Profit Sharing In Leases

Profit Sharing In Leases

by Bryan Mashian, Esq.  

To take advantage of today’s commercial real estate market, the tenant would like a long term lease to lock in the current low rental rates. The landlord, however, is reticent to forego the anticipated future rise in market rents by entering into a long term lease. A means of resolving this conflict is for the parties to agree to share any profits generated from an assignment of the lease or sublease of the premises. While this is a seemingly straightforward resolution, many issues require consideration and resolution.

Will there be “profits?”

• Before negotiating a profit sharing provision, both sides should make a sober assessment of the likelihood that any profit will be made from an assignment or sublease.
• In short term leases, the chance of there being a profit is less than in longer term leases, because market rental rates are more likely to increase and possibly exceed the lease rental rates as the term of a lease becomes longer.
• If a lease requires frequent increases in rent, however, it is less likely that the lease rental rate will be less than market rents for a substantial period of time.
• Also, savvy landlords often increase the lease rental rate by requiring an adjustment to market rates, or by annual increases which are predetermined or are based on increases in the consumer price index.

“Splitting the baby”  

• How profits are shared is generally a product of the parties’ relative leverage in the negotiations and market conditions.
• The landlord often insists on retaining all or most of the profits. After all, the landlord is in the real estate business and not the tenant.
• The tenant believes, however, that it is entitled to the profits since the tenant is taking the risk of market rents declining and it should enjoy any increases.
• The most common compromise is for the parties to agree to equally share any profits generated from an assignment or sublease.
• If the landlord insists on receiving 100% of the profits, then the tenant has no incentive to generate any “profits” and seek rents above the tenant’s contract rent. By insisting on receiving all of the profit, the landlord may never see any.
• Sharing part of the profits financially incentivizes the tenant to generate some rents higher than the lease rate, which benefits both parties.

Income

• Whether there is a “profit” from a lease transfer depends on what the parties consider “income” and “expense” in regards to an assignment or subletting, which are negotiable.
• The landlord will insist on the broadest definition of “income” for calculating profits. The landlord would like to include, for example, good will, key money, sale of any property (such as furniture, fixtures, equipment), compensation for any services, and amounts paid for a covenant not to compete.
• But, such a broad definition may allow the landlord to inadvertently profit from the sale of the tenant’s business, which the tenant typically will not intend to include. So, the tenant should be sure to exclude income not generated solely for occupancy of the premises.
• The landlord may be concerned that an unscrupulous tenant may hide money received as part of a lease transfer by creatively allocating payments to something other than rent. Therefore, the landlord should require the tenant to provide a copy of all documents pertaining to a transaction and insist on having audit rights.

Expenses 

• In determining profits, the tenant would like to deduct real estate brokerage commissions, tenant improvement allowances, relocation allowances and similar out of pocket costs.
• The more controversial and negotiated categories of “expenses” are items that are not out-of-pocket costs, such as free rent provided to the assignee or subtenant.
• The tenant will try to expense the rent paid while the space was vacant and unused. To prevent an abuse of this “down time” rent as an expense item, the landlord should consider only the rent paid after the space was actually vacated, and only if the tenant had listed the space with a broker, and while the space was being actively marketed.
• If the tenant spent its own money (beyond the landlord’s improvement allowance) to create a more attractive space, then this investment by the tenant contributes to higher rents being generated. So, the tenant will want to recoup such costs.
• If the landlord agrees to this expense item, the landlord will require the tenant’s investment to be amortized over the term of the lease. Then, the tenant would recoup the unamortized portion over the term of the proposed transfer, which will enable the landlord to receive its share of the profits earlier. Conversely, the tenant prefers to recoup all such costs upfront and for the cost reimbursement to be immediate.

While the parties’ relative bargaining positions and market conditions affect who will benefit the most from an assignment or subletting, sharing profits effectively allows the landlord and the tenant to allocate the risks and rewards of market fluctuations.