Leases Grow Knotty Over Toxics Issue : Asbestos Problem Sometimes Has Role as a ‘Deal Buster’

When Cushman & Wakefield broker John Knott started leasing commercial real estate just five years ago, it was a relatively simple business.

Negotiations were dominated by economic issues, such as how much the rent would be and how much money the landlord would allocate for tenant-related improvements.

But while basic financial matters remain the core of negotiating today, several items that were barely mentioned just a few years ago now play a crucial role in the multimillion dollar bargaining between prospective tenants and owners of big office buildings and industrial complexes.

Concerns over asbestos, on-site toxics and fire-sprinkler systems are rapidly changing the face of the commercial real estate industry.

And increasingly, they’re becoming “deal busters�--brokers’ jargon for a stumbling block that simply can’t be overcome, even when all the other terms have been ironed out.

One easy measure of the complexity of negotiating today: The length of lease contracts for deals that have been worked out.

“After we’re done addressing all these new concerns, our leases are running 30 or 40 pages,� said Knott, who specializes in representing tenants working with Cushman & Wakefield’s West Los Angeles office. “Five years ago, you could say everything you needed to say in five or 10.�

Asbestos seems to be the most vexing problem. Widely used in construction from the 1920s to about 1970, it can cause cancer and other illnesses when disturbed and inhaled.

Assumed Responsibility

The mere presence of asbestos can have a dramatic effect on real estate deals.

When Shuwa Investments Corp. bought the landmark Arco Plaza downtown in 1986 for about $650 million, several brokers say the company got a discount ranging from $30 million to $50 million because it agreed to assume future responsibility for curing the asbestos problem and accepted liability for paying court-awarded damages to plaintiffs who may eventually sue.

Shuwa didn’t have to worry about financing its transaction; it paid cash. But some firms are having a tough time finding the huge loans usually needed to complete the purchase of an office complex, because a growing number of financial institutions simply won’t lend money on a building with asbestos in it.

Other lenders will only loan money on such projects if the borrower agrees to remove or repair any problems before escrow closes.

One main reason for lenders’ fears: “If a lender has to eventually foreclose on the property, it could be considered part of the chain of ownership,� said Doug Ring, who heads up the real estate practice for the Los Angeles office of the Shea & Gould law firm.

Potentially Costly

“Anybody who’s part of that chain could eventually be responsible for paying part of the awards made to plaintiffs who successfully file suit over an illness linked to the asbestos.�

As a result, Ring said, a lender pondering foreclosure on a building with asbestos is stuck in a potentially costly Catch-22 position.

If the bank refuses to foreclose, it won’t get its money back; if it does foreclose and takes back title to the building, it injects itself into the chain of ownership and could eventually be found liable for jury awards that could exceed the value of the loan itself.

Meanwhile, some tenants who are shopping for new office space are using the presence of asbestos as leverage to get a potential landlord to make concessions.

In buildings where loose asbestos must be removed or contained, Knott says he has usually been able to get the landlord to pay all the costs. “But that could change if the market tightens and space becomes harder to get,� he added.

Seek Reduced Rent

If a landlord won’t agree to removal or repair, says Knott, “some tenants will say, ‘fine, we’re going somewhere else.’ �

Others will still take space in a building with asbestos, but at a reduced rent. Knott says buildings with asbestos are renting for about 5% less than comparable buildings without it, even if the asbestos doesn’t currently pose a health risk.

Since removal can cost up to $35 a square foot--not much different than rents at many top-notch buildings and even more than rents at others--several building owners have been loath to take out asbestos that doesn’t currently pose a health hazard.

Likewise, many don’t want to initiate lawsuits against asbestos manufacturers because of the publicity and high attorney fees usually involved.

But such delays may prove costly to building owners in the long run, contends Jeffrey D. Masters, a partner in the real estate litigation department of the Los Angeles-based law firm Cox, Castle & Nicholson.

The chances of being sued by tenants will grow with each passing month, and there’s a good chance that the statute of limitations for the owner to sue the manufacturer will run out before the landlord files his action.

Then there’s the question of the manufacturer’s own insurance policy. “If you wait a couple of years, file a lawsuit and win, your claim is going to go behind all the other building owners who sued before you and won,� Masters said. “By the time you get to the front of the line, the company that insured the manufacturer might be broke.�

Although asbestos is the most widely publicized environmental issue facing the commercial real estate industry, other types of hazardous materials--from the cyanide used by jewelers to the solvents used by dry-cleaners--are also causing growing concern.

Increasingly, authorities are going after every party in a contaminated property’s “chain of ownership� to pay at least part of its cleanup costs.

“The clock starts ticking on the day the property is first contaminated,� said attorney Masters. “Anyone who owned the property from that point on can be held liable.�

As a result, commercial real estate investors are increasingly insisting upon a full “environmental audit� of a property that they are considering buying to see if it has been contaminated, said Alexis Fafenrodt, real estate law partner in the Los Angeles office of Rogers & Wells.

Proposition 65

“If a problem is uncovered, the investor usually won’t buy the property until the situation is resolved,� he said. “Even though the buyer didn’t have anything to do with the contamination, he doesn’t want to get stuck paying for the cleanup.�

Compounding the real estate industry’s toxics concerns is Proposition 65, the anti-toxics initiative passed in 1986. Since last February, the measure has required property owners to warn the public if certain chemicals known to cause cancer and birth defects are on their property. The law also allows judges to slap violators with fines of up to $2,500 a day for each exposure.

Since some of these chemicals are found in common building materials, some landlords are hiring consultants to determine whether they must notify tenants or visitors to their building about the possible dangers, Masters said.

Toxics on Premises

Some attorneys say greedy landlords could use another provision in Proposition 65 to evict tenants who signed long-term leases several years ago, and are now paying below-market rents.

The provision allows landlords to cancel the lease of any tenant who doesn’t notify the landlord of certain toxics that are on the tenant’s premises.

“It’s conceivable that a landlord might use this as leverage to raise a tenant’s rent or break the lease altogether,� Fafenrodt said. Adding to his concern: New chemicals may be put on the disclosure list that the tenant won’t find out about until it’s too late.

The Los Angeles City Council’s expected decision to require commercial landlords to install fire-sprinkler systems in the wake of last month’s fire at the First Interstate Bank Building raises an interesting question: Who must pay for it, the landlord or the tenant?

Most commercial leases contain a provision that makes the tenant responsible for complying with any government requirements when the lease is signed, as well as any laws enacted in the future.

But such broadly worded “compliance with laws� provisions don’t always stand up in court--especially when a landlord tries to get a tenant to pay for a big-ticket item such as a fire-sprinkler system.

No California court has specifically addressed the issue of compliance with a newly enacted sprinkler law, Masters said.

Key Question

But in other cases regarding costly items required by new laws, the courts have often decided that the landlord must pay for upgrading the building even if the landlord has a lease that says it’s the tenant’s responsibility.

One key question the court will ask: Who will derive the greater benefit from the alteration?

“If the tenant doesn’t have much time left on his lease and he doesn’t have option or renewal rights, the judge would lean toward making the landlord pay for the system because the landlord’s going to be there longer and would get the greater benefit of the alterations,� Masters said.

“But if it looks like the tenant might be there for another 10 or 20 years, or if he might wind up buying part of the building, there’s a better chance the court might rule that the tenant has to pay for the system.�

Depend on Language

Much will also depend on the specificity of the language in the lease.

“If there’s simply a clause in there that says, ‘tenant will comply with all laws,’ courts tend to look beyond the law and will let the tenant off the hook,� Masters said.

“But if the lease specifically says the tenant will be responsible for meeting any changes in the fire safety laws, there’s a much better chance that the tenant will have to pay for it.�

Not surprisingly, most of the leases that have been drawn up since the First Interstate fire contain language that specifically makes tenants liable for any changes in fire safety laws, Masters said.

Meantime, local commercial brokers say the First Interstate fire has potential tenants more interested in a building’s entire “lifesafety� system--not just sprinklers, but exits, location of fire walls, the actions of elevators when there’s a fire and related items.

“It wasn’t a big concern of a lot of my clients before last month, but now it’s one of the first things that come up,� broker Knott said. “And frankly, I’m happy that that they’re thinking about it.�