Negotiating the Dental Office Lease

Barry H. Josselson, a Professional Law Corporation, and A. Lee Maddox, DDS, a Professional Law Corporation

Copyright 2001 Journal of the California Dental Association.

The dentist’s office lease is one of the most critical legal agreements the dentist will sign in his or her professional career. Understanding the numerous economic and non-economic points of a lease is integral to the success of one’s practice. This article discusses 10 key points that will ensure a fair and equitable lease agreement.

The dentist’s office lease is one of the most critical legal agreements the dentist will sign in his or her professional career. Unlike associateship relationships, which can be terminated, or partnerships/corporations with other dentists, which can be dissolved, the dentist’s office lease cannot be ended unilaterally by the tenant or breached with impunity without the dentist’s incurring substantial legal risk, liability, and economic fallout. Accordingly, the dentist’s understanding the numerous economic and non-economic points during the course of negotiations with the landlord and the dentist’s attorney’s perusal of the dental lease are integral factors to the success of the dentist’s practice. Considering the following 10 key points will ensure a fair and equitable lease agreement and business relationship with a landlord for years to come.

Negotiability

The proposed lease submitted to the dentist is simply the landlord’s first offer of the terms of the contemplated relationship. Many dentists believe that because the lease offered to them is in writing or in a pre-printed form, it is not subject to modification or revision. Some dentists are wrongfully informed by their leasing agents that their proposed lease has been signed by all of the other tenants without revision (the incorrect implication being that the lease must be fair; otherwise, tenants would not have signed it). Nothing is further from the truth. All office leases are drafted in favor of the landlord; the only issue is whether the lease has been drafted slightly one-sided, moderately one-sided, or extremely and unilaterally one-sided in favor of the landlord. Lease provisions favoring the landlord, however, will not be prominently noted nor highlighted in the document. Instead, the dentist’s lease will be prepared by the landlord’s attorney or landlord’s real estate association to favor either their client or their constituents, respectively, and not to accentuate those lease provisions that have been intentionally drafted in favor of the landlord rather than the dentist tenant. Any agreement can be negotiated. An analysis of the lease and negotiations of the terms with the landlord need not be an acrimonious nor hostile event, but simply a first step in communicating to the landlord the dentist’s desire to have the landlord-tenant relationship be fair and equitable. Recommendation: The dentist should always consult with a real estate attorney specializing in dental office leases before signing any long-term leases.

Option to Renew the Lease

An option to renew is a wonderful tool to provide the dentist with flexibility. At the end of the lease term, the tenant has the "option" to remain in the premises by notifying the landlord of the dentist’s intent to stay. Or, to the contrary, if the dentist determines that it makes more sense to relocate to new premises, he or she reserves the right to leave without having previously entered into a longer-term lease. Options to renew, therefore, give one the security of a possible long-term lease without having to make a commitment to a long-term lease. Most options to renew are for periods from three to five years. The value of one’s option to renew, however, can be severely limited by the landlord in the following ways:

1. Many leases allow only the original tenant to exercise the option to renew, not any buyer of the dental practice. This limitation will not be conspicuously disclosed in the document. Instead, most leases innocuously state that the option to renew is "personal" or "unique" to the original "tenant" of the lease. If the proposed purchaser of one’s dental practice is not able to exercise the previously negotiated option to renew, this could adversely affect the value of the practice, especially if there are only a few years left on the dentist’s current lease. The risk that the current landlord might not renew the lease to the prospective buyer or that the lease may be renewed albeit at a substantially higher rental rate is significant and should be avoided.

2. The determination of fair market rent can also be fraught with risk. A careful perusal of the rental rate formula found in many options to renew reveals what appears to be an equitable definition of the fair market rental of the premises based upon current rents being charged for comparable space in similarly situated properties. However, the dentist must examine more closely many of these formulas. Some will state that the rental rate shall be the greater of fair market rental or the last year’s rental rate. The result: In an escalating rental real estate market, fair market value shall provide the landlord with great upside potential. In a falling rental real estate market, if true fair market rents are below the last year’s rental rate paid by the dentist, the lease mandates that the rental rate paid by the dentist during the option period shall still be the last year’s rental rate (even though such rental rate could be far in excess of the lower fair market rental rate).

Assignment or Subletting of the Lease

The assignment or subletting of the dental lease to a prospective purchaser is critical to the later sale of the dentist’s practice. Very few practices are sold to buyers who intend to move the practice to another location. Moving can cause substantial patient attrition as well as substantial costs in building out a new office. Therefore, the dentist’s ability to assign or sublet his or her lease freely and without unreasonable restraint to the buyer is crucial. The landlord can limit the dentist’s ability to assign or sublet the lease in the following ways:

1. If the lease states that the landlord’s consent "may be arbitrarily withheld," "withheld at the landlord’s sole discretion," or words similar in effect, the landlord can unilaterally withhold consent at the time that the dentist requests the lease to be transferred to his or her buyer. No buyer of a dental practice will consummate a sale without a long-term lease securing the investment the buyer has just made. Moreover, sophisticated dental lenders will not lend money to purchase the practice without the lease term (with an option to renew) being equal in length to the term of the practice purchase loan. Instead, the lease should state that the landlord’s consent "shall not be unreasonably withheld."

2. An increasing number of dental office leases provide that 100 percent of the rental income (received by the dentist subletting the premises) in excess of the rent obligation due under the lease (by the subletting dentist) must be paid to the landlord. The dentist should try to delete such obligation or negotiate a lesser percentage than 100 percent. Most importantly, the description of the "consideration" to be paid to the landlord should be limited to only sublease rental income and not any consideration for goodwill, covenant not to compete, or leasehold improvements received by the dentist when selling his or her practice. Otherwise, the landlord may legitimately claim a right to part or all of the practice sale proceeds received by the seller from the buyer of the dental practice.

3. The "recapture clause" gives a landlord the right to "take back" the premises even if the dentist has followed the protocol of first seeking the landlord’s approval of the proposed buyer of the practice prior to transferring the lease. Such a recapture clause innocuously states that the landlord can consent to the assignment or, in the alternative, assign the lease to itself in lieu of the proposed buyer. Such recapture clause is placed in leases and is exercised by landlords in escalating real estate markets or in those situations in which the landlord is not able to withhold its consent to the proposed buyer. Such a "recapture clause" must be stricken from the lease document.

4. Rent increases and repayment of tenant improvement allowances can be costly hidden surprises. When a dentist assigns his or her lease to a new buyer, the buyer has purchased the dental practice in contemplation of paying rent under the lease according to the selling dentist’s rent schedule negotiated at the time when the selling dentist signed such document. More and more leases have language in the documents stating that "as a condition for the landlord’s consent to any assignment," the landlord may raise the rent or be repaid by the selling dentist all of the money which the landlord spent for the leasehold improvements in building out the seller’s dental office. Such provisions are unacceptable and should be removed from the agreement.

5. All leases provide that the selling dentist’s assignment of the lease to another dentist will not release the seller from any liability if such buyer later defaults under the lease. The language that provides that the selling dentist shall remain liable should be deleted, especially since the landlord will have previously approved the buyer as a bona fide and qualified party to assume the seller’s lease.

Exclusivity

In some shopping centers or other facilities that are not solely dental- or medical-related, being the only general dentist or specialist in that building or shopping center can enhance the value of the dental practice and the attractiveness of the office lease. Many landlords will initially object to any efforts by the dentist to restrict their freedom to lease to any prospective tenants; however, the dentist’s limiting the scope of the exclusivity can mitigate the landlord’s reluctance to provide such exclusion. For example, the request for exclusivity as a general dentist would not adversely affect the landlord’s ability to lease to orthodontists, endodontists, periodontists, oral surgeons, or other specialists that could complement the general practice.

Relocation Clause

Many leases grant the landlord the right to relocate the dentist from existing office space to other premises within the building or center. Such clause permits the landlord to achieve higher occupancy by providing space to potential tenants who would otherwise not be able to secure needed square footage or a desired location but for the landlord’s right to move the tenant. If location is critical to the success of the dentist’s practice (for example, visibility to the public or existing patients), the dentist should delete the relocation clause from the document. At the very least, irrespective of the significance of the dentist’s office premises’ location, the landlord’s right to relocate the dentist should be subject to the following conditions:

1. The cost to rebuild the new premises to the condition of the dentist’s former practice should be borne entirely by the landlord.

2. The new premises should be substantially the same in size, dimension, configuration, decor, and nature as the dentist’s original office.

3. The landlord should not have more than one right to relocate the dentist during the lease term (including options to renew).

4. All of the costs incurred because of the relocation (new stationery, business cards, directory advertising, etc.) should be paid by the landlord.

Partial or Total Destruction of the Premises

This provision in the office lease is the most ignored and least understood by dentists and their legal counsel. Those California dentists who have survived the havoc earthquakes have wreaked on the state’s economy and their practices can attest to the relevance and impact of this clause. Damage and destruction clauses are significant for the following reasons: They identify the rights and obligations of the landlord and the dentist if the premises (or the building or shopping center in which the premises are located) are damaged by an "act of God" such as fire, flood, or earthquake. Such clauses allocate responsibility to the landlord or the dentist for repairs to be made to the premises, determine the right, if any, to terminate the lease, and dictate whether the dentist is responsible to continue to pay rent during the period when the premises are not available for occupancy.

The dentist can protect him- or herself in the following ways:

1. By specifying a period within which the landlord must complete the restoration of the premises with the dentist beyond when the dentist may have the right to terminate the lease. Because dental office leases uniformly state that the landlord’s obligation is to make repairs "as soon as reasonably possible" or to use "due diligence," such language does not give the dentist sufficient protection if the repairs cannot be made within a short period regardless of the landlord’s good faith efforts. If the dentist is unable to practice dentistry within, for example, six months from the date that the office was unusable, patients will find new practitioners to satisfy their imminent or urgent dental needs.

2. By making certain that the rent obligation will abate if the dentist is unable to use the premises during the time that it has been damaged. Rather than a rent reduction in proportion to the amount of square footage that has been destroyed or rendered untenantable, there should be a rent abatement based upon the percentage of lost production in the practice. If the dentist is unable to practice dentistry or generate any substantial revenue, the diminution in value of the premises is absolute and the dentist should have no rent obligation (regardless of the availability of part of the premises for dentistry).

3. By deleting language in the lease regarding rent abatement being a function of the landlord’s "rental interruption insurance" paying such deficiency. The dentist’s obligation not to pay rent should in no way be determined by the landlord’s procuring such an insurance policy or the insurance company’s election to pay such rental interruption proceeds to the landlord.

Right to Terminate

A properly drafted dental lease should recognize the frailty of health care professionals and the substantial likelihood of a long-term disability at some point in their careers. Accordingly, the lease should address the dentist’s right to terminate in the event of his or her death or long-term disability (whether partial or total). Such right to terminate exercisable instead by the landlord is not appropriate and should not be included in the lease. The dentist’s right to terminate the lease, however, would be exercised only in limited circumstances. As previously noted, the value of a dental practice is integrally tied to the dentist’s ability to assign the underlying lease to another buyer. The practice’s value would be substantially compromised if the buyer were not able to take over the existing lease. When then would it make sense to terminate one’s lease? It would certainly make sense to terminate the lease in a situation where the practice is a startup, and the disabled or deceased dentist does not have a "viable" practice to sell, but merely a dental practice location with equipment, leasehold improvements, and some patients’ charts and records. It would also make sense to terminate the lease in situations in which a selling dentist’s health history or cause of death (HIV, substance abuse) could dramatically affect the salability of the practice.

Pass-Through of Expenses

The dentist and his or her dental real estate attorney must thoroughly understand and precisely define the total rent obligation for the entire term of the lease. Few leases provide for only a basic monthly rent obligation. Instead, leases more commonly provide for a "minimum rent" to be paid to the landlord with a pass-through of "operating costs or expenses" associated with the operation and management of the building or shopping center in which the practice is located. The lease will provide that the dentist pays a percentage or "pro-rata share" of such operating costs. Such pro-rata share is generally determined by a fraction equal to the total square footage of the office divided by the total square footage of the building or shopping center in which the practice is situated. However, the dentist needs to be aware of the following nuances.

1. Leases vary among passing through all of the operating costs to the tenants, all of the operating costs in excess of the costs incurred in a certain "base year," and none of the operating costs. For example, if operating costs of one’s building were $100,000 per year in calendar year 2000 and $110,000 in calendar year 2001, note the substantial difference in the dentist’s responsibility for costs if based on 10 percent of the total square footage in the building. In the first scenario, the dentist would be responsible for 10 percent of all the operating expenses ($100,000). In the second scenario, the dentist would be responsible for only 10 percent of the increase in operating expenses ($10,000).

2. When the "pro-rata share" or fraction is computed for determining one’s liability for operating costs, the dentist needs to peruse how the denominator of the fraction is defined. Some leases provide that the denominator is the "total square footage then currently occupied and leased up" rather than "the total leasable square footage." Obviously, this subtle distinction can create economic trauma to the practice if the dentist is located in a building or shopping center with substantial vacancy. For example, if the dentist’s building has total "leasable" square footage of 20,000 square feet, and the dental office is 2,000 square feet, the dentist is then responsible for 10 percent of the operating expenses. However, if the building has substantial vacancy and only 8,000 square feet of the 20,000 square foot building is "then currently occupied and leased up," the dentist’s responsibility for the operating expense has increased from 10 percent to 25 percent because the denominator of the fraction has been reduced. Again, these nuances in legal drafting of documents are not highlighted or pointed out to tenants prior to their executing their lease agreements.

3. Nearly all dental office leases have all or some portion of the operating costs shifted to the dentist-tenant. There are very few leases that provide that the landlord is solely responsible to pay for the building’s operating expenses such as repairs, insurance, and property taxes.

Hold-Over Rental Clause

Leases provide for precipitous increases in rent when the dentist’s lease has terminated, and the dentist has neither exercised the option to renew nor vacated the space. In such a situation, the landlord may permit the dentist to remain in the premises albeit at a substantially increased rental rate (usually 150 percent to 200 percent of the rent at time of conclusion of the lease term). While dentists often believe that they would not fail to exercise their option to renew or would vacate the premises in a timely manner if they chose not to remain, the stark reality is that sometimes their moves do not occur as punctually as anticipated. Architects and general contractors for the dentist’s new space can be delayed in completing the project. Tenants can forget to exercise their option. They may endeavor in good faith to negotiate a new lease without success only to find these onerous rental rate provisions applicable to them. Recommendation: The application of such a penalty rate should be negotiated to occur only after a certain period of time (for example, 30 to 60 days) after the lease terminates; or there should be a substantially reduced penalty provision (125 percent) if there is no "grace period" of time before its being enforced.

Indemnification

All well-drafted leases provide that the tenant "indemnify, defend, and hold harmless" the landlord from any losses or damages that the landlord suffers because of the negligent acts or omissions committed by the tenant. Such an indemnification provision has nothing to do with the rendering of dental services. Instead, it is an acknowledgment that if a patient or employee becomes injured on the premises through no fault of the landlord, there is great probability that the landlord will be named as a defendant in any litigation. Until such time that the landlord can be dismissed from the lawsuit or judged not responsible for the injury suffered by another party, the landlord will be incurring legal fees and court costs to defend itself. This provision addresses reimbursing the landlord for its out-of-pocket costs. Recommendation: A reciprocal provision should be sought to protect the dentist in the event that patients, staff, or third parties are injured on the premises or in the building due to the negligence of the landlord or its failure to abide by the terms of the lease. Most importantly, office leases also provide that the tenant waive any rights it may have against the landlord for the landlord’s breach or default of the terms of the lease. Such a provision should be stricken in its entirety from the document.

Conclusion

Most dental office leases do not require extended negotiations between the landlord and the tenant’s dental real estate attorney. Adversarial, acrimonious, or divisive communications between the parties in consummating a lease are the exception.

Very few leases are truly non-negotiable. Leases are never offered to a dentist on a "take it or leave it" basis (even if real estate agents or other parties involved may present the lease in this way or intimate this position by the landlord).

Instead, rational and meaningful explanations made by the dentist and his or her dental real estate attorney to the landlord will confirm the seriousness with which the dentist is entering into this relationship and the thoroughness with which the dentist reviews contractual obligations. The dentist’s securing and obtaining a good lease protects the dentist and the practice during the time that the dentist owns it, plays a substantial role in the financial success of the practice during the dentist’s career, and enhances the practice’s value and the dentist’s ability to sell when he or she wishes to relocate or retire.

Authors

Barry H. Josselson is an attorney with law offices in Orange, Calif.; Walnut Creek, Calif.; and Sacramento, Calif. that specialize in business, real estate, estate planning, and insurance planning for dentists and other health care professionals. He currently serves as an instructor in the General Practice Residency Program at the University of California at Los Angeles School of Dentistry. He also guest lectures at the University of Southern California, UC San Francisco and Loma Linda University schools of dentistry

A. Lee Maddox, DDS, is an attorney with law offices in Orange, Calif.; Walnut Creek, Calif.; and Sacramento, Calif. that specialize in business, real estate, estate planning, and insurance planning for dentists and other health care professionals. He is a diplomate of the American Board of Endodontics and has served as an instructor at the University of Southern California and Loma Linda schools of dentistry Departments of Endodontics. He guests lectures at the USC, UC San Francisco and Loma Linda schools of dentistry.

To request a printed copy of the article, please contact: The Law Offices of Barry H. Josselson, a Professional Law Corporation, 1100 Executive Tower, 1100 Town & Country Road, Suite 810, Orange, CA 92868; (800) 300-3525; or bhjlaw@winstarmail.com.