I’ve had the opportunity to meet with numerous agents and lawyers who specialize in commercial leasing and they’ve all said the same thing: it’s a tedious, difficult and boring job to read a full lease, but it’s necessary. Why? There’s always a risk that something’s lurking behind the shadows of clause 34.12 (r) and that something will bite you when you least suspect it.
The biggest mistake landlords, tenants and leasing agents make is that they shine their intellectual and negotiation flashlight strictly on rent charges, term and size of the unit; they avoid casting their flashlight across the shadows. The shadows are too complicated and irrelevant to the bottom line. Little do they know, however, that the harshest rental hikes don’t hide in the broad daylight. Rather, they’re hidden in those shadows waiting to pounce at the worst possible time.
The best protection against a litigious, reputation-damaging bite is to understand the shadows. And understanding can only be done if you know what to look for and what to do when you find it. Start with one clause at a time.
Percent Rent and Gross Revenue Reports
The scenario
You recently launched your commercial leasing career with a focus on the retail sector. You worked hard at building your reputation, so it’s no surprise that a national pet store chain calls upon you to represent its move into the downtown Toronto area. The chain, now your client, needs 8,000 square feet of space, as they have a lot of inventory. They expect to gross about $75,000 per month in first year sales.
Eager to prove your worth, you show the company’s leasing representative, Jennifer, several spaces and provide extensive details about the rent, square footage and layout of the spaces. After a lot of demographic research and rent projections you decide on the third property that is owned by a reputable landlord.
You’re able to negotiate favourable percentage rent* terms with a monthly break-even figure of $115,000 per month; well above your client’s monthly revenue projections for their first year. The landlord is very appeasing regarding the term length and is generous with the tenant improvement allowance. You’re confident that this landlord-tenant relationship is made to last.
Jennifer is thrilled with your work. Cash flow is very important for any business and you’ve nailed her top priorities – avoiding percentage rent in the first year and the costs of renovating the space.
Without much more debate, Jennifer signs the Offer to Lease and the lease. You manage the entire move-in process and you don’t hear from them until…
You get a frantic call from the company’s head office. They received a notice from the landlord claiming that it failed to provide a Monthly Report. The landlord further claims that because of this failure the tenant’s gross revenue is deemed to be $287,500 and the tenant must pay the percent tent based on this “deemed” value. The landlord says, “It’s all according to the lease. Didn’t you read it?”
Your client is livid and asks how you let this happen. This bump in rent caused a huge cash flow problem, prevented them from paying their manufacturers and damaged their relationships and reputation with key stakeholders. They vow to never use you again. They also vow to tell everyone of your negligence.
What happened?
You didn’t fully read the Gross Revenue Reports clause. Overlooking a few key sentences exposed your client to huge financial risk and the unnecessary conflict with the landlord.
The Gross Revenue Reports clause alleviates the landlord’s concern that the tenant is “cooking the books” so as to avoid paying percentage rent. Without this clause, unethical tenants would be free to claim fake losses and under-report gross revenue. If the landlord doesn’t have a broad right to audit the tenant, then the landlord would be stuck with a dishonest tenant, as well as an unfair loss of revenue.
In the context of a percent rent lease, monthly and annual gross revenue reporting requirements are neither unreasonable nor uncommon. What is unreasonable, however, is how quickly, by whom and at what level of detail the tenant must provide the reports, as well as the repercussions for failing to do so.
The Gross Monthly Reporting clause in our example is as follows:
[quote_box_center]
“Within five (5) days following the end of each calendar month during the Term, the Tenant shall deliver to the Landlord, together with the payments of monthly Percentage Rent, a written statement (the “Monthly Statement”)… duly audited by an independent chartered accountant … and the Monthly Statement is in such detail, form and scope as the Landlord determines.
In the event the Tenant shall fail or refuse to submit the Monthly Statement within five (5) days following the end of each calendar month during the Term, then it shall be deemed conclusively that the Tenant’s Gross Revenue for that month is two and a half (2.5) the amount that would normally be the payment of Percentage Rent, which Percentage Rent shall be immediately due and paid by the Tenant to the Landlord.”
[/quote_box_center]
This clause states that if the tenant fails to submit its monthly growth revenue statements for the previous month, then it is conclusively deemed that the tenant’s gross revenue for that month is two and a half times the monthly break-even figure. The tenant must then pay the “deemed” percentage rent to the landlord immediately, even if the tenant had a terrible first month and made no money.
It gets worse. This “deemed” rent penalty kicks in even if the tenant submits monthly growth revenue statements only one day late. Using the clause and example above, if your client submitted the report six days after the month end, as opposed to five days after the month end, then the “deemed” rent is applied. No negotiation. No excuses.
There’s another qualifier that can get very expensive. The third line of the clause states that a chartered accountant must produce/audit the statements. In other words, the tenant has to hire a professional every month. The landlord also retains the right to determine whether or not what is submitted is “good enough”, a very broad and potentially dangerous right.
What should you do?
The first step is to alleviate the restraints and pressures associated with the monthly reporting burden placed on your client. Ensure that the client can produce a report only five days after the end of the month. If not, request more time.
The second step is to remove any requirement that “an independent chartered accountant” produce/audit the monthly statement. It’s costly, time consuming and unnecessary to have a CPA do such work more than once a year, especially since current accounting software can produce high quality and verifiable statements. If the landlord is hostile to such as change, offer a compromise whereby a CPA will produce an annual statement, as opposed to the monthly statements.
The third step, which is applicable to all clauses, is to always look out for language that allows the landlord to make unqualified determinations. When you find such language, remove it. In this example, the landlord can reject the monthly statement at whim. How? The landlord just has to decide that the form is not “in such detail, form and scope as the landlord determines.” Where does this right stop? What if the landlord wants something that is unreasonable, such as a minute-by-minute play of every transaction, dust bunny and paper clip? Delete this completely to avoid future abuses or add the word reasonably: “as the landlord reasonably determines”. As a general rule, it is always wise to insert wording that forces the landlord to “act reasonably” whenever making any determinations.
Finally, delete any “up-charging” clause that stems from the failure to produce the report. Remember, this “up-charge” even applies to late reports. In the example above, you would strike out any reference to the deemed rent. This is very inflexible and doesn’t allow for the tenant to rectify the issue.
Always look beyond the obvious and don’t be afraid of the shadows. With a bit of knowledge you’ll be able to prevent a surprise attack, protect your client and grow your business.
*Percentage rent, also known as “overage”, is an additional rent above the base fixed rent and additional rent. Percentage rent is typical in many retail leases as it allows the landlord to partake in the tenant’s sales. The rational behind percentage rent is that it aligns the landlord’s and tenant’s interests, compelling the landlord to take all measures possible to help the tenant’s business grow. If percent rents are not payable in a lease, strike out all language obligating a tenant to provide any form of revenue reports – whether it is monthly, quarterly or even annually.
This article offers general comments on legal issues and developments of concern to business organizations and individuals and is not intended to provide legal opinions. Readers should seek professional legal advice on the particular issues that concern.
Natalka Falcomer is a lawyer, real estate broker and Certified Leasing Officer who started her real estate career in private equity. She created, hosted and co-produced a popular legal call-in show on Rogers TV and founded and recently sold Groundworks, a firm specializing in commercial leasing law. She is currently the Chief Real Estate Officer of Houseful.ca, leading the development and expansion of the company’s personalized home buying and selling experience for the Canadian market. She sits as an advisor on NAR REACH Canada and is the former multi-year board member of the Ontario Trillium Foundation.
