The standard American Industrial Real Estate Association multi-tenant commercial lease form, at Paragraph 2, contains certain express representations by the lessor regarding the condition of the Leased Premises. Included are the representation that the operating systems will be in “good operating condition” on the commencement of the Lease. Additionally, the lessor represents that structural elements are “free of material defect.” The lessor also typically represents that, to its best knowledge, the Leased Premises and the Common Areas are in compliance with all building codes in effect at the time the improvements were constructed, and “also with all applicable laws, covenants or restrictions of record, regulations and ordinances” in effect on the commencement of the lease. The foregoing are collectively defined as the “Applicable Requirements.” Breach of any of these representations give the lessee the right to compel lessor to rectify any noncompliance, malfunction or failure at its sole expense. Any breach might also adversely affect the limited maintenance and repair obligations of lessor set forth in Section 7.2 of the form lease.
In reliance upon the foregoing, the lessee expressly agrees to “materially comply with all Applicable Requirements” during the term of the Lease. Assuming lessor’s representations are correct, or have been modified or qualified to make them correct, who is responsible for repairs or maintenance, and the cost thereof, not specifically contemplated by the parties at the inception of the lease?
Following the issuance of two companion cases by the California Supreme Court in 1994, the AIREA form leases were modified to address two particular circumstances where unanticipated capital expenditures may be required as a result of “non-voluntary, unexpected and new Applicable Requirements.” To the extent the “specific and unique” use of the Leased Premises by the lessee requires the expenditure of funds to make the Leased Premises or related property compliant with applicable laws, the form lease allocates the entire responsibility for such expenditure to the lessee. However, if the cost is more than six month’s base rent and the requirement for the expenditure arises during the last two years of the term, the lessee has the right to terminate the lease, rather than incurring the cost.
Conversely, if the expenditures are required irrespective of the lessee’s use of the Leased Premises, for example in the context of government mandated seismic upgrades, the cost is the responsibility of the lessor, and the lessee’s liability is limited to its pro-rata share of the amortization of the cost over a twelve year period, which is payable monthly only during the remaining term of the lease. Where the required expenditure arises during the last two years of the lease and is so significant that the lessor reasonably determines that the expenditure is not economically feasible, the lessor has the right to terminate the lease, rather than incurring the cost.
In reaching its decisions regarding allocation of responsibility for unanticipated capital expenditures the California Supreme Court considered the following six factors.
The first consideration was the relationship which the anticipated expenditure bears to the aggregate rental obligations over the term of the lease. Where the cost is equal to or a substantial fraction of the total rent, it is unlikely that the parties reasonably anticipated that the burden should be borne by the lessee. Conversely, if the cost is relatively low in relationship with the rental obligations, it may be reasonable to assume that the burden should be on the lessee.
The second factor addressed was the term of the lease. Where the lease term is short, it is unlikely that the lessee would have expected to bear the risk of a capital expenditure which will benefit the lessor for a period beyond the expiration of the lease. However, a longer term lease will possibly convey a greater benefit on the lessee as a result of the mandated improvements.
A third consideration was the relative benefits of the expenditure to the lessee and lessor. If the nature of the improvement is of no benefit to the lessor, but enables the lessee to continue to operate in accordance with its lease expectations, it is reasonable to burden the lessee. If the improvements are such that the value of lessor’s interests at the expiration of the term are substantially enhanced, the burden should be allocated to the lessor.
A fourth factor taken into account was whether the mandated work was structural or non-structural. If the former, they are more likely to be characterized with greater permanence which necessarily benefits the lessor.
The fifth factor considered was the degree to which the required work will interfere with the lessee’s use and enjoyment of the premises. To the extent there is a material interference, it is reasonable to assume that the work is substantial and should be the responsibility of the lessor.
The final factor addressed was the likelihood that the parties contemplated the potential that the work might be required. In the one case considered by the Supreme Court, where the expenditure was required to comply with an asbestos abatement order and the lessee took possession with knowledge that asbestos might be present, this factor tilted the allocation to lessee. The other, involving a seismic retrofit program, not likely considered by either, warranted the allocation of the principal cost burden to lessor.
As water and energy savings programs are mandated, and sustainable development initiatives proliferate, it is likely that lessors and lessees will increasingly be asked to grapple with unanticipated capital expenditures. In this regard, as owners and tenants enter into leases, and administer leases, it should be recognized that despite the treatment of the allocation of unanticipated capital expenditures in the AIREA form leases, other provisions of the lease may affect a court’s interpretation of the parties’ intent to allocate such costs.
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