Encumbrances
An encumbrance is a burden or impediment. Office leases often contain rights which are exclusive to a specific tenant and which place constraints on the landlord’s ability to lease space to other, 3rd party tenants. These rights are referred to as encumbrances. When tenants consider leasing space in a building, one of the first things they should qualify is the extent to which the landlord’s ability to lease the subject space is subject to any encumbrances. If so, the specific terms of these encumbrances must be understood before proceeding.
It’s all too common for tenants to pursue a lease for office space only to learn (after months of negotiations) the space was subject to the superior right of an existing tenant. This can create problems for tenants, including increased cost and loss of critical schedule. The most common issue is when an existing tenant has an expansion right relating to the subject space. Expansion rights come in all shapes and sizes, but the most common are the Right of First Offer, or ROFO, and the Right of First Refusal, or ROFR. Each of these rights encumber the landlord in that they cloud its ability to lease the subject space to third parties unless and until the superior right holder has declined to lease the subject space in accordance with the terms of the lease.
The ROFO typically states that a landlord must first offer space in a designated portion of the building (or possibly the entire building) to a specific tenant on the terms it would otherwise offer to a third-party tenant before it leases any such space to a third-party tenant. The existing tenant is then given a set period in which to respond. The normal response options include, declining the first offer, accepting the first offer, or expressing binding interest in the first offer space, but electing to negotiate the terms of the first offer. In the latter scenario, the lease will typically provide for a set period during which landlord and tenant are to negotiate in good faith, after which point, if the parties have not reached agreement, the terms are to be determined via arbitration. ROFOs require careful administration from property management professionals, something that doesn’t always happen. Ideally, the ROFO obligation is satisfied well in advance of the landlord agreeing to terms with a third-party tenant. However, it’s not uncommon, especially in smaller buildings, for the landlord to discover it must satisfy a ROFO obligation just as it’s about to execute a new lease with a third-party.
The ROFR is a more complex mechanism. It calls for the landlord to secure a bona-fide term sheet with a third-party tenant and then provide those same terms to the existing tenant, giving the existing tenant the right to accept or refuse the terms. Landlords are (generally) more inclined to disclose the presence of a ROFR because failure to do so can result in reputational damage in the brokerage community. The tenant who negotiates in good faith believing they’ve agreed to terms only to learn the proposal must now be “shopped” to an existing tenant, understandably, feels like they’ve been used.
Landlords aren’t obligated to disclose any of these rights to prospective tenants and their brokers. Good brokers will always seek to clarify the presence of any existing encumbrances which would affect the landlord’s ability to lease the subject space. It’s a critical element of good due diligence.