Drafting Licenses & Leases for Nontraditional Commercial Space
By Sujata Yalamanchili, Esq. and Elizabeth A. Holden, Esq.
Shared workspaces have grown 200 percent over the last five years, which is an astonishing number. As of 2018 co-working space represents 27 million square feet just in the office segment alone. Some owners lease entire floors to long-term tenants like WeWork that turn the premises into co-working space. Other owners are creating co-working spaces in their buildings themselves, and rather than using traditional leases, using a membership model where a business or individual buys a membership that comes with so many hours per week of office space and related amenities. The number of such co-working “members” is expected to rise to 3.8 million in just a little over a year and to 5.1 million by 2022. In other words, co-working is forecast to grow by 15 percent per year over the next five years. So if you thought this trend might be just a flash in the pan, it’s not. It’s growing.
Consider some prominent examples: WeWork recently bought the flagship Lord & Taylor building on Fifth Avenue in Manhattan. The first two floors will stay retail, while the upper floors will be co-working space. Although WeWork purchased this particular building, the company typically rents the space it operates in—in fact, WeWork is rumored to be the largest single tenant in New York City. Its typical model is to sign a long-term lease at a fixed rent for an entire building or multiple floors of a building, and then it takes the risk of finding individuals or companies to fill the space. WeWork is a relatively new company, but it has grown tremendously and is a market leader.
In Montreal, the beautiful Royal Bank Tower, which had been largely abandoned by the bank in 2010, repurposed its original lobby into shared office space. Today, Crew Collective operates there in about 12,000 square feet using a membership model, where for a monthly fee its members can get a desk or rent meeting rooms by the hour. Standard business services like WiFi and copiers are provided along with other amenities.
The co-working environment is supposed to foster collaboration. Consider the Innovation Center in Buffalo, N.Y., a membership-based incubator space for approximately 75 tech companies. It offers a host of amenities: a snack bar, a fitness center, game areas, foosball tables, pool tables, etc.
This model also applies to retail, in the form of pop-up shops. Bryant Park in New York City has pop-up retail during the holiday season—largely arts and crafts vendors that couldn’t afford a Fifth Avenue lease, but can afford to license a small, seasonal pop-up store.
While pop-up shops have long been popular among landlords looking to fill temporarily vacant space until a long-term tenant comes along, short-term pop-ups and co-working spaces are fast becoming a new building-wide business model for commercial property owners.
Short-Term Mentality
Traditionally, commercial property owners have preferred stable, long-term tenants. Having at least one 20-year lease with a Fortune 500 tenant would give your building stability and financing opportunities. Now, an owner may have a building that doesn’t have a rent roll. Instead, the owner has month-to-month tenants of varying shapes and sizes. Not only does the owner not have a five-year lease, but it also doesn’t necessarily want a five-year lease. The owner actually wants people coming in and out.
How are bankers going to underwrite such a building? A bank might require a personal guaranty from the building owner and the principles. A bank might require other credit enhancements—maybe a mortgage on another building to support the mortgage on the “co-working” building. Banks haven’t quite figured this out yet, and many of these buildings are being underwritten by private equity, hedge funds, and other nontraditional lenders.
Over time, a building that adopts the co-working or pop-up model may develop a successful track record. Even though no one tenant is there for very long, if the building can show a track record that for three years, it has had 90 percent occupancy and a certain level of stability in the rents, a bank may consider the history of the building and not necessarily the specific tenants.
License or Lease?
If you have space that’s suitable for these nontraditional co-working or pop-up uses, you should consider whether to lease your space or license it. A license is the privilege to go on the owner’s premises for a certain purpose, but it doesn’t give the licensee any title or interest in the property. A license is a non-exclusive, revocable right to enter a space and perform an act. It’s not an interest in land. It’s a temporary privilege.
Conversely, a lease is a conveyance of exclusive possession of a specific property for a specific period of time in return for rent payment. Leases are transfer of possession and control of the premises in the most basic form.
Distinguishing elements of leases generally include: the landlord’s surrender of possession and control of the property; unlimited and exclusive access to the property by the tenant; and the rights of the tenant to make improvements, install major equipment including HVAC, furnish the space, and transfer the lease.
For businesses seeking to rent a space for a short term, property owners are initially drawn to using a license agreement, because a license is easily revocable. Removing a tenant, as opposed to a licensee, can be time consuming and expensive. Licensors can revoke the license at will and can use self-help, under certain circumstances, to remove a licensee from property.
Note, however, that courts have stressed that they will look beyond just the title of your document to resolve disputes. So if the document says “license” but you treat your occupant as a tenant, courts will look at the relationship that you’ve created and the equity of the parties involved.
For example, in a 1994 New York case, American Jewish Theater v. Roundabout Theater, the court wrote, “What defines the relationship between the parties is not its characterization or the technical language used in the instrument but rather the manifestation of the intent of the parties. The nature of the transfer of absolute control and possession is what differentiates a lease from a license or any other arrangement dealing with property rights whereas a license connotes use or occupancy of the grantor’s premises a lease grants exclusive possession of designated space to a tenant subject to the rights specifically reserved by the lessor. The former will be cancellable at will.”
In this case the theater company sued for injunctive relief, which could be given only to a tenant, not a licensee. The court’s decision weighed heavily on the facts that the theater had a six-month fixed term for space, and the agreement wasn’t revocable at will according to the document. So the court found that the agreement between the parties was a lease even though the document stated at the top “license” and the parties were referred to as “licensee” and “licensor.”
15 ISSUES TO CONSIDER
WHEN LEASING OR LICENSING NONTRADITIONAL SPACE
When deciding whether to use a license or a lease for nontraditional space, consider the following traditional lease issues and how they might apply in a licensing or short-term leasing situation.
[] Permitted Use
In a short-term leasing or licensing deal, owners will want to encourage their tenants or licensees to file permit applications well in advance of their actual occupation of the space as a requirement for getting into the space. A licensee would want to make sure it can get all permits—health, fire, and anything else related to its operations—in a timely manner that maximizes its limited time in the space.
[] Exclusive Use
When you license space to pop-up stores it’s very difficult to exclude competitors. For example, in a typical mall food court, you may have one burger vendor and one noodle vendor, but you’re not going to have both a McDonald’s and a Burger King. In a food hall made up of pop-up vendors, though, the more good food that’s there, the more likely you are to draw traffic to the hall. A customer might buy a noodle dish from one Burmese restaurant and a soup from another Burmese restaurant.
If a food vendor is investing in a five-year lease and spending a million dollars to build out a fancy restaurant, it will demand to have use provisions that would exclude competitors. But a vendor in a food hall that’s acting as an incubator to build traffic may not care the same way about competitors.
Another example is a seasonal use location, such as Bryant Park’s holiday pop-ups. There you might find 10 vendors selling handmade jewelry. None of them care to exclude the other handmade jewelry makers because the more handmade jewelers there are, the more they’re going to attract customers who are interested in buying handcrafted jewelry.
[] Hours of Access
Leases generally don’t restrict hours of access. If you really want to curtail how often somebody is in the space, however, a license is preferable to a lease.
[] Signage
Licensors may want to have a set of rules and standards to follow that will make the approval process quicker for licensees that are looking to set up quickly or use the space for just a short period of time.
[] Maintenance
A licensee will expect the owner to perform more maintenance than it would in a normal lease situation. In the typical vanilla box lease, the owner would take care of the exterior and the building systems that service all the common areas. But the tenants themselves would take care of their interior spaces, including any HVAC or equipment that serves only their premises. A pop-up licensee may not have the wherewithal to maintain its space or benefit from maintaining the space in a way that a long-term tenant would. So an owner would assume more of those obligations under a license than it would under a lease.
[] Buildouts
Some pop-ups, like Kate Spade or Adidas shops, are specially built to be experiential atmospheres. Kate Spade creates pop-up shops in the shape of a jewelry box; Adidas has a shoebox store. These individual designs aren’t going to be used by anybody else, so these tenants will want broad alteration and buildout rights.
On the opposite end of the spectrum is WeWork and pop-up shops that may be trendy, but not for just one type of tenant. When the license or short-term lease is over the owner doesn’t want to have to rip out everything that’s there. The owner wants to replace the outgoing business with the next paying customer the next day. So there’s a push towards visionary, exciting spaces that are nonetheless kind of generic. Especially in pop-up retail spaces, owners are planning for flexibility, so there are typically no concrete walls between shops; instead, there are movable walls or curtains.
[] Rent
Normal commercial leases set a base rent for the premises. The landlord may then tack on additional rent for the tenant’s portion of common maintenance charges and insurance, so that all the tenants share equally in those costs. But in a pop-up or co-working space, where the business or individual isn’t necessarily in the premises for a long period of time, a short-term license or membership agreement will simply stipulate a flat fee.
Also, whereas a lease often has a lookback period at the end of the year when the owner reconciles the operating or CAM costs, landlords/licensors of short-term tenants/licensees will charge a grossed-up amount of those potential costs, sometimes one and a half times or two times what they think they’re going to be, so they don’t have to reconcile costs after the fact—and chase after a pop-up for the money after it has left the property.
Kate Spade and Adidas pop-ups and WeWork-type co-working tenants are usually paying above market price for these trendy new spaces. But the Etsy-type mom-and-pop shops are just trying to get their feet wet to see if they can actually afford to be in the space. So, depending on the situation, an owner may offer a lower rent or license fee to drive interest in the space, and then, once the pop-up has established itself, impose a rent escalator that you might see in a regular commercial lease. Or the owner might move the pop-up to more expensive space.
Similarly, as licensor, WeWork offers its members different spaces—a table, an office, a meeting room—for different prices. In other words, it uses an a la carte fee structure.
[] Compliance with Laws
Under a lease the responsibility for complying with laws is allocated to either the landlord or the tenant, or both to varying degrees. For example, an office building lease might say that the landlord is responsible for making sure the building is in compliance with the fire code and building code, and that the elevators have proper certificates and the restrooms are accessible to people with disabilities.
But will a short-term food vendor want to spend tens of thousands of dollars to make its space compliant if it’s going to be there for only two months? As a practical matter, some of that compliance may fall more on the owner, which may result in higher rental rates or license fees. The law might evolve to where a property owner might be able to get its space certified by the health department for use by, say, 20 different food vendors because it has all the appropriate grease traps, ventilation, smoke detectors, etc.
One law that can present compliance challenges in co-working space is the Americans with Disabilities Act (ADA). One of the triggers for compliance under the ADA is whether the space is a “place of public accommodation.” So if an office tenant provides, for example, translation services, and the general public doesn’t come to its office, that space might not be considered a place of public accommodation. But let’s say you’re the owner of a co-working space, and a co-working “member” who’s a financial advisor advertises seminars to the general public, and anybody off the street can come in and attend the seminar. Now that co-working space may be a place of public accommodation, and you have greater obligations under the ADA.
Owners of co-working space, therefore, may have to police what exactly their co-working members are doing. It’s not enough to offer conference room space; you may need to build into your license agreement or lease some restriction that says if the member or tenant does something that causes this space to be considered a place of public accommodation, the member or tenant is responsible for full compliance with the ADA.
[] Environmental Issues
Most co-working spaces and pop-up shops don’t involve uses or products that would cause environmental concerns. But in a collaborative space for scientists, how do you determine if there’s been some sort of environmental contamination? With a traditional tenant, an owner can have an environmental assessment done. But with co-working space, especially if you have multiple people using the same lab space at different times—for example, company A uses the space on Monday, Wednesday, and Friday, and company B uses it Tuesday and Thursday—it’s much harder to determine who has done what and what contamination might be caused by which company. Special provisions may need to be added to the license or lease.
[] Damage and Destruction
Under a typical lease, if the building burns down, the owner is obligated to rebuild and make the space available to its tenants again. But a licensee will have to find another space. Its license is revocable; the deal is done.
[] Options
The most common lease options are the options to extend, expand, and terminate early. A five-year lease might grant the tenant the right to extend for another five years, subject to a notice requirement, and the rental rate will be determined by a certain formula. With an expansion option, a small retailer might want the unilateral right to take more space a certain date or be given the right of first refusal if more space becomes available later. Early termination is particularly important to startups.
With licenses each of these three types of options have been completely turned on its head. So, for example, early termination is virtually a non-issue. When someone is renting a desk and paying month to month or day by day, early termination is moot. These arrangements are so short term that they provide the maximum flexibility for the member. Extension and expansion options also are non-issues because most of these spaces are designed to grow with the business. A member can start off just using a desk or space on a table and can grow into more desks or offices as her business grows.
[] Assignment and Subletting
With traditional leases the parties agonize over these provisions. Most pop-up shops, however, aren’t looking to sublet.
[] Holdover and Eviction
Most leases deal with tenants that have stayed in the space past their lease terms by considering the holdover a month-to-month tenant subject to certain penalties or enforcement rights, such as having to pay double or triple rent. Holdover is a lot different with pop-ups and co-working members because generally they are using a smaller space. If a member refuses to give up his space on a table, you don’t have to evict him, you just charge him more or deactivate his key card. Even in the retail setting these smaller businesses are much easier to remove than, say, a Sears at a shopping center.
[] Recapture and Relocation
This is more a concern for short-term leases, because licenses are revocable, so recapturing the space isn’t as difficult. Licenses allow for easy relocation, too. For example, you may put a mom-and-pop shop in an exciting upfront space. Then a new, more promising pop-up comes along, or the original mom-and-pop finds they really can’t afford that space. So you can move them to a cheaper space, subject to relocation requirements. And that’s another reason you’d want to keep buildout costs low, so that you can relocate licensees as the needs arise.
[] Defaults
A typical commercial lease lists the following types of defaults: monetary defaults, nonmonetary defaults, and voluntary or involuntary entry into bankruptcy. The payment of rent in the short-term licensing or leasing situation will be the most important and will dwarf the other types of defaults. So you can cut what might be a three-page default provision in a lease down to a one-page provision in a license and focus on making sure that the payment is made. Some owners and co-working space operators encourage increased security deposits or complete payment upfront. In WeWork agreements, the risk of nonpayment is shifted somewhat to the credit card companies.
Regarding cure periods, commercial leases often have a five- or 10-day window to cure the nonpayment of rent, and usually a 15- or 30-day window for curing nonmonetary default obligations like repairing and cleaning up a condition. But the owner of nontraditional space might want to make the cure period only two days. After all, what are the tenant’s or licensor’s real obligations? It’s probably not obligated to maintain the HVAC; it’s probably just supposed to keep the room clean.
Editor’s Note: For more information, you can watch a video of the authors’ recent presentation, “Drafting Licenses and Leases for Nontraditional CRE Space,” a continuing legal education program the Insider co-sponsored with the New York County Lawyers Association.
About the Authors
Sujata Yalamanchili, Esq. is a Partner in the Buffalo, N.Y., office of Hodgson Russ, LLP. She leads the firm’s Real Estate, Finance & Bankruptcy Practice. She can be reached at syalaman@hodgsonruss.com.
Elizabeth A. Holden, Esq. is also a Partner in the Buffalo, N.Y., office of Hodgson Russ, LLP. She concentrates her practice on commercial real estate development projects and in real estate aspects of large-scale renewable energy projects. She can be reached at eholden@hodgsonruss.com.