In the last issue of Real Estate Report, we provided some background and general guidelines for letters of intent (LOIs). The focus in this issue is more specific, and considers letters of intent for commercial lease transactions.
Letters of intent are routinely prepared in commercial real estate leasing because they can be a useful tool as a prelude to more formal negotiations. But there is risk in unduly focusing on LOIs in lieu of negotiating actual lease terms. It is important to understand that the LOI is a malleable framework, for better or worse, and heavily negotiating an LOI may inure to the benefit of an institutional landlord more than the future tenant.
An LOI, even though not binding, is beneficial because it can ensure there is a meeting of the minds on key business issues, such as the rent or lease term. In actual lease negotiations the parties tend to attempt to stick to the LOI because there is a shaming effect on the party that first breaks or ignores the LOI. A party that ignores an LOI is designated by the other party as “backing out of the deal,” “not keeping its word,” or “acting in bad faith.” This can lead to a breakdown in negotiations. LOIs, while typically non-binding, are very sticky as guidelines to the fundamental terms of the deal. That is why it is important to involve a lawyer during LOI negotiations as soon as possible.
A tenant should be cautious about engaging in extensive negotiations of LOI terms. A detailed LOI should not be seen as a condition precedent to entering into a lease or commencing negotiation of the lease form. Given the prevalence of institutional landlords in the leasing market, for the majority of smaller tenants there is an asymmetry of information between the landlord and the tenant at the LOI stage. The landlord knows the details of the lease form it will use and impose; the tenant does not. So the landlord is negotiating knowing the context and exact wording of the lease while the tenant generally will not have that context. Those who advocate the use of detailed LOIs argue that what is agreed to in the LOI can simply be dropped into a lease. But landlords are only willing to concede around the edges of their form leases and the details and context of the lease can often cut against the generic language that is pasted into the lease from the LOI.
There is a risk in detailed negotiation of specific business issues without the context of the legal terms. Negotiating both in context allows the tenant to negotiate all of its legal and business points at the same time with full knowledge of the landlord’s lease terms, and, ideally, to come to a better lease moving forward. As mentioned earlier, LOIs are malleable because they are non-binding. Even items such as rent and terms may be re-negotiated once the particular details of the lease are reviewed. A tenant may want a termination option or right of first refusal, which the landlord may be happy to concede in exchange for a longer lease term or different rent schedule. All the time spent negotiating those items up-front may be squandered as details of the lease and building emerge through negotiating the terms of the lease.
In addition, some of the initial goodwill and capital will have been expended at the LOI negotiating stage so there will be less to spend when negotiating the business and legal points together. For smaller tenants, the faster the basic business and financial terms can be agreed to at the LOI stage, the better the odds that the landlord will be willing to concede on some of the important legal clauses in the actual lease. Detailed business terms and legal terms are best addressed at the same time when the landlord and tenant have the lease form available to negotiate holistically.
At bottom, negotiating an LOI is a balancing act. There is a risk of going into negotiations entirely blind to the intent of the other party as relates to the term of the lease, the size of the premises, or the rent for the same, but there is also a risk in exchanging multiple detailed drafts of an LOI. Long negotiations of an LOI do not always lead to a positive outcome but it will always lead to additional expenses because a misunderstood detailed LOI will lead to protracted negotiations at both the LOI and lease stage.
Deal fatigue can set in from the start of LOI negotiations as opposed to when negotiations of the actual language of the lease commence. The longer the negotiation, the more likely the landlord will find another tenant, at which point all of the tenant’s time negotiating the LOI and expenses incurred during the process will have been in vain.
An LOI serves a useful purpose, but attempting to address too many items at the LOI stage, without the benefit of knowing all of the negotiating points in the lease, can be a costly waste of time. It is generally more efficient to keep the LOI high-level and then negotiate the business and legal points in the lease at a time when there remains goodwill between the parties and the knowledge asymmetry between the parties is significantly reduced.