The Art of Abstracting: Due Diligence, Ownership/Investment and Management Through Accurate Lease Abstracting
Developing and maintaining the integrity of lease data on a timely basis is essential to providing a solid foundation for due diligence, property ownership/investment and management.
By Zenobia Tambuvala and Cheryl Clark, Esq.
Lease abstracts are an integral part of the commercial real estate (CRE) cycle. Developing and maintaining the integrity of lease data on a timely basis is essential to providing a solid foundation for due diligence purposes, property ownership/investment and management. If the provisions in a lease are not abstracted accurately, there can be significant negative consequences for all parties involved in the CRE cycle; however, fast, accurate lease abstracting is not always readily available. Mining through numerous pages of complex lease documents and deciphering legal terms into a digestible summary is an art form which requires lease abstract specialists and demands hundreds of man-hours – something most lenders, owners/investors and managers either do not have or cannot afford.
The level of detail and number of provisions needed in an abstract can vary depending on the end-user. For example, clients on the due diligence side generally need an accurate and concise snapshot of just the financial provisions of a lease, whereas owners/investors and managers may need more detailed information in addition to the financial terms to properly manage and administer their lease portfolio. In order to receive quick and accurate lease abstracts, all parties in the CRE cycle should look for an abstracting partner that utilizes CRE subject matter specialists with legal expertise, have vast abstracting knowledge and robust data management and integration capabilities.
While lenders, owners/investors and managers may have different abstracting needs, the financial terms of a lease are at the core of every real estate transaction. Below are some of the most important elements to keep in mind to abstract accurately regardless of the ultimate end-user:
- Overlooking tenant termination rights could be a deal killer: Tenant termination rights are the most important part of a lease abstract. Termination rights usually involve the tenant’s ability to end the lease for a variety of reasons, including if the (retail) tenant fails to achieve a gross sales amount for a certain period or if the landlord rents space to a tenant which violates the tenant’s exclusive right, among others. On the due diligence side, it is essential for these termination rights to be identified during the underwriting process, since these can lead the lender to restructure the deal or kill the contract altogether. If the tenant exercises one or more of the termination rights, the cash flow of the property would decrease, thereby impacting the borrower’s ability to pay the debt service on the loan. For owner/investors and managers, missing a termination right can have negative consequences for many years. For example, if an owner/manager is unaware of a termination right in an exclusive use provision because an abstract fails to capture it, he/she may unwittingly enter into a lease with a tenant whose business use is prohibited by this clause. This can cause the tenant with the exclusive to exercise its termination remedy, causing a loss of cash flow and potentially affecting the ability to sell the property.
- Because tenant termination rights are not always highlighted in a lease, an inexperienced abstractor may miss one. These provisions are often included, many times intentionally, in an unexpected section of the lease. Experienced abstractors know to be on the lookout for these rights anywhere in the lease and understand what keywords to look for so as not to miss them.
- Inaccurate co-tenancy summaries can impact income and sell-ability: A co-tenancy is a lease provision that conditions the continued occupancy and/or rental obligations of one tenant upon the occupancy of one or more other tenants. This provision is typically found in a retail center environment and commonly allows a tenant to terminate its lease if an anchor or a specified percentage of other tenants discontinue operation or leave the premises. It is imperative to capture these provisions accurately as the income stream from the property and the ability to sell or refinance can be severely impacted if a co-tenancy provision is triggered and a tenant or tenants exercise the remedies provided. While co-tenancy provisions can be easily identified in a lease, summarizing them in a way that a lender, owner/investor or property manager can easily understand without compromising the full meaning of the provision is a challenge and takes a level of expertise to do well.
- Rights to reimbursements can be diminished due to poor abstracts: Accurately capturing items that are to be reimbursed by tenants to the landlord, and those that are to be excluded from reimbursement, is important for all parties. A full understanding of the recoveries structure in a lease is essential for accurate due diligence and underwriting in order to give a full picture of the revenue stream of the property. For owners/investors and managers, not fully capturing what the landlord is able to recover could lead to the landlord not receiving the full amount of recoveries to which he or she is entitled under a lease. If the landlord fails to charge a tenant the full reimbursement amount, it is very difficult for a landlord to then recapture the funds. Additionally, it is essential for owners/investors and managers to understand recoveries so not to overcharge the tenants and risk costly litigation initiated by the tenant when the overcharges are discovered.
- Prop 13 provisions vary from state to state: Proposition 13 (Prop 13) is a provision that governs whether the landlord is able to pass through the cost of any increase in real estate taxes on the property due to a change in ownership. It is extremely important for an abstractor to capture if the landlord is unable to pass through this cost, as this will decrease the landlord’s total recovery from the tenant. It is not unusual for a lease to prohibit the pass-through of increased property taxes, or alternatively, to limit the frequency of such pass-throughs during the term of a lease. While many CRE professionals are familiar with Prop 13 as a key provision to capture in California leases, the challenge lies in being aware that leases in other states may contain similar language, but it might not be easily identifiable as the Prop 13 language. CRE Lease specialists are aware of these provisions and can decipher very quickly whether these increased costs can be passed along to the landlord. Not accurately capturing Prop 13 provisions can lead to the same issues for lenders, owner/investors and managers as outlined above regarding reimbursements.
- Improperly identified ground leases could introduce risk: A true ground lease on a property can be difficult to identify, as at times the lease forms will include “ground lease” language when referring to a build-to-suit lease. A build-to-suit lease resembles a ground lease because it identifies the land as the interest actually being leased. One of the key elements of which to be aware is who has ownership of the improvements – the building – during the term of the lease. In a ground lease, the tenant typically owns the building until the end of the lease term when ownership reverts back to the landlord. In a build-to-suit contract, the landlord retains ownership of the land and the development.
- A ground lease can have specific advantages and disadvantages for a landlord and tenant, which may affect a lender’s decision to proceed with lending on the property; thus properly identifying a ground lease is a crucial aspect to underwriting a property. In a ground lease scenario, the interests of the fee owner must often be subordinated to the ground lease in order for the ground lessee (tenant) to secure leasehold financing. A loan that is secured by a property, and which is subject to a ground lease, is often seen to have more risk than one that is secured by a fee simple interest. As such, the existence of a ground lease can greatly affect the underwriting of a property and must be properly identified by the abstractor.
- Similar to lenders’ concerns regarding ground leases, owners and investors need to be cautious about the ability to sell or refinance a ground leased property. For property managers, the reimbursement structure under a ground lease can differ greatly from other regular space leases at the property. An inexperienced abstractor may not understand the unusual structure and thus may not capture accurately.
There are many nuanced elements of which a lender, property owner/investor or manager needs to be aware when entering into a real estate deal or managing a property. With the increasing amount of data tied to lease contracts, it is ideal to have a combination of legal and real estate expertise for lease abstracting. Firms should be looking for the real estate subject matter experts with legal expertise who can provide accurate and timely lease abstracts they can trust to lean on during the transaction process.
Zenobia Tambuvala is executive managing director of due diligence and underwriting and Cheryl Clark, Esq., is director of lease and loan abstracting at Situs. A leading provider of commercial real estate advisory services and innovative solutions to the global financial services industry, Situs has an experienced team dedicated to providing lease abstracting services.