Let’s face it: commercial real estate can be tricky; especially if you are unfamiliar with the common practices used in the commercial real estate realm. Thankfully, a lease agreement will more than likely (or at least should) define the substantive terms used within the agreement. The lease agreement will most likely not, however, explain how the terms are applied under the circumstances. One contractual provision that has become more relevant in the recent past is referred to as a ‘transfer premium.’
While the term ‘transfer premium’ will typically be included and defined as part of the applicable contract, a transfer premium, generally, may be defined as all rent, additional rent, and/or other consideration payable by such transferee in connection with the transfer in excess of the rent and additional rent payable by a tenant under the lease terms. In other words, a transfer premium may be thought of as a tool available to a landlord that protects her interests in the case of a future transfer to prevent a tenant from obtaining a monetary advantage using the current market conditions.
The concept of a transfer premium is rather novel in Texas courts, as there is little to no case law on the subject. Similarly, the term is not defined in other standard legal resources, such as Black’s Law Dictionary. Thus, it follows that transfer premium provisions do not appear to have made their way into the commonplace of commercial lease agreements. However, transfer premium provisions have become more prevalent in larger urban areas/cities1.
This concept may best be demonstrated by an example. In the simplest terms, if tenant pays yearly rent of $100 to landlord, and tenant assigns the lease to assignee for a yearly rent of $150, tenant may be subject to pay landlord a transfer premium because the amount tenant is to receive exceeds the amount landlord is owed pursuant to the underlying lease. Below is a more in-depth example of how two common transfer premium provisions may be applied.
Larry Landlord owns a property in Dallas, Texas, which sits a building that has been built out for commercial retail (the “Property”). The building is approximately 1,000 square feet. Three years ago, Larry leased the Property to Tara Tenant so that Tara could pursue her dream of opening his own apparel store. Larry and Tara entered into a five (5) year commercial lease (the “Lease”).
Pursuant to the Lease, Tara would pay to Larry a minimum monthly base rent of $20,000.00.2 Over the Lease term, the minimum monthly base rent would increase 5% yearly (i.e., Year 1: $20,000.00; Year 2: $21,000.00; Year 3: $22,000.00; Year 4: $23,000.00; Year 5%: 24,000.00) to account for inflation.
Further, the Lease contained a section addressing assignment and subletting, requiring Landlord’s express written consent of any assignment or sublet. This section of the lease also contained a provision entitled ‘Transfer Premium,” which reads as follows:
If Tenant shall enter into a transfer hereunder Tenant shall pay to Landlord fifty percent (50%) of any “Transfer Premium,” as defined herein. In the event of a sublease, license, or similar agreement, the term “Transfer Premium” shall mean all Fixed Minimum Rent and other consideration payable by the transferee to Tenant or on behalf of Tenant in connection with the occupancy agreement in excess of the Fixed Minimum Rent payable by Tenant to Landlord under the terms of this Lease.
In the event of an assignment, “Transfer Premium” shall mean any consideration paid by the assignee to Tenant in connection with such Transfer which is allocable to the leasehold value3 of this Lease.
At the time the Lease was presented, Tara was so excited about operating her own business that she did not consult with an attorney prior to executing the Lease. While she understood the majority of the Lease terms, there were some that she was unfamiliar with – such as the above cited Transfer Premium provision. Nevertheless, Tara executed the Lease and began her new adventure.
To Tara’s pleasure, the area surrounding the Property absolutely flourished and she operated the business at a profit for two years without issue until she decided it was time to move on to her next adventure. In the two years Tara operated her business, the reasonable market rate for a substantially similar commercial building located in the same area increased from $20.00 per square foot (“PSF”) to $35.00 PSF, thus making the leasehold value of the Property (at that time during Year 3 of the Lease) approximately $15.00! Tara spoke with Larry who provided written consent to her request to transfer the Lease. After becoming a more sophisticated businesswoman over the past two years, Tara elected to consult with an attorney regarding her options in addressing the Lease and the remaining three years of the Lease term remaining. Tara has two friends interested in the Property, Andy Assignee and Sarah Subletter, both of which intend to operate a substantially similar business. Because the Lease defines the term “Transfer Premium,” Tara’s attorney explained her obligations under the Lease and how the same would be affected by her choice to assign or sublet the Lease. Tara understands that she is obligated under the Lease to pay Larry 50% of the Transfer Premium associated with the Lease transfer but intends to make her decision as to whom to transfer the Lease to based upon the amount of Transfer Premium which would be owed. Because the area the Property is located has developed so much over the last two years, Tara knows she can charge a higher fixed minimum rent and is excited at the thought of making a profit.4
Sarah has asked Tara to sublease the Property to her for a term of 2 (of the remaining 3) years. A sublease is a lease by a lessee to a third-party, transferring the right to possession to some or all of the leased property for a term shorter than that of the lessee, who retains a right of reversion. 5 Under the Lease, in the event of a sublease, the Transfer Premium is determined by finding 50% of the difference of the minimum base rent paid by tenant and the fixed minimum rent paid by the assignee.
If Tara subleases the Property to Sarah, she will owe Larry a total of $39,000.00 following the expiration of the 2-year sublease, Tara will regain control of the Property and owe to Larry a Monthly Minimum Base Rent of $24,000 under the terms of the original Lease. She would not owe any transfer premiums to Larry during Year 5 of the Lease. Thus, at the end of the Lease term, following the assignment, Tara would owe to Landlord $327,000.7
Andy would like Tara to assign the Lease to him for the remaining three (3) years of the Lease term. An assignment of a lease is a transfer in which a lessee transfers the entire unexpired remainder of the lease term, as distinguished from a sublease transferring only a portion of the remaining term.8 Under the terms of the Lease, the Transfer Premium owed is determined by taking the consideration paid to tenant in connection to a transfer which is allocable to the leasehold value of the Lease. While the Transfer Premium connected to a sublease grants the tenant some control by considering the amount charged by tenant to assignee, the assignment analysis is out of the tenant’s control, being based on the leasehold value of the Property. Again, leasehold value may be found by finding the difference between the minimum base rent and the current market value of the Property. Again, in the two years Tara operated her business, the reasonable market rate for a substantially similar commercial building located in the same area increased from $20.00 PSF to $35.00 PSF, thus making the leasehold value of the Property (at that time during Year 3 of the Lease) approximately $15.00!
|Year||Monthly Minimum Base Rent (Tenant)||Monthly Minimum Base Rent (Tenant) / PSF (Monthly)||Yearly Minimum Base Rent (Tenant) / PSF||Current Reasonable Market Rate of Comparable Property / PSF 9 (Monthly)||Current Reasonable Market Rate of Comparable Property (Monthly)||Current Reasonable Market Rate of Comparable Property (Yearly)||Difference (Yearly)||Transfer Premium Owed to Landlord||Transfer Premium Owed|
If Tara assigns the Lease to Andy, she will owe Larry $247,500.00 in transfer premiums. Tara will not regain control of the Property, outside of circumstances not considered in this article and thus will not be responsible for future rent payments. Thus, at the end of the Lease term, following the assignment, Tara would owe to Landlord a total $247,500.00 representing only the amount owed in transfer premiums.10
Here, Tara is left with a decision as to how she wishes to transfer the Property. Considering the analysis above, and without
consideration of any business income Tara could potentially have during the 5th year in the sublet analysis, Tara will pay $79,500.0011 less in transfer premium if she elects to assign the Property as opposed to subleasing it. Again, this does not account for any income Tara could have in Year 5 in the sublet analysis, which could offset Year 5’s Minimum Base Rent. Thus, in this example, it will be more prudent for Tara to assign the lease to Andy than subleasing the Property to Sarah.
The above illustration offers a basic example of how a transfer premium may be applied in the transfer of a real estate lease. There, of course, may be other considerations to account for in making a decision involving a transfer premium, such as additional costs/fees/expenses or a landlord’s right to recapture.
When weighing your lease transfer options in the presence of a transfer premium clause, there are several considerations that should be considered. The following questions may act as a general guiding path in a transferring tenant’s analysis:
– Does the underlying lease allow a tenant to transfer the lease?
– Does the underlying lease require landlord approval prior to lease transfer? Are there other prerequisites to lease transfer?
– How will the underlying lease be transferred (i.e., assignment, sublease, license, etc.)?
– What is the square footage of the property in question?
– How does the underlying lease determine minimum base rent owed?
– Does the underlying lease contain a “Transfer Premium” provision? If so, how is the term defined?
– Does the “Transfer Premium” provision in the underlying lease differentiate as to the type of lease transfer (i.e., assignment, sublease, license, etc.)?
– How does the underlying lease determine future market conditions?
– What is the current market rate of a substantially similar property in the same/similar location?
– How has the market rate of a substantially similar property in the same/similar location risen and/or fallen in the recent past and how is the same anticipated to record in the foreseeable future?
– If the tenant is transferring the underlying lease for less than the remaining term, will the original tenant be willing and/or able to resume business upon completion of the assignment pursuant to the terms of the underlying lease?
– If a transfer premium is owed under the underlying lease, when and how is it to be paid?
– Are there any other provisions/considerations to account for in the underlying lease that affect the transfer premium owed?
It is apparent the concept of a transfer premium was conceived to act as a tool available to landlords that protects their interests in the case of a future transfer to prevent a tenant from obtaining a monetary advantage using the current market conditions. While this principle plays to the benefit of a landlord, an assigning tenant may nevertheless use a lease transfer to take advantage of market conditions and potentially profit by transferring the lease. If the underlying lease contains a transfer premium provision, said assigning tenant must take into consideration the amounts which may be owed to the landlord. Without taking this into account, a business owner, like Tara, may find themselves paying an additional $79,500.00 in transfer premium.
Whether you are the lessor or lessee in a situation wherein the tenant is seeking to transfer the underlying lease, we at the Sul Lee Law Firm are ready to help. Please contact us today to discuss your rights and obligations relating to lease transfers.
1 – See, e.g., Landlord STANDARD OFFICE LEASE, VCCF0203 ALI-CLE 571.
2 – For the purpose of this article, other costs, fees, and expenses often attributable to a commercial tenant are not considered for the purpose of clarity.
3 – The value of a leasehold interest. This term applies to a long-term lease when the rent paid under the lease is lower than current market rates. Some states permit the lessee to claim the leasehold interest from the landlord in a condemnation proceeding unless the lease prohibits such a claim. Other states prohibit these claims by statute. LEASEHOLD VALUE, Black’s Law Dictionary (11th ed. 2019)
4 – For the purposes of this illustration, the fixed minimum rent will increase 10% yearly.
5 – SUBLEASE, Black’s Law Dictionary (11th ed. 2019).
6 – (($300,000 – $264,000) + ($318,000-$276,000))/2 = $39,000
7 – Representing the sum of $39,000.00 in transfer premium and $288,000 in Minimum Base Rent paid in Year 5.
8 – ASSIGNMENT, Black’s Law Dictionary (11th ed. 2019).
9 – The Current Reasonable Market Rate of Comparable Property/PSF for Years 4 and 5 is determined by taking the current reasonable market rate for a substantially similar commercial building located in the same area and increasing the same 5% yearly, the same yearly increase used by Larry Landlord in the
underlying Lease in this illustration.
10 – 50% of the leasehold value of the Property (Current market rate (yearly, at 5% yearly increase) – Yearly Minimum Rent under Lease (Yearly)).
11 – $327,000 – $247,500.00 = $79,500.00.