that can be earned by the tenant selling its property (i.e., its interest in the lease) belongs exclusively to the tenant. Of course, any loss is solely the tenant’s burden. The notion that a tenant is profiting from the landlord’s property is nonsense. The landlord made its profit when it sold (i.e., conveyed by way of a lease) a real property interest to its tenant.

None of this is to say that parties can’t bargain to reach a result that would impair or condition or even bar a lease assignment by a landlord or by a tenant (though restrictions on a landlord’s right are rare). The marketplace has norms in this regard. Those norms are based on bargaining power, with the assumption that big tenants get more rights than do small tenants. Presumably, assignment restrictions are “priced” into the rent, granted that only a theoretical economist would understand it that way.

Before going on to some (limited) nuts and bolts, Ruminations has a few other rebellious thoughts.

Landlords also assert the following explanations for the assignment restrictions they seek. Much of this discussion is equally applicable to subletting, but the demand for simplicity begs for a discussion that only uses words of “assignment.” So, that’s what we’re going to do. Experienced tenants and their representatives will easily be able to extrapolate the concepts into the subleasing scenario.

“I picked you. I know you. I like the way you run your business. Your financial strength meets my requirements.” The first is true, though it is more likely that the tenant first picked its landlord. No one can argue that the landlord is the sole arbiter as to whether a prospective tenant is financially qualified. But, come on – “I know you; I like the way you run your business”? Give us a break. Common sense tells us that even if any landlords thought so, how many really do “know” those things, especially when it comes to a small tenant. Yet, this is a common “reason” expressed by landlords to explain why they want to approve (read that: “choose”) their tenant’s assignee.

The problem with this argument is that large tenants often get the right to freely assign their leases and their landlords, taking a much greater risk than with a small space, wind up accepting whoever the tenant chooses.

The fact is that a tenant assumes a much greater risk in the case of an assignment than does its landlord. The tenant is still on the hook for the lease and, in an assignment, the assigning tenant is giving up control over the space. So, it behooves a tenant to be careful in selecting its successor.

As to “financial” strength, assuming (as is almost always the case) that an assigning tenant remains liable for all of a tenant’s obligations under the lease, a landlord always winds up with more “money” behind a lease after an assignment than before an assignment. If the old tenant is worth a million dollars at the time of assignment and the new tenant is worth only a dollar, the landlord still has a dollar more behind the lease after the assignment than it had beforehand. That should be a comfort, not a worry, for a landlord. After all, the landlord took a risk in the first place when it signed the lease. At that point in time it knew (or could have known) just how financially strong was its prospective tenant. [That’s pretending that landlords regularly even make such an investigation when it comes to small tenants.] Landlords ask for security deposits and personal guaranties at that point.

There are two main reasons why a tenant assigns its lease: (a) it can’t afford the space; and (b) it has outgrown the space, with (a) being much more common than (b). At the point where a tenant can’t afford the space any longer, its landlord usually won’t have the same “financial” strength behind the lease as it had at the outset of the landlord-tenant relationship. Where the tenant is expanding, it is likely that its finances have improved since it signed the lease. In either case, having an occupant for the space, even one the tenant has chosen, seems like it ought to be a good deal.

None of the foregoing tears against negotiating for, and getting, reasonable conditions in a lease. There are three common places these conditions appear: directly in the “lease transfer” provisions; in the form of use restrictions; and in the form of restrictions on alterations (including signage items). That’s not to say that there aren’t other items in a lease that need to be considered, such as a continuous operation provision or a trade name restriction, but those three are the mainstream places to look. None of these “speak” to the particular tenant behind the lease, and thus a landlord can legitimately and honestly negotiate for limitations on how a space is to be used. That’s different than “who” the tenant may turn out to be.

In general, meaning in most cases, a landlord has a legitimate interest in shaping its property for one kind of use or another. In the shopping center context, this is called “deciding on tenant mix.” If a landlord really needs, and can bargain for, a coffee shop because its image of the property “requires” a coffee shop, then it should stick to its guns and refuse to sign a lease unless the permitted use is limited to that of a coffee shop. In the majority of cases where this is true, a landlord’s legitimate needs most likely are best served by barring certain uses and probably by barring changes in use to ones that would cannibalize another tenant’s business. Whatever turns out to be the result, every tenant should be aware that the principal impact of a use clause is on its ability to assign a lease (or sublet its premises) because it is much less common for a tenant to change its own business.

The same analysis should be applied to a tenant’s right to make interior, non-structural improvements that don’t adversely affect common features (HVAC, utilities, etc.) in any significant way. Why should a landlord care how its tenant alters the interior of its premises so long as the work is lawfully done in a professional manner, and looks like a retail store (or a regular office, or a typical warehouse, etc.)? Ruminations thinks landlords impose approval restrictions and even fixed rules because they are afraid of the unknown and think that their fear should override the business judgment of the real “owner” of the leased space (during the lease term), i.e., its tenant. Again, this is not to say that a tenant should be able to do something that will leave the owner with a larger than normal ‘bill” at the end of the lease or should allow for conversion of a typical retail store into a rats nest of little rooms, but to reach into painting and decorating – come on! Even to insist on “approving” construction plans where the government is going to review them and issue permits seems to be going too far. Yes, we know that landlords can offer a lot of “but, but, and buts,” BUT can you really argue with the “starting” principal – landlords just want to butt in; they just don’t trust their tenants, even though: “I picked you; I know you; I like the way you run your business; Your financial strength meets my requirements.”

Ruminations knows that just because it says so, doesn’t mean that it is so. There is no right or wrong when it comes to balancing the rights and duties of landlords and tenants. What is right (with some outside limits) is whatever the parties freely negotiate. But, for the sake of intellectual honestly, let’s not start the discussion with false premises. That’s not the way to build confidence or to begin a relationship. So, while it’s fine (though not helpful) to say “I want it because I want it,” it isn’t fine for a landlord to claim that a tenant shouldn’t profit from “my” real estate because, in fact, during the term of the lease, the “real estate” in question doesn’t really belong to the landlord; a tenant’s leasehold interest in a lease belongs ENTIRELY to the tenant.

Brickbats are cheerfully being accepted at www.retailrealestatelaw.com. And, don’t think that we are pushovers when it comes to representing landlords, something we do a lot of. The difference is that we like our reasoning to be supported by the laws of real property and the laws of economics. So, if anyone thinks Ruminations has violated either of those laws today, let us know.

Print

Comments

  1. Ira, while you absolutely correct on the common law principles, that is rarely persuasive to a landlord. The practical business realities will determine the outcome. Frankly, I am never shocked, but always dismayed, that I would get such an unsophisticated response to a request for assignment rights (like the example in your first sentence) when landlords deal with it all of the time . With a 5 or 10 year (or longer) lease, I am also in the real estate business in additional to the retail business. The question is, under what circumstances can I do (or want to do) this? If I’m assigning to an affiliate, merging, consolidating with or being acquired by another for bona fide corporate or business reasons, every landlord (including the one in the first sentence of your post) allow this. They will also allow this if I’m assigning the lease in connection with an group assignment of a certain number (but less than all) of my stores (perhaps in a geographic area).

    As far as making profit on an assignment – especially with periodic rent bumps built in- I am not only supported by the common law but by the practical reality that the landlord made his bargain when the rent bumps were set up. If the market rental value is higher than that, I am entitled to the excess. But hey, I’m not greedy One of the most common solutions to this issue is to split the “profit” 50-50 but only after the tenant recovers its expenses off the top (its remaining unamortized leaseholds being the largest deduction).

    As far as the assigning tenant remaining liable, it is also common to negotiate for a release of liability figure – i.e. if the assignee has a net worth in excess of “X” dollars, the assigning tenant is off the hook. There is always a dollar figure that works. And it doesn’t have to be that of the original tenant. If the original tenant had a $100 million dollars worth, is a landlord going to feel half-naked if the assignee has a $50 million net worth, although substantially less than the original tenant’s? There is no guarantee that the original tenant’s net worth would not have shrunk because of business reversals and recessions in the absence of an assignment.

    There are legitimate conditions and reasonable consent standards that can be imposed on the transfer – issues like tenant mix or adherence to the use clause in the lease. There are even tradename restrictions that could kill a transfer. Those are the areas that the tenant must also massage to enjoy reasonable assignment right. This response merely is the tip of the iceberg on a much discussed topic. However, in current leasing practice I find them less difficult to with through than co-tenancy issues, which I would replace on your 3 hottest topic list.

  2. Just had to share a twist on the above. In a recent complex office deal, I tried to go with the Landlord’s argument about who is in the real estate business to avoid the Landlord’s suggestion that we sub-license to the existing tenant until they could relocate. The other side retorted, “Now that’s a first for a tenant to tell me they aren’t in the real estate business!” We prevailed on not taking on the extra headache and liability of the proposed structure even if that argument by itself didn’t fly…and, yes, there were business and utility reasons that made their proposed structure not as outlandish as it might first appear.
    Thanks again for the blog and all of the discussion, the collective stories always give me new insight.

Leave a Reply