Commercial Tenant's Lease Insider Compendium 2016

2016:
Top 5 Stories
From
1 vendomerealestatemedia.com
Presents...
Prepare for Eight Requests from Owner Giving Payout Agreement.........2
Three Strategies for Limiting Your Indemnity Obligation....................4
Make Sublet Deal Work for You..................................................8
Eight Things You Need to Know About
the New Lease Accounting Rules...............................................12
Get Nine Protections When Leasing Property
for Your Cannabis Business......................................................22

Prepare for Eight Requests from
Owner Giving Payout Agreement
Q: My business is located in an area where the local economy hasn’t been
doing well. As a result, my sales have been slow—and now I’m dealing with
unexpected increases in year-end operating expenses, which are more
painful than usual. The center has become a bit neglected and other tenants
suspect that the owner is also feeling the financial pinch. Can you suggest a
solution that would work for both of us?
A: If you’re struggling to pay the rent, chances are, the center’s owner
would rather work with you than have to evict you. One option that has
consistently worked for both tenants and owners in this situation is the
“payout agreement.”
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Know What You’ll Go Up Against
Under this type of agreement, you, the tenant, agree to pay the increased
operating expenses with scheduled payments over a designated period of
time. The agreement outlines the amount and due date of each payment.
While the payout agreement has been a successful solution for owners and
tenants, owners are not obligated to grant your request for one. Because
the owner has the upper hand, it will expect you to agree to its terms.
Before deciding whether the payout option is right for you, consider
what the owner is likely to want in exchange for granting you a payout
agreement. Your owner will probably want you to agree to the
following requests:
Request #1: Produce financial statements. When you request a payout
agreement, the owner will first want to see a copy of your financial
statements. Make sure these statements are detailed, accurate, and up to
date, as you’re going to have to prove that you need the
payout arrangement.
Request #2: Put agreement in writing. If the owner grants the request for
a payout agreement, it will want the agreement in writing. As a tenant,
you might think that an oral agreement is sufficient. But most owners will

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disagree because oral agreements tend to turn into expensive, drawn-out
disputes that can’t be easily settled in court.
Request #3: Acknowledge you have no defenses or claims. The owner
will ask you to acknowledge in the agreement that you have no defenses
or claims under the lease for not making payout payments. If at some
point after the inception of the agreement the owner needs to sue you for
nonpayment, it wants to make sure you’ve agreed in writing not to claim
that you refused to pay because the owner violated the lease.
Request #4: Continue to pay rent. Regardless of the agreement you make,
the owner is more than likely going to require you to continue to make
regular monthly payments of rent, operating expenses, and other amounts
due under your lease.
Request #5: Pay accelerated rent for missed payment. To protect itself,
the owner will want the right to accelerate the debt for any payments you
miss. That means that if you miss a payment, the owner has the right to
make all outstanding and future payments become due.
Request #6: Concede certain lease rights. When you ask for a payout
agreement, a savvy owner might take the opportunity to get you to agree
to some concessions. For example, the owner might say, “In exchange for
your giving up your right to expand your space, I’ll grant your request for a
payout agreement.”
Request #7: Apply payments to current charges first. The owner will be
adamant that any payments that you make will be applied to your current
charges due under the lease, such as operating expenses or rent, and then
to the amount you owe under the payout agreement.
Request #8: Acknowledge owner’s right to sue. To keep its options open,
the owner will want to add a clause in the agreement that preserves its
right to sue you for past and future lease defaults, including failure to pay
the amount due under the payout agreement. Owners add this clause to
prevent tenants that violate the payout agreement from arguing that by
entering into the agreement, they’ve waived their right under the lease to
sue you for not making the required payments.

Three Strategies for Limiting
Your Indemnity Obligation
Virtually every commercial lease includes a provision requiring the tenant
to indemnify the owner for damages caused by the tenant and the tenant’s
guests. Some indemnity provisions require the tenant to indemnify the
owner for damages caused through no fault of the tenant. Many owners
are reluctant to compromise when it comes to indemnity, but an overly
broad indemnity provision can lead to significant exposure for a commercial
tenant. The Colorado Supreme Court’s 2011 decision in Constable v.
Northglenn, LLC illustrates why careful attention must be paid to the
precise language used in an indemnity provision.
In Constable a shopping center owner was named as a defendant in a lawsuit
filed by a woman who slipped on ice in the shopping center’s parking lot.
The shopping center owner sought indemnity from a tenant who operated a
flower shop in the shopping center because the woman was at the shopping
center to visit the tenant’s business. The owner relied on the following
provision in its lease: “Tenant agrees to exonerate, hold harmless, protect
and indemnity [sic] Landlord from and against any and all losses, damages,
liability, claims, suits or actions, judgments, costs and expenses which may
arise as a result of any bodily injury, personal injury, loss of life or property
damage sustained during the term of this lease by any person or entity ...
in the Premises, or elsewhere in the Center if present in order to visit the
Premises, or as a result of Tenant’s business....”
Both the lease and Colorado law required the owner to maintain the parking
lot. The tenant argued the indemnity provision was unenforceable because
it purported to require it to indemnify the owner against liability for its
own negligence. The Colorado Supreme Court disagreed, and held the lease
reflected the parties’ mutual intent that the tenant indemnify the owner for
injuries sustained in the community areas by her customers, whether or not
the owner exercised exclusive control over those areas and whether or not
those injuries resulted from the owner’s own negligence. According to the
Colorado Supreme Court, “…an agreement purporting to indemnify a party
against liability for its own negligence will be enforced as written as long as
it contains a clear and unequivocal expression that the parties intended
that result.”
By Alan M. Cohen, Esq.

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Thus, even though the shopper’s injuries may have resulted from the
owner’s failure to comply with its obligation to maintain the parking lot, the
tenant was obligated to indemnify the owner with respect to the shopper’s
damages. The outcome of Constable may have been different had the lease
been governed by the law of a state other than Colorado. For instance,
under New York law any lease provision that purports to exempt an owner
from liability for its own acts of negligence is void and unenforceable.
Because state laws vary with respect to indemnity, careful attention should
be paid to the precise language used in the lease.
Consider using the following three strategies to mitigate the risks associated
with most indemnity agreements included in owner lease forms.
Strategy #1: Never Agree to Indemnify Owner
for Damages Caused Through Its Fault
Many indemnity provisions include an express obligation on the part of the
tenant to indemnify the owner for damages caused by the owner’s fault.
Any language that explicitly requires the tenant to indemnify the owner for
damages caused by the owner’s negligence, gross negligence, or intentional
misconduct should be deleted.
In Constable, even though the Colorado Supreme Court held that an
agreement whereby one party agrees to indemnify another for its own
negligence is enforceable, the court recognized that an agreement
whereby one party indemnifies another for its own intentional or wrongful
acts is unenforceable. Nevertheless, a tenant should never accept
language requiring it to indemnify the owner for damages caused by the
owner’s own acts or omissions, whether negligent, grossly negligent, or
intentional. Instead, your indemnity provision, like our Model Lease Clause:
Draft Airtight Indemnity Clause, should explicitly state that under no
circumstances will you be obligated to indemnify any party to the extent
that the injury, loss, or damage was caused by the negligence or willful
misconduct of that party.
Although certain states will not enforce an agreement whereby one party
agrees to indemnify another for its own negligent or intentional misconduct,
it’s always better to address the issue in the lease than to rely on state law.
Most reasonable owners, when presented with a controlling anti-indemnity
statute or judicial opinion, will concede and delete any requirement
inconsistent with state law.

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Strategy #2: Limit Indemnity to Your Proportionate Fault
Owners frequently seek broad indemnity with respect to any injuries or
damages in any way attributable to a tenant or the lease, no matter how
attenuated the connection between the tenant and the loss. A tenant’s
indemnity obligation should be limited “to the extent” of the tenant’s
negligent or intentional misconduct. The insertion of the words “to the
extent” is critical because it introduces the concept of proportionate
responsibility or comparative fault to an indemnity provision, if used
properly, as in our Model Lease Clause. In other words, to the extent
damages are caused by your conduct, you are responsible, but to the extent
damages are caused by the conduct of a party other than you, you should
owe no indemnity.
Under many leases the indemnity obligation is not tied to conduct, but
rather to the lease itself, or to the tenant’s occupancy of the leased
premises. Every effort should be made to tie your indemnity obligation to
your negligent or intentional misconduct, but even if you must agree to
indemnify the owner against risks arising from the lease or your occupancy,
insertion of the words “to the extent” can narrow the scope of the
indemnity agreement.
By limiting your indemnity obligation “to the extent” of damages arising
from the lease or your occupancy, you disclaim responsibility for damages
arising from something other than the lease, such as the owner’s failure to
maintain the building’s parking lot.
Damages and injuries occurring during a lease often result from more than
one cause. It is reasonable to require a tenant to indemnify an owner with
respect to losses that are the fault of the tenant, but if losses result from
the fault of the tenant and the fault of the owner, the tenant’s indemnity
obligation should be limited to the tenant’s percentage of fault.

Strategy #3: Delete Any Duty to Defend
Many indemnity provisions require the tenant not only to indemnify the
owner, but also to defend the owner against any claims for which the tenant
owes an indemnity obligation. The duty to defend generally obligates the
tenant to pay to defend the owner against claims made against it that fit
within the scope of the indemnity set forth in the lease.
That said, the duty to defend is generally broader than the duty to
indemnify because the duty to defend generally is triggered by allegations
alone. A duty to defend may be owed with respect to a claim in which no
damages are ultimately awarded. So even though a claim against an owner
may be completely frivolous, if the tenant agreed to defend the owner
against the claim, the tenant might be obligated to hire an attorney to
defend the owner at the tenant’s expense.
If the claim ultimately is dismissed, no indemnity will be owed by the
tenant to the owner, but the expenses of defending the lawsuit against the
owner may be the tenant’s responsibility. In many instances the expenses of
defending a lawsuit, which typically include attorneys’ fees, expert witness
fees, deposition expenses, and court costs, far exceed the actual amount in
controversy. If both the tenant and owner were named as defendants in the
lawsuit, the tenant might be required to pay for two lawyers, one to defend
it, and one to defend the owner.
Accordingly, you should delete any duty to defend from the general
indemnity provisions in your lease.
In the absence of a duty to defend you still may be liable for the owner’s
legal costs and fees if you owe indemnity and the underlying claim has
merit, but deleting the duty to defend should limit your obligation to only
those claims found to have merit.
Incorporate Three Strategies in Clause
Much like insurance policies, contractual indemnity provisions transfer risk.
An overly broad indemnity provision could require you to insure the owner
against damages resulting from the owner’s fault. Thus, efforts should be
made to limit your indemnity obligation to damages resulting from your
negligence or intentional misconduct, and to delete any requirement that

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Alan M. Cohen, Esq. is in-house counsel for URS Corporation in its
Austin, Texas, office. His practice focuses on real estate, construction,
and government contracts. He is admitted to practice law in Texas and
Louisiana, and is an Insider board member.
About the Author
Commercial Lease Law Insider Top Stories
you defend the owner against any claims. If the defense obligation cannot
be deleted entirely, the duty to defend should be limited to those claims
resulting from your negligent or intentional misconduct.
Make Sublet Deal Work for You
Subletting your space can be a good option under a variety of
circumstances: A better location for your business has popped up before
your current lease will come to an end; your sales are suffering and you
need to downsize; or your business model is shifting from a retail storefront
to primarily online sales.
Your lease provisions regarding subletting will determine if and how you
can sublet. And you’ll want to be sure that the arrangement with the
replacement business for your space doesn’t conflict with your rights and
responsibilities to the shopping center’s owner. Here’s what savvy tenants
need to know before negotiating and then exercising their sublet rights.
Understand Transformation
Some tenants, and especially those running a business for the first time,
don’t fully understand how a sublet works. Once you understand the nature
of the new relationship, you’ll be able to navigate it successfully. Subletting
puts you in the role of a landlord—a “sublandlord”—but at the same time
that doesn’t mean you can set aside your obligations as a tenant, with
respect to the subleased space. Your arrangement is now among three
parties with varied interests. Because each party has obligations and rights,
each will want protections.

Ensure that Permission Is Possible
Before making plans to sublet, the very first thing you should do is check
your lease with the owner to ensure that you have the right to sublet at all.
Depending on the terms of the “master lease,” the owner might require
prior notice or consent, or may have the right to recapture that space—that
is, take it back.
But what if the master lease says nothing about subletting? If the lease is
silent on the subject, you can assume that you can sublet without owner
consent. However, you should always notify the owner of your intent to
sublet, even if the lease says nothing on the subject. If you anticipate that
there could be a problem, be proactive in communicating your plans to
prevent unexpected conflicts down the road and unfulfilled promises to a
prospective new tenant that thought it would be able to use the space.
Remember that your subtenant will want your owner to know, for its
own practical purposes. If you, as the tenant, default on your lease, your
subtenant may want the right to cure your default or protect its interest
under the sublease even though there is no relationship directly between
the subtenant and your owner.
Don’t Assume Rent Profit
The issue of rent when subletting can be complex, and you should be
prepared to negotiate with the subtenant. The subtenant could suggest
paying a rent rate that’s lower than yours if it doesn’t have as many rights
as you have in the master lease.
In addition to any rent issues you’ll have with the subtenant, the language
of the master lease also can affect rent. If you’re subletting in part because
you think you’ll make a profit, don’t let that be a deciding factor. That’s
because often an owner won’t let you make money on subletting its space.
If what you collect in rent is in excess of what you already pay in rent, you
may be bound to give all or a percentage of that excess to the owner.

Protect Your Right to Remedies
Typically a sublandlord wants to retain a self-help right. If the subtenant
defaults on the sublease and doesn’t cure the problem, the self-help right
allows the sublandlord to do what needs to be done. It also gives the
sublandlord the right to be compensated for doing what the subtenant
should have done.
Common remedies for such a situation give the sublandlord the option
to terminate the sublease, enter and repossess the space, and sue the
subtenant for damages. These are the same kinds of remedies the owner
would seek from you as the original tenant should you default on your
lease obligations.
Ensure Other Rights as Landlord
In your sublease, you should ensure that you have the same rights and
remedies that the master lease gives the owner. If your subtenant causes
a problem, the owner is likely to expect you to handle and remedy the
problem. Tenants sometimes look for a release from the owner for such
obligations, but rarely get it. So be cautious in this scenario—you don’t want
to be liable, in the subtenant’s view, for things the owner should have done.
For example, you’ve paid your pro rata share of common utilities, but the
owner has failed to pay and utility service is cut off. Your subtenant would
probably look to you to remedy the situation.
So don’t put yourself in a position where your subtenant would have a claim
against you for providing services that the owner is required to provide.
Instead make sure that your sublease is clear that your aren’t liable to the
subtenant for things that are the owner’s obligations. Some things, if not
spelled out in a lease, are nonetheless legally implied obligations for a
landlord, such as maintaining a habitable space. This implied warranty could
include providing utility service for which tenants have paid.

Correlate Expiration Dates
Be sure the term of the sublease expires with, or earlier than, the term of
the master lease. The sublease should be written so that it automatically
terminates in the event your lease terminates. If you go bankrupt, for
example, you don’t want a situation where your subtenant files a claim
against you, saying you owe him for the loss of the sublet space.
Seek Pre-Approval for Modifications
The earlier you know what improvements or modifications (if any) your
subtenant wants to make to the space, the better. Your master lease most
likely addresses the issue of space modifications, and your subtenant’s plans
will be bound by the master lease requirements.
Any plans for interior construction or design will be subject to any pre-
approval requirements of your master lease. It’s best to work this out in
advance and attach the general design sketches or specifications directly to
the sublease.
Practical Pointer: Don’t forget to address the issue of signage. Expect
the owner to have a say in this. Signage is most likely addressed in the
master lease. It may say that you, as the tenant, get a sign based on
the square footage of your leased space. Your subtenant may want to
and expect to be able to put up signage. That’s something you’ll need
to agree upon and clear with the owner and then make clear to
the subtenant.
Create Identical Sublease
Make sure that your sublease says the subtenant is bound by all the terms of
the master lease as it relates to the subleased space. Be sure to cover:
• Maintenance;
• Pro rata share of common expenses, such as utilities and janitorial
services; and
• Reconstruction or removal of improvements at the term’s end.

All the provisions related to you as a tenant should apply to your subtenant
and be spelled out in the sublease. The biggest mistake in subletting is
that the sublease doesn’t mirror the provisions of the master lease. In
order to have a good sublease, you have to do a full review and have a full
understanding of the master lease.
Be aware that you can add any other control you want as a sublandlord,
like having the right to approve space modifications along with your owner’s
approval. Just be sure the sublease specifies the items that are sticking
points for you. While you can negotiate provisions with the subtenant, if the
sublease terms are not aligned with the master lease, both you and your
subtenant could cause a default under your original lease.
Eight Things You Need to Know About
the New Lease Accounting Rules
You don’t need us to tell you that big changes in lease accounting rules
are afoot. And if you’re looking for technical analysis of the new rules,
you’ll find tons of it online. The problem is that without an accounting
background, you’ll have a hard time digesting it. And what you won’t find
on the Internet is a plain English explanation for non-accountants. So we
decided to create one. Here are the eight things that tenants of commercial
real estate need to know about the proposed new accounting rules and their
impact on leasing.
Create Identical Sublease
1. What’s at Stake
Accounting rules require companies to keep two basic financial statements:
• A balance sheet listing assets and liabilities showing what the company
owns and owes, with recorded assets equaling, or “balancing,” recorded
liabilities plus equity; and
• An income statement (a.k.a. P&L) listing the company’s revenues and
expenses, which makes it possible to calculate the company’s profits
and losses.

These financial statements aren’t just a technical exercise in bean counting.
They directly affect a company’s ability to attract investors and get bank
loans, and even affect how much it pays in taxes.
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2. How Current Lease Accounting Rules Work
A lease is one of the transactions that a company must account for on its
financial statements. How the company does that depends on the kind of
lease. There are two possibilities:
Operating leases are transactions in which the owner (a.k.a. “lessor”) gives
the tenant (a.k.a. “lessee”) a right to use land or another asset. The tenant
doesn’t own the asset and must return it to the owner after the lease ends.
Most standard commercial real estate leases are operating leases.
Capital leases are essentially purchases in which the tenant acquires an
ownership interest in the leased asset. Examples include leases that transfer
ownership of the property to the tenant at term’s end, give the tenant an
option to purchase the property at less than its fair value and/or last for as
long as the asset’s remaining economic life.
Accounting-wise, the most important difference between the two kinds of
leases is that tenants aren’t required to record operating leases on their
balance sheet. The chart below summarizes the rules:

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Notes:
(1) Rent income/expense is shown as a straight line even though most leases
provide for higher rent over each year of the lease.

Capital leases are treated like purchases in which the tenant acquires
an ownership interest that’s recognized on the balance sheet and P&L.
Summary:
3. Why the Rules Are Changing
The new accounting rules propose to change how leases must be recorded
on the balance sheet and P&L. The biggest change: elimination of the rule
that tenants don’t have to list operating leases on their balance sheet. From
now on, all leases will have to be shown on the balance sheet.
Explanation: The point of accounting rules and financial statements is
ensuring that investors, banks, regulators, and other stakeholders in the
financial system get the information they need to make sound judgments
about a company’s financial condition. The boards that make the accounting

standards [like the Financial Accounting Standards Board (FASB) and
International Accounting Standards Board (IASB)] felt that letting tenants
keep operating leases off their balance sheets was creating too big a blind
spot in the system. According to one government report, off-balance sheet
leasing commitments total approximately $1.25 trillion—and that’s only
among publicly registered companies.
4. When the New Rules Will Take Effect
FASB and IASB are still working on the rules (which are contained in a 343-
page document called the “Revised Exposure Draft,” published on May 16,
2013). And experts say the rules probably won’t take effect until Jan. 1,
2017, at the earliest.
That sounds like a long time. But like objects in the passenger-side
rearview mirror, 2017 is closer than it appears. For one thing, there’ll be no
“grandfathering” of existing leases. All leases will have to be accounted for
in accordance with the new rules on the effective date no matter when they
were signed or took effect. Result: Owners and tenants will have to revise
their balance sheet and P&L before the rules actually take effect so they
comply on day one of the new regime. And if your company is required to
provide a three-year comparison in its financial statements, once the final
rules come out, you’ll have to revise your 2015 and 2016
financial statements.
5. The Four Things You’ll Have to Do to Comply
Under the proposed rules, companies will have to record all leases longer
than 12 months on their balance sheet and follow new rules for calculating
and recording leases on their financial statements. Compliance will be a
four-step process:
Step 1: Determine if your lease is covered. Remember that the rules
apply only to leases that last 12 months or more. Most commercial real
estate leases will satisfy the 12-month rule, explains Indianapolis CPA Ron
Smith, including leases of less than 12 months:
• That give the tenant an option to renew the lease or purchase the
property; and
• Where the tenant is “reasonably certain” to exercise the option in light
of all the economic factors.

Step 2: Classify the lease as Type A or B. Once you determine that the
lease is covered, you must figure out what type of lease it is. “Operating”
and “capital leases” are going away. Under the new rules, leases will be
classified as either:

• Type A leases, which are effectively a sale or financing; or
•
• Type B leases, which are essentially the same as operating leases under
the current rules.
Smith’s recommendation: In making the classification, tenants should
ask this question: Is the lease effectively an installment purchase of the
property? If so, the lease is a Type A; if not, the lease is a Type B.

• Rule of thumb: Office building, retail, and other standard commercial
real estate leases classified as operating leases under current rules are
likely to be Type B leases under the new rules; leases currently classified
as capital leases are likely to be Type A leases.
Step 3: Properly account for the lease on your balance sheet. You must
record Type A and B leases on the balance sheet—both at inception and on
a subsequent basis in response to significant economic changes:

First Phase: Initial Recognition. To recognize a Type A or B lease when the
lease begins, list:
1. A new asset representing the value of your right to use the property
(ROU asset). Formula: The ROU asset’s value is the present value (that is, a
dollar value that’s discounted to reflect the fact that a dollar in the future
is worth less than a dollar right now) of future lease payments over the
lease term. Include your initial direct costs in relation to the ROU asset,
Smith advises. Also make sure you know what future lease payments do and
don’t count:

Notes
(1) Residual value guarantees are amounts the tenant promises to pay
the owner at the end of the lease to protect the owner against excessive
depreciation of the property over the lease term.

Once you total up future lease payments, discount them to get their present
value. The discount rate is the rate your owner charges its tenants. If you
can’t determine that rate, use your incremental borrowing rate—that is, the
interest rate you’d have to pay to borrow an asset of similar value to the
ROU asset. If your company is a nonpublic entity, you can make an election
to use the risk-free rate as your discount rate, Smith adds.
2. A lease liability. Formula: Remember that under accounting rules, the
value of the liability must be the same as the corresponding asset.
You must present your Type A and Type B lease ROU assets and liabilities as
separate line items on your balance sheet or in the notes to your balance
sheet.

Second Phase: Reassessment. Over the course of the lease, you’ll
have to reassess the value of lease payments you reported as well as the
discount rate you used to calculate their present value to reflect lease
modifications and other important changes affecting:
• The term of the lease caused by a significant event or change in
circumstances that are within your control;
• Variable lease payments based on an index or rate to the extent you
decide to re-measure the ROU liability for other reasons; and/or
• The discount rate you used to calculate the ROU asset in response to
changes in the lease term or your option to purchase the property.
Step 4: Properly account for lease expenses on your P&L. As under
current rules, you’ll have to account for all lease-related expenses on your

P&L. You must recognize two lease-related expenses on the P&L:
• Amortization of the ROU asset—that is, the amount by which the asset’s
value is reduced as it’s consumed over the lease term. The ROU asset
is amortized on a straight-line basis over the term of the lease. For
example, an ROU asset recorded at $1 million for a 10-year lease is
amortized at $100,000 per year; and
• Interest expense related to the lease liability.
While the lease-related expenses are the same for both types of leases,
there are important differences in the method you use to recognize them on
the P&L:

• Type B lease: Combine the amortization and interest on a Type B
lease into a single lease expense that you recognize on a straight-line
basis over the course of the lease.

• Type A lease: Treat amortization and interest on a Type A lease
as separate costs. That’s a big deal because while amortization costs are
straight-line, interest expenses are higher in the early years of the lease
and decrease over time. The result of this “front-loading” is that you’ll
have to recognize significant interest costs on your P&L when you enter
into a Type A lease. Those added P&L expenses could affect your paper
profitability and harm your standing with investors and creditors.
Click here for a visual comparison of the impact of the different expense
recognition rules for Type A and B leases over a 10-year lease term.
6. How the New Rules Will Affect You
The P&L accounting rules for Type A lease expenses are like the current
rules for capital leases (although Type A leases are defined more broadly
than capital leases under current rules and may sweep in some leases that
are today classified as operating leases). But the real impact of the new
rules is that you will no longer be able to keep leases off your balance sheet
by structuring them as operating leases.
The scary part of the new rules isn’t just that you have to list leases on
the balance sheet, it’s how you have to do that. You must record your
total lease payment obligations over the course of the lease as an up-
front liability at the start of the lease. And that’s not chump change: Total
payments due under a commercial lease can run into six, seven, and
eight figures.

Adding a massive new liability to the balance sheet each time you enter
into a lease may do at least some harm to your company’s financial position.
The more leases you make, the more your financial statements and ratios
will suffer, and the harder it will be to lure new investment and loans.
The added liabilities may even cause you to default on your current loans.
Consider the following example:
Example of Proposed New Rules’
Impact on Existing Bank Loans
Tenant leases 15,000 square feet of retail space for seven years for $32 per
square foot on a triple net basis for total rent of $3.36 million.
Tenant’s bank loan agreement requires tenant to have a debt-to-equity ratio
of below 1.0:1.0. Before entering the lease, tenant has total debt of $5
million and total equity of $7 million, for a ratio of 0.71:1.
Current Rules: Tenant doesn’t have to list the lease on its balance sheet, so
its ratio remains at 0.71:1.
Proposed New Rules: Tenant must record the new lease on its balance sheet
at the start of the lease by listing an asset (right to occupy the space) of
$3.36 million and a corresponding liability (total rent due) of $3.36 million,
and reduce them both over the lease term. (For simplicity, the total lease
payments will be used and not the net present value of the total lease
payments.)
Result: At lease start, assets and liabilities increase by $3.36 million. So the
tenant’s liabilities are now $8.36 million. (There’s no change to equity). This
changes the tenant’s ratio to 1.19:1. By going above 1.0:1.0, the tenant is in
default under the loan.

7. Why Shorter Term Leases May Not Be the Best Answer
It’s imperative that you factor the new balance sheet reporting
requirements into your lease negotiations. You need to consider whether the
lease you’re negotiating is a Type A or Type B and how the lease’s economic
terms will be reflected as assets, liabilities, revenues, and costs on your
financial statements. One possibility is to negotiate for shorter lease terms
and renewal options. After all, the shorter the lease term, the smaller
the ROU asset and future lease payment liability you’ll have to initially
recognize on your balance sheet at the start of the lease.
Caveat: The short-term lease strategy won’t work for all tenants. You
shouldn’t use it if significant construction is planned for the space since
any reductions in the ROU asset are likely to be wiped out by higher
amortization costs over the initial lease term. Explanation: Regardless of
who pays them, construction costs must be amortized over the lease. The
shorter the lease, the higher the amortization rate (for example, $10,000 is
amortized at $2,000 per year in a five-year lease and $5,000 per year in a
two-year lease).
Getting a renewal option to extend the amortization period won’t solve
the problem. That’s because extending the amortization period gives you
“a significant economic incentive” (see the chart on counting future lease
expenses above) to exercise the option. Result: You have to count future
lease payments during the renewal period in calculating the ROU asset. In
essence, the renewal option plus incentive to exercise turns the lease into a
longer term lease, effectively undoing the short-term lease strategy.
And, of course, there’s more to leasing than accounting. Thus, if you’re
in retail or another business where staying in one location is crucial,
minimizing the ROU asset may be less significant than the stability of a long-
term lease.
8. Four Leasing Strategies You Can Use to Protect Your Company
Leasing strategies for tenants that do make sense in a balance-sheet
reporting world include:

Strategy 1: Shift costs to non-reportable expenses. Remember that the
value of the ROU asset recognized on the balance sheet is the present value
of future lease payments, including fixed rent, variable lease payments
pegged to an index or rate, and residual value guarantee payments. Result:
You can reduce the value of the ROU asset by shifting payment obligations
to payments that don’t count, like variable payments based on sales,
performance, or usage of the asset such as CAM, and other
operational expenses.
Strategy 2: Make leases triple net. One of the best ways to shift future
lease payments to non-reportable operating costs is via a triple net lease in
which you agree to pay fixed rent and a pro rata share of CAM, insurance,
and taxes. You also want to make sure that operating cost payments are
based on actual costs rather than adjustments against a base year since
lease payments become reportable when they’re tied to an index or rate.
Strategy 3: Make owner commit to financial transparency. Remember
that new rules require you—and the owner—not only to recognize the
initial value of the ROU asset but reassess it to reflect significant economic
changes. So require the owner to:
• Monitor the relevant variables, such as the index or rate to which a
particular lease payment is pegged;
• Notify you of changes; and
• Provide the data you need to make your own reassessments.
Strategy 4: Structure leases as Type B, not Type A. Although both types of
leases must be recognized on the balance sheet in the form of the bloated
ROU asset, the P&L recognition rules for Type Bs are kinder and gentler
because they let you combine amortization and interest expense as a single
lease cost on a straight-line basis. So structuring leases as Type Bs enables
you to avoid the dreaded front-loaded, downhill interest expense slope that
must be shown on the Type A P&L.

Glenn S. Demby is a corporate attorney and award-winning legal journalist
who specializes in explaining the law in plain English and helping business
leaders overcome their regulatory challenges. He can be contacted
at glennsdemby@gmail.com.
Insider Source
Ron Smith, CPA: Partner, Katz, Sapper & Miller, 800 East 96 St., Ste. 500,
Indianapolis, IN 46240, rsmith@ksmcpa.com
Get Nine Protections When Leasing
Property for Your Cannabis Business
Finally found an owner willing to lease commercial property to your legal
cannabis business? Congratulations! But while securing a lease is a major
accomplishment, you still have work to do. Now you have to negotiate the
terms of the lease. If your owner doesn’t have a lot of experience leasing to
cannabis businesses, it will probably ask you to sign the same standard form
commercial lease it uses with its other tenants. Don’t do it! You’re not like
the owner’s other tenants, and you can’t use the same lease they do. As a
purveyor of cannabis, your business poses unique legal challenges, and you
need special lease provisions to deal with them. So, you need to get your
owner to revise the boilerplate lease to make it work for cannabis.
Here’s how.
By Glenn S. Demby, Esq.
Context: The Contradictory & Confusing Cannabis Laws
Never for an instant forget that your owner is taking enormous legal risks by
leasing to you. Cannabis laws are complex and incredibly confusing. Here’s
a quick rundown of the key facts you need to appreciate when leasing
commercial property for your cannabis business.

Fact 1: Cannabis is currently illegal in most states—of course, that’s
changing fast.
Fact 2: Twenty-three states (and the District of Columbia) have laws
allowing doctors to recommend and patients to use cannabis for specific
medical conditions. In all but two of these states, licensed businesses can
grow and sell the medical cannabis patients need. Presumably, you’re
licensed or are seeking such a license in one of these states. Of course, you
could be in one of the two states—Colorado and Washington—that have also
legalized adult-use cannabis. Several other states are considering legalizing
medical or adult-use cannabis. (See below for a state-by-state survey of
cannabis laws.)
Fact 3: Selling and growing cannabis is illegal under federal law. Leasing to
you makes your owner part of a criminal enterprise and a potential target
for the local U.S. attorney, the U.S. Drug Enforcement Agency (DEA), and
other federal agencies, including the IRS. It can also get the bank that holds
the owner’s mortgage into trouble with federal banking regulators.
Fact 4: The federal government can enforce its anti-cannabis laws anywhere
in the U.S., including within states that have adopted cannabis laws. In
other words, the fact that a cannabis business is legal under the laws of
your state is no defense against a federal charge. In fact, U.S. attorneys
have gone after owners and tenants alike for entering into commercial
leases in medical cannabis states like Montana and California.
Question: Given these facts, why would any owner ever lease to a
cannabis business? For the answer, see Fact 5.
Fact 5: Current federal policy is to live and let live and not carry out
enforcement activities against cannabis businesses in states where those
activities are legal under state laws, provided that the state takes effective
action to keep legal cannabis out of the hands of kids and neighboring states
where it’s illegal. Congress is also trying to cut off DEA funding for federal
raids in cannabis states.

THE NINE LEASE PROTECTIONS YOU NEED
The current dormant state of federal enforcement makes it possible for
owners in cannabis states to lease to cannabis businesses; and the fact that
they can collect premium rents for taking these risks makes it profitable.
But while they have the potential to help both sides, cannabis leases can
also backfire if they’re not done right. Over the decades, the commercial
real estate industry has developed standard lease forms addressing the
different legal issues that arise between owners and tenants. Although it
provides the framework for a cannabis lease, the standard commercial
lease form wasn’t created with cannabis in mind. You need to rework
certain parts of the lease so it works for cannabis. Specifically, there are
nine clauses that need to be revised. We’ll review them below and give
you Model Lease Clauses: Make Sure Your Cannabis Lease Protects You from
Legal Risks.
1. Permitted Use
Problem: Every lease has a clause that lists the activities the tenant can
conduct on the premises. Normally, both sides are scrupulous about nailing
down these details. But when it comes to cannabis, owners and tenants
sometimes get skittish and prefer to gloss over the specifics. That’s a
big problem because if the permitted use isn’t clear, you run the risk of
accidentally breaking the lease by conducting an activity not permitted.
Solution: Don’t be cute and try to cover up what you’ll be doing with the
property. Indicate that you’ll be conducting a cannabis business and list the
cannabis-related activities that you’re allowed to conduct on the
premises, including:
• Prescription sale—list product form, e.g., bud, leaf, edible,
drinkable;
• Recreational sale (if you’re in Colorado or Washington)—list product
form;
• Cultivation—list maximum number of plants;
• Processing of plant parts and resin into products; and
• Storage for transport [Clause, Sec. 2].

2. Covenant to Comply with All Laws
Problem: Because cannabis is illegal under federal law, boilerplate clauses
requiring tenants to comply with all laws and making any illegal activity a
default of the lease won’t work.
Solution: The covenant needs to be modified to deal with the weird legal
dynamics of cannabis:
• You should be required to comply with all applicable state and
local laws, including but not limited to the state cannabis licensing
and program rules;
• Since compliance with all federal laws is impossible, you should
only have to comply with all applicable federal laws to the extent
they’re not inconsistent with your right to use the premises to run
a cannabis business; and
• It’s okay to leave in the parts of the boilerplate that require you
to comply with other federal laws that are not directly related to
the growth, storage, and sale of cannabis—for instance, the duty to
make reasonable accommodations for the disabled under the ADA
[Clause, Secs. 5.1 and 5.2].
3. Owner’s Early Termination Rights
Problem: The ever-looming threat of federal intervention makes cannabis
more volatile than other businesses and places an imperative on flexibility
not typically found in boilerplate leases.
Solution: The lease should include an exit clause that allows for both sides
to terminate the lease immediately and without further obligation to the
other if specified deal-breaking legal developments take place after the
lease is signed. The biggest challenge is defining the triggers.
Tenant triggers: You should be able to terminate early if new regulations,
fees, taxes, or other laws are adopted that make it illegal or commercially
impracticable to run your business. Expect owners to require specific,
detailed notice; they might even want a “rescue” option like cutting your
rent so that you can continue the lease.
Owner triggers: Your owner will probably want early termination rights in
the event that leasing to you results in federal criminal prosecution, seizure
of the property under federal forfeiture laws, “nuisance” prosecutions or
lawsuits, foreclosure by the owner’s bank, and/or tenant rebellions. Be

prepared to accept these triggers, but you may also want to make your
owner fight back and not simply roll over in the face of legal proceedings.
Thus, for example, the owner’s right to terminate could kick in upon not
the filing of but conviction for criminal charges [Clause, Secs. 1.1 and 1.2].
4. Mode of Lease Payments
Problem: Boilerplate leases typically require tenants to pay rent by check
or other financial instrument from a bank. Of course, banks are federally
regulated and thus not allowed to offer loans, checking, credit cards, and
other financial services to cannabis businesses. Even though the Obama
administration has loosened the restrictions, many cannabis businesses are
still having trouble getting access to financial services.
Solution: If you can’t get a checking account or credit card services, make
sure the lease gives you the right to make payments in cash.
5. Warranty of Suitability
Problem: Many standard leases include an owner warranty that the premises
are suitable for the tenant’s proposed use. Don’t expect your owner to
offer you such a warranty. Keep in mind that making premises suitable for
a cannabis tenant may require significant alterations, as well as approval
under building codes, zoning, state licensing, and other regulations.
Solution: List the improvements necessary to make the premises suitable
for your cannabis business. Be prepared to accept sole responsibility for
securing any necessary permits, licenses, and other approvals, but require
the owner to take all reasonable actions to cooperate with and support
your efforts, including providing information to state licensing and other
regulatory authorities. If you have the leverage, you might even try to
negotiate to have the owner pay part of the costs of securing the necessary
approvals [Clause, Sec. 3].

6. Tenant Improvements
Like casinos, cannabis establishments must meet elaborate security
requirements to get (and keep) an operating license. We’re talking exterior
walls, access barriers, wall-to-wall surveillance camera systems, exterior
lighting, etc. And if you intend to grow cannabis on the property, you’ll
also need to install special lighting, heat lamps, and other elaborate
environmental systems.
Solution: Make sure your lease specifically deals with responsibility for
improvements and alterations. Key questions to negotiate:
• Who’s financially responsible for making the necessary
improvements?
• If you pay costs out-of-pocket, how much, if anything, will the
owner reimburse you for improvements that will remain part of the
premises after the lease ends?
• Which, if any, improvements need to be dismantled at the end of
the lease and at whose financial expense? [Clause, Secs. 3, and 7.1
to 7.3]
7. Owner’s Right to Inspect
Problem: Standard leases give owners the right to enter and inspect the
premises to ensure that the tenant is complying with all lease requirements.
But state security rules require cannabis establishments to limit access to
storage, sales, and other sensitive areas. Result: You may not be allowed to
let the owner enter and inspect the way it does with its other tenants.
Solution: Establish a procedure that enables the owner to inspect but that
doesn’t force you to violate your duty to limit access to limited access
areas. One possible solution is to require the owner to be accompanied by
your own authorized employees—that is, employees or security guards who
are allowed to access limited access areas. If the owner wants the right to
take photos and video during inspection, make it promise to keep your trade
secrets and patient records confidential as required by HIPAA and other
privacy laws [Clause, Sec. 4].

8. Utilities & Other Operating Expenses
Problem: Indoor growing and storage of cannabis consumes copious amounts
of water and energy. According to Forbes, an indoor module for handling
four cannabis plants uses as much electricity as 29 standard refrigerators.
So don’t be surprised if the owner expects you to pay for excessive
consumption of water and electricity.
Solution: Although it’s fair and reasonable to pay for any excessive utilities
you consume, make sure you require the owner to:
• Disclose the building’s overall electric and water costs;
• Tell you what the baseline rate is for tenant consumption of water
and electricity;
• Set out a clear and fair formula for allocating excessive costs to
you based on your actual consumption; and
• Let you review utility bills to verify allocated charges [Clause, Sec.
6].
9. Common Areas
Problem: Owners typically worry that cannabis establishments will cause
smoke, odors, loitering, and excessive demands on parking facilities. As a
result, you may be asked to take measures to minimize risk of collateral
damage to common areas, including:
• Preventing employees and customers from consuming cannabis anywhere
in the premises or common areas;
• Using ventilation or other mechanical devices or systems to minimize
odors and keep them out of shared air circulating systems;
• Implementing measures to prevent loitering; and
• Appropriately disposing of waste products.
Solution: Although they may be more than the owner asks of its other
tenants, these measures are typically things you need to do anyway under
the cannabis program rules of your state. But if the owner asks you to
do more than the state requires, such as deploy 24/7/365 security guards,
you should probably negotiate for some kind of
cost-sharing arrangement.

Glenn S. Demby is a corporate attorney and award-winning legal journalist
who specializes in explaining the law in plain English and helping business
leaders overcome their regulatory challenges. He can be contacted
at glennsdemby@gmail.com. He thanks Professor Michael N. Widener, of
Bonnett, Fairbourn, Friedman & Balint, P.C., in Phoenix, Ariz., for his help in
preparing this article.
About the Author
States Where Cannabis Businesses Are and Aren’t Legal
Property owners can’t lease to a cannabis business unless growing and
selling cannabis is legal under your state’s laws. Nearly half of the states
allow this—in most states, medical is the only form of legal cannabis. Here’s
a look at the current legal landscape:
Legal to grow and sell medical and recreational cannabis:
Colorado
Washington
Legal to grow and sell medical cannabis:
Arizona
California
Connecticut
Delaware
Illinois
Maine
Maryland
Massachusetts
Michigan
Minnesota
Nevada
New Hampshire
New Jersey
New Mexico
New York
Oregon
Rhode Island
Vermont

Legal to use but not sell and grow medical cannabis:
Illegal to grow and sell cannabis:
Alabama
Arkansas
Florida
Georgia
Idaho
Indiana
Iowa
Kansas
Kentucky
Louisiana
Mississippi
Missouri
Nebraska
North Carolina
Notes:
• It’s legal to sell and grow medical cannabis in Washington, D.C.
• Florida and Pennsylvania are considering medical cannabis.
• California, Arizona, and Oregon are considering recreational cannabis.
Alaska
Hawaii
Montana
North Dakota
Ohio
Oklahoma
Pennsylvania
South Carolina
South Dakota
Tennessee
Texas
Utah
Virginia
West Virginia
Wisconsin
Wyoming

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