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www.lawtimesnews.com Law Times / January 21, 2008 Page 9 ReAl eSTATe lAw Professional Appraisal Opinions - Trusted Values www.oaaic.on.ca 416-695-9333 Asset Review Find a professional real estate appraiser Some important leasing issues don't jump out Due diligence takes the surprise out of the equation T he value of commercial real estate, such as a shop- ping centre or an office tower, is to a large degree deter- mined by the value of the leases in the buildings and spaces com- prising the property. "The purchase price is usually calculated based on a capitaliza- tion rate applied to the net cash flow for the property, and the leases are the main source. In fact, they are often the only sig- nificant source of revenue for the property," says Dennis Daoust of Daoust Vukovich LLP, a Toronto boutique that specializes in prop- erty leasing. No surprise then that a pur- chaser would have a great deal of interest in reviewing the leases that run with a property. What is surprising is clients' unfamiliarity with some of the issues. "Leasing due diligence has been around a long time, but it's striking how often you come across certain important issues that don't jump out at clients," says John Hutmacher of Blake Cassels & Graydon LLP's To- ronto office. Hutmacher calls them "gut check" issues. "Everybody in the field un- derstands these issues once someone points them out," he says. "But the difficulty is that clients frequently do the due diligence themselves, so there may not be anyone around to do that." Some issues are missed be- cause they're so obvious. Take the completeness of the lease docu- mentation, for example. "Landlords don't always have their lease records intact," Hutmacher says. "There may be missing pages or unsigned or missing amendments and extension agreements." Purchasers can deal with this by making further in- quiries of the vendor. They should also ensure that estop- pel certificates signed by ten- ants match the information in the leases. "If the purchaser waits until after the due-diligence date or the closing date to investigate gaps or discrep- ancies in lease documenta- tion, it will likely be too late to do anything about it," Hutmacher says. Outstanding tenant in- ducements, such as unexpired free rent, rent abatement pe- riods, payments of leasehold- improvement allowances and completion of outstanding landlord's work can all prove problematic. "Again, if any of these run beyond the closing date, the purchaser may be responsible for the obligations," Hut- macher says. Operating costs are a special problem. "There are no longer any typical definitions of operating costs," Hutmacher says. "So it's important that what the purchas- er thinks is recoverable from the tenants is actually recoverable, especially costs of capital repairs and replacements." Operating costs' definitions are also relevant to manage- ment fees, which are usually calculated as a percentage of operating costs. Similarly, exclusive-use pro- visions can be tricky in a world where even drugstores have be- come multi-purpose shopping destinations. "You've really got to be care- ful not to paint yourself into a corner, in light of all the cross- selling that goes on these days," Hutmacher says. Hutmacher recommends that purchasers identify all tenants with restrictive covenants and canvass their business activities to ensure there are no conflicts. This type of investigation will also shed light on what future leasing opportunities are possible. And believe it or not, landlords have been known to grant more rights than they have to give. By way of example, the total number of parking spaces allocated may exceed the available spaces. "This type of thing may never pose a problem in practice — say if you're dealing with a large shopping centre parking lot," Hutmacher says. "But if you don't identify the problem, you'll be stuck with it." Purchasers should also watch out for tenants who have first- refusal purchase rights, and be sure to obtain waivers where appropriate. Even if the ten- ant waives rights for the trans- action at hand, the purchaser will want to take a hard look at the terms of these rights to see whether there are ongo- ing aspects that can affect the property's future value and marketability. "Go dark" provisions, allowing tenants to cease op- erations while continuing to pay rent, are also a concern. "In a retail setting, 'dark' premises reflect poorly on the project as a vibrant operating location," Hutmacher says. Purchasers should also check to see what measure of control they will have at the end of the lease regarding tenants' obligation to return premises to base-building condition. Which is not to say that it's always in the landlord's interest to have the tenant do so. "If the tenant has expended significant resources in rendering premises operative, the landlord might wish to limit the tenant's ability to remove leasehold im- provements without consent," Hutmacher says. "This may leave things in better shape for new tenants." Similarly, it's important to keep an eye out for early termi- nation rights. But, as Daoust points out, leases aren't the only documen- tation that should be included in purchasers' due diligence. "A purchaser or a lender needs to examine audited operating statements for the property for the most recent fiscal year and as many prior years as feasible," he says. "Purchasers should also review the current budget, and variances therefrom." Unfortunately, net cash flow, even as verified by audited state- ments, is not always a reliable indicator of a property's income stream. "There is generally a risk that revenue, though accurately re- ported for each particular period, is not supported by the provi- sion of the leases from which it is derived," Daoust notes. This puts leases in play again. For example, purchasers must ensure that rent roll accurately reflects lease provisions regarding measurement of leased premises, and that cost recoveries reflected in the rent roll also correspond with the leases. "It's not unusual to encoun- ter large claims by a tenant par- ticularly if they retain lease audit firms," Daoust says. "Such au- dits may disclose that the rent roll amounts contemplate the recovery of items that on a care- ful reading of the leases are not recoverable. This can happen when tenants have negotiated changes to the lease definition of operating costs." After all, the whole purpose of due diligence is to take the sur- prise out of the equation. 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Access to and use of the Closure service and Teraview software are subject to the terms and conditions, availability and pricing available at these www.closure.ca and www.teraview.ca, all of which can be changed without notice. 3518.01/08 3518.CL.Law Times.indd 1 1/15/08 11:27:14 AM 'Leasing due diligence has been around a long time, but it's striking how often you come across certain important issues that don't jump out at clients,' says John Hutmacher. BY JULIUS MELNITZER For Law Times LT REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS REPRINTS Been in Law Times? Want a record of it? $175 - $225/reprint We provide a color PDF and unlimited reproduction rights. For more information or to order reprints, please e-mail Gail Cohen at: gcohen@clbmedia.ca LAW TIMES *Pages 1-16.indd 9 1/17/08 7:18:43 PM