Compromise on Requiring Defaulting Tenant to Pay Back Rent Credit

Issue to Negotiate

You decide to offer a tenant a rent credit—that is, the right to stay in the space rent-free for one or more months—to entice it to sign your lease. But should you have the right to require the tenant to pay back the rent credit if it defaults under the lease?

Owner's View

You'll argue that you should have the right to require the tenant to pay back the rent credit when it defaults under the lease. This requirement will give the tenant an incentive not to default. After all, the tenant could literally walk out on its lease immediately after the rent credit period ends—leaving you with no rent, no tenant, and an empty space. Also, a rent credit is a concession meant only for your most desirable tenants. If a tenant defaults, it's an undesirable tenant that shouldn't have gotten the concession in the first place.

Tenant's View

The tenant will argue that you shouldn't have the right to require it to pay back its rent credit. The rent credit is an economic term that you've agreed to as part of the lease deal, just as if you'd agreed to give the tenant a lower rent. Once you've offered the rent credit to the tenant, it would be unfair to change the deal and get the money back.

Compromise: You Get Pay-Back Right, Subject to Three Key Limits

To avoid disputes with the tenant on this issue, consider this compromise: Agree to put three key limits on your right to require the tenant to pay back its rent credit when it defaults, says Chicago attorney Daniel Kopp. Though these key limits will probably make it impossible for you to get back the entire rent credit from a tenant if it defaults, you could still get back some—or most—of the rent credit under certain circumstances, he says. We'll tell you what those three key limits are. And we'll give you a Model Lease Clause that includes these limits, at right, that you can adapt and use in your lease.

Spell Out Terms of Rent Credit

Before you discuss the compromise in your lease, spell out the terms of the rent credit (called the “Rent Abatement” in the Model Lease Clause). For instance, you should:

• Specify in which months the tenant will get the rent credit (called the “Abatement Months” in the Model Lease Clause) [Clause, par. a];

• Indicate what the rent credit will cover—such as both base rent and additional rent (CAM costs and operating expenses) [Clause, par. a]; and

• Indicate that the tenant will get the rent credit—but only if it hasn't committed a default under the lease, says Kopp. In other words, not committing a default becomes a condition for getting the rent credit [Clause, par. b].

Setting Up Compromise in Lease

After you've spelled out the terms of rent credit, state in the lease that if the tenant defaults, you'll have the right to require the tenant to pay back the rent credit it already got. (That includes both base rent and additional rent.) However, also say that your pay-back right is subject to these three key limits:

Limit #1: Tenant's default must be monetary. The tenant must have committed a monetary default or else you can't require it to pay back the rent credit, says Kopp. For instance, the tenant stopped paying rent or hasn't made some other required lease payment, he explains. Also, the tenant shouldn't lose its rent credit if it owes only a small amount of money, Kopp adds. Therefore, require the monetary default to exceed a minimum dollar amount—for example, one month's rent, he says [Clause, par. b].

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Practical Pointer: Although you may be inclined to also make the tenant responsible for paying back a rent credit if it commits a “material”—that is, important—default that doesn't involve money, Kopp thinks that's not a good idea. “Material” is an ambiguous term—so you could end up in a fight with a tenant over whether a default is material or minor, he warns. It's better to leave out references to material defaults in the rent credit clause, he says.

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Limit #2: Tenant must have time to cure default. You can't require a tenant to pay back its rent credit unless it's allowed first to cure its monetary default within the time period set out in the lease, says Kopp. If the tenant successfully cures the default within the set time, it doesn't have to pay back the rent credit, he says [Clause, par. c].

Limit #3: Tenant pays back only amortized portion of rent credit. If the tenant complies with its lease obligations during most of the lease, it's unfair to demand that the tenant pay back all of the rent credit it had gotten so far when it defaulted. Suppose that a tenant got a one-year rent credit when the lease started, and it defaulted in year eight of a 10-year lease. The tenant will argue that it complied with the lease for four-fifths of the lease, so it shouldn't have to give back more than one-fifth of its rent credit. So agree to “amortize” the tenant's obligation to pay back the rent credit over the length of the lease, says Kopp [Clause, par. c(i)].

To do this, first determine the total amount of the rent credit over the life of the lease, and then multiply that amount by a fraction—the numerator being the number of months remaining in the lease, and the denominator being the total months of the lease, says Kopp. That's the amount that the tenant is required to repay you, he says.

Example: A tenant's monthly rent under a 10-year (120 months) lease is $5,000, but during the first six months of the lease, rent is free. The tenant defaults in the 60th month of the lease. The tenant must repay you $15,000 ($5,000/month free rent x 6 months = $30,000; $30,000 × 60 ÷ 120, which is the number of months remaining in the lease divided by the total lease months). Because the tenant defaulted halfway through the lease, it must repay you only half of the rent credit.

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Practical Pointer: If you use this compromise, your lease clause should also specifically say that if the tenant cures its default in time, not only does it not have to pay back any of the rent credit, but also it's still entitled to any remaining rent credit, says Kopp [Clause, par. c(ii)].

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Will Compromise Clause Work?

Can the compromise clause guarantee that a tenant that commits a large monetary default will pay you the rent credit? No. After all, many tenants that default are short on cash; otherwise, they would meet their lease obligations. But Kopp believes that you're better off including the clause in your lease if it gives the tenant a rent credit or some other rent abatement, rather than leaving it out. If you must take the tenant to court, having the clause may increase the amount of money awarded to you, he says.

However, before putting the compromise clause in your lease, check with an attorney in your area to make sure your state's laws allow you to require the tenant to pay back a rent credit if it defaults, notes Kopp. Some states—such as Illinois—have cases limiting an owner's ability to get back rent credits, he says.

CLLI Source

Daniel J. Kopp, Esq.: Principal, Schwartz Cooper Chartered, 180 N. La Salle St., Ste. 2700, Chicago, IL 60601; (312) 845-5400; dkopp@scgk.com.