Who Pays for the Roof, Structure and Capital Repairs?

In an ordinary lease the landlord has owned and maintained the building, and the tenant is a newcomer. In a sale-leaseback it is reversed. You have run the building for years, you know the age of every roof section and rooftop unit, and the buyer has a short diligence period to catch up. Investors use that fact to argue that the seller should keep all of the building's physical risk: you know it, you maintained it, you stay responsible for it.

There is logic to that, and many sale-leasebacks are signed on that basis. But it means that after closing you may hold the obligations of an owner without the benefits of one. If you replace the roof near the end of the term, the new roof belongs to the landlord and you may be gone a few years later. The purpose of negotiating this clause is to line up who pays with who benefits.

Net lease labels are used loosely in the market, so read the repair language and do not rely on the name. Broadly, there are three positions.

• Absolute net, sometimes called bondable. The tenant is responsible for every cost of the property: taxes, insurance, maintenance, repairs and replacements of all kinds, structural and nonstructural, foreseen and unforeseen. Rent is generally not reduced for casualty or other interruptions. The landlord's role is to collect rent.
• Triple net with tenant replacements. The tenant maintains, repairs and replaces building components, but the lease includes ordinary protections such as rent abatement or termination rights after a major casualty or condemnation.
• Net lease with landlord carve-outs. The tenant handles routine maintenance and repair, and the landlord remains responsible for defined capital items, commonly some combination of roof, foundation, exterior walls and structural frame, and sometimes replacement of major systems.

Investors generally pay the most for the first structure, because it gives the most predictable income, and less as responsibility moves to the landlord. That is a trade you can price: ask bidders what a landlord-responsible roof and structure would do to their offer, and compare the answer with the cost and risk you would be keeping.

You cannot negotiate this clause well without a current view of what the building will need. Buyers will commission a property condition report during diligence. Getting your own assessment first, before the building is marketed, puts you ahead of that report instead of reacting to it.

• ✓What is the age, type and remaining useful life of each roof section, and is any warranty transferable?
• ✓What is the condition of the structure, slab, foundation and exterior walls?
• ✓How old are the HVAC units, boilers, electrical service, fire protection and plumbing, and when is replacement likely?
• ✓What is the condition of paving, loading docks, drainage and exterior lighting?
• ✓Are there known code, accessibility or life-safety items that would have to be corrected in a renovation?
• ✓Are there environmental conditions tied to past operations, and who will be responsible for them after closing?
• ✓Which of these items fall due within the proposed lease term, and what would they cost in today's dollars?

With that list in hand you can make a deliberate choice for each large item: fix it before the sale, give the buyer a credit and make it the landlord's responsibility, or accept it as yours with protections in the lease.

The hardest case is a major replacement late in the lease. A new roof or HVAC system installed in the final years will serve the building long after the tenant's obligation ends. Paying the full cost for a few years of use is the outcome to avoid.

The usual solution is amortization. The cost of a capital replacement is spread over the useful life of the new component, and the tenant pays only the share that falls within the remaining lease term. Here is an example that is hypothetical, for illustration only: a replacement costing $300,000, with an agreed useful life of 20 years, made when 5 years remain on the lease. The tenant's share would be 5 of the 20 years, or $75,000, and the landlord would carry the rest. If the tenant later exercises a renewal option, it picks up the additional years.

Points to settle in the drafting:

• Which items count as capital replacements, as opposed to repairs the tenant pays in full.
• Who performs the work and controls the specification, and who must approve the cost.
• How useful life is determined, and whether an interest factor is added to the landlord's share.
• Whether the tenant pays its share up front or as additional rent over time.
• What happens on renewal or early termination.
• A period at the end of the term during which the tenant is not required to make replacements at all, only repairs needed to keep systems operating.

Tie the surrender clause to the repair clause. A lease that limits your replacement obligation but then requires you to return every system in good working order at expiration can undo the protection you negotiated.

• Casualty and condemnation: rent abatement, a duty to rebuild with insurance proceeds, and a right to terminate if the building cannot be restored within a stated time or if the damage occurs near the end of the term.
• Legal compliance: the tenant complies with laws that arise from its own use, while structural changes required by laws of general application are capital items subject to amortization.
• Pre-existing environmental conditions: a clear allocation, consistent with the purchase agreement, of who is responsible for what was in the ground before closing.
• Warranties: assignment to the party responsible for the item, with the right to enforce them.
• Reserves: if the landlord requires a reserve for capital items, define what it can be spent on and who keeps any balance at expiration.
• Landlord's work: where the landlord is responsible for an item, a deadline to act and a right for the tenant to perform the work and recover the cost if the landlord does not.

The purchase agreement and the lease have to agree with each other on all of this. A seller who gives the buyer broad representations about the building's condition in the purchase agreement and also accepts every repair obligation in the lease has taken the same risk twice.

1. Commission a building condition assessment and a roof survey before going to market.
2. List capital items expected during the proposed term with rough costs and timing.
3. Decide for each one: repair before sale, credit to buyer, landlord responsibility or tenant responsibility with amortization.
4. State the repair structure in the offering materials and the letter of intent so bidders price the same lease.
5. Ask bidders to quote more than one structure so you can see what landlord responsibility costs in price.
6. Have your attorney align the repair, casualty, compliance and surrender clauses with each other and with the purchase agreement.

This is one of the places where having represented tenants for a long time is directly useful. We negotiate repair and replacement clauses from the occupier's side in ordinary leases, and we bring the same approach to a leaseback, where the pressure to accept an absolute net form is strongest.