You have found the ideal space for your company, you’ve generally agreed to business terms, and when you receive the draft lease, you see a clause about ‘indemnification’. There has been no mention of the word ‘indemnification’ and you have no idea what it means.
Like many terms you only encounter when you lease commercial space, indemnification is likely a new concept to you. If you ‘indemnify’ a lease, what you are doing is promising to reimburse the landlord if the tenant doesn’t fulfill the terms of the lease.
For example, if you sign a lease a five-year lease, of 5,000 sq. ft., paying $25.00 gross per sq. ft., on behalf of your company, the company is making a $650,000 (5,000 sq. ft. x $25.00 per sq. ft. x 5 years) rent commitment to the landlord in return for the use of the space.
If you agree to personally indemnify the lease, depending on the language of the clause or separate indemnity agreement, you may be promising that you will compensate the landlord for their loses if the tenant (your company) stops paying rent and is in default.
So, if your company is in default at the end of the third year of the lease because it is not paying rent, the landlord can seek damages for their losses from you (your personal assets) as the indemnifier.
These damages could include the remaining value of the lease – $250,000 (5,000 sq. ft. x $25.00 per sq. ft. x 2 years) and costs incurred finding a new tenant. The terms of the indemnity clause or agreement may even require you to pay back the remaining value of the lease if the landlord finds a new tenant before the end of your lease term.
So why would anyone agree to the financial exposure of an indemnity agreement? The reality is, it’s standard practice in Ottawa commercial leasing.
It’s About Risk
You see, when landlord’s lease a space, they may have to spend money on prepping the space for a tenants leasehold improvements (aka landlord’s work), leasehold improvement allowances, leasing fees, and legal expenses.
If a tenant breaks the lease before the end of the term, the landlord is not going to be able to recover the full value of the money they have invested in the lease.
As a result, they do their best to mitigate this risk with indemnification agreements.
If you have a new business or an existing business with financials that don’t give a landlord confidence, don’t be surprised if they ask for an indemnifier.
This is especially true if it’s a retail space because retailers’ rate of default is typically higher than industrial and office tenants. It can also be the case if there is a strong demand for the space, driven by low vacancy or the uniqueness of a property.
Ways Around Indemnification
If a landlord wants you to indemnify a lease, the best way to reduce your financial exposure is to minimize the landlord’s perceived risk of leasing you the space. Here are a few ways to accomplish this:
- Reduce the landlord’s upfront costs – for example, minimize the landlord’s work and reduce the leasehold improvement allowance.
- Increase the deposit amount – increase the deposit amount from first and last month’s rent to the value to of 3, 4, or more months of rent.
- Provide a letter of credit – a letter of credit or ‘LC’, is a contract created by your lender saying that they promise to compensate your landlord for their loses should your company be in default.
When There’s No Way Around It
Sometimes, there’s no getting around an indemnity agreement.
If that’s the case, do you best to:
- Reduce the amount of the indemnity – agree to pay back the landlord’s unamortized upfront costs and the rent until another tenant has leased the space.
- Introduce an expiry date to the indemnity – have the indemnity expire after a few years of faithfully paying rent and living up to the terms of the lease.
Do you have a question about indemnification? Please email me at jeff.daniels@royallepagecommercial.com
