A Different Sort of “Change Management”
If you’re working in the 21st century, you are constantly dealing with a variety of “change management” scenarios – some internally driven by larger strategic concerns, others due to externalities. However, there is a good chance you’ve never thought much of this topic – how the sale of a building can impact your costs as a tenant. And why should you? Your lease doesn’t change, and the only discernible impact might be that you send your rent payments to someone new. Why should any of that matter?
In our experience, it can actually matter, A LOT. It’s no secret that when buildings are being sold, the buyer wants to know that all of the tenants are okay – that they have no claims and their accounts are current. Buyers obtain this information by asking the tenant to sign an estoppel certificate. When you are asked to sign an estoppel certificate, you should think two things: change and caution.
What to Watch Out for Pre-Sale
When an owner is positioning a building for sale it will often take measures to make the building more attractive to buyers. Some of these can have a direct, financial impact on the operating expenses of the current tenants. For instance, landlords may embark on more aggressive capital expenditure projects to improve the building’s infrastructure and marketability, and attempt to pass the cost of these initiatives through in operating expenses. It is not uncommon to see major replacements of building components pile up during the year or two immediately prior to a sale. Additionally, in modified gross leases, `the landlord may manipulate the timing of projects to drive up the revenue and cap rate. Because low base year expenses will directly cause significant increases in later years, a subtle effort to increase long term revenue can be to hold back expenditures during a major tenant’s base year. Although this can happen anytime, it is more common when an owner is positioning a building for sale. It is difficult (but possible) to challenge this behavior because most leases do not require expenditures to be made on a steady basis.
What to Watch Out for Post-Sale
A very common problem for tenants is new building owners embarking on major projects to replace old and outdated building components in an effort to ‘rehabilitate’ the building. Most of these are capital in nature, but are passed through in operating expenses as ordinary repairs or ‘deferred maintenance.’ Unless the lease has clear capital exclusion language, which most do not, the tenant could find it difficult to object to them. Another problem is that new owners do not always treat expenses the same way. It is very common to see new owners establish a different method for tenant electric reimbursement or a new calculation method or rate for management fees. This is exacerbated by new owners reading and interpreting their tenants’ leases differently than their predecessors. For net leases, such behavior can lead to unpredictable costs that undermine even the most carefully planned budgets; but for modified gross leases with base years, this can lead to huge additional liability because it causes escalation years to lose their “apples-to-apples” comparability to base year expenses. Although many of these practices are not technically violations of the lease, they still result in unwarranted additional costs and need to be remedied.
After every building sale, it should be a tenant’s top priority to maintain consistency and accuracy in its rent charges; changes in the liability due to changes in building ownership should be unacceptable.
How to Manage this Sort of Change
Luckily, there are some relatively clear dos and don’ts when it comes to protecting yourself against any negative impact that may flow from an ownership change (note that some of these also apply to changes to building management, even though ownership may stay the same).
Have an expert review your historical charges against the lease BEFORE signing an estoppel certificate. This will provide you with a better understanding of the financial “health” of your occupancy. If there are issues with the way the current landlord has been billing you, the best time to try to address them is before you sign it. It’s when your leverage is at its peak. If you’ve already signed an estoppel, it’s still possible to remedy potential issues if approached strategically.
Continue to monitor new management’s treatment of your specific lease provisions as they related to financial liability. Even if you had no issues with the prior owner, it is essential to catch any deviations associated with new ownership/management early. This way you set the tone of the new relationship and ensure that your expense levels continue as anticipated.
Don’t wait for the completion of the sale to address historical issues. Obtaining the necessary documentation from a past owner to verify/substantiate claims can be difficult. Also, the farther away the selling party is from ownership, the harder it will be to claw back any value related to past overcharges. And while the new landlord legally must accept the prior owner’s liabilities, it is harder to get new management to remedy the mistakes of the old owner.
Don’t assume that new ownership understands your individually negotiated lease provisions, or even cares about them. Landlords are in the business of making money, so any errors that may occur tend to fall in their favor. When lease provisions allow for interpretation, or are vague, new ownership may take advantage of it – how many times have we seen buildings marketed with the line, “significant measurement potential.” A good lease compliance/audit expert should know the areas most vulnerable to exposure, and understand industry/market norms so that it can help ensure that the tenant is not overpaying under new ownership, even in cases where the lease isn’t clear.
If you have any questions regarding estoppels or building ownership/management changes and how these may be impacting your lease deal, please feel free to contact us. We’re always here to help.