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LEASING LIABILITY
A Site Selection Web Exclusive, March 2010
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Life Sciences Industry
Property Leasing: A Primer

A real estate attorney details the idiosyncrasies of securing space for life sciences enterprises.

Leasing Liability
by Kevin A. Corbett
E

xciting new discoveries in biomedical sciences in the past decade, like the mapping of the human genome, have had an unintended effect on the real estate world — a growing need for laboratory or life sciences oriented real estate where scientific research can be conducted to develop new drugs, study disease process or exploit advances in such fields as genetics. The growing demand for life sciences related real estate is not a temporary phenomenon. Just as fortunes were made in transportation in the 19th century (railroads, steel and energy production) and in communications in the 20th century (telephones, computers and the Internet), in the 21st century great fortunes will be made in advances in life sciences research. What is the cure for AIDS worth? The potential economics of life sciences research virtually assures that research will continue to grow, and with it will grow the demand for laboratory and life sciences real estate.

Lab space users run a considerable gamut from giant, international pharmaceutical companies with unlimited resources on one hand, to a couple scientists with a good idea and a little capital — a VISA card with a $50,000 credit line perhaps — on the other hand. They all need someplace to work. The leasing of laboratory space is unlike the leasing of general office space or industrial space. Many provisions common in office or industrial leases simply do not work in lab space leases.

 In many cases, the lab space lease contemplates taking a cold, dark shell of a building and developing it into a fully functioning laboratory for world class research. Lab space can be very expensive to build. It is not unusual for the landlord's contribution to tenant improvements to be in the tens of millions of dollars for a single tenant, which may be more than the landlord paid for the building. The tenant improvement budget for high-end office space might be $80 per square foot. The budget for lab space can be $400 per square foot. The property may need a special water-filtration system, or rooms in which air pressure can be regulated. Often the properties require "cold rooms" and "warm rooms". There is always a wide variety of equipment, most of which is not recognizable by real estate lawyers and service providers. The work letters or agreements for tenant improvements in these leases are very elaborate, and many details, like whose money gets spent first or the timeline for construction, are heavily negotiated.

Several areas in a lab space lease deserve special consideration if the lease is to be effective in protecting the interests of the parties. Provisions in an office or industrial lease will not work well in the lab space context.

Here are some thoughts on those:

1. Landlord's Liability: It is not unusual in office leases for landlords to indemnify tenants against damage caused by the landlord's negligence or misconduct. In a lab space lease, this needs to be considered very carefully. A lab tenant on the verge of developing a cure to a given disease may have lab work potentially worth billions. The landlord cannot take the risk of being liable for the loss of the work product. If a landlord can be held liable for the loss of a scientific experiment worth billions of dollars, there is no reason to be in the lab space business. So it is prudent and fair to include provisions to the effect that the tenant is solely responsible for protecting its work product, and the landlord has no liability for any lab work which is lost, irrespective of the landlord's role in the loss. At the same time, it is prudent and fair in these leases for tenants to have far greater control over access to the leased premises than one would expect in office or industrial leases. The lease may provide that the tenant has the right to restrict access to all lab areas, and may permit the landlord to enter only with a tenant escort. If the landlord is not responsible for the loss of any work product, scientific experiment, loss of specimens or samples or loss of potential revenue because of anything that happens in the premises, then the tenant should be able to control who comes and goes in the lab.

2. Environmental Provisions: One thing is virtually certain about a lab space tenant: the tenant is going to use hazardous materials or "haz mats". There is rarely a question about that. Common office lease language to the effect that the tenant shall not use haz mats in the premises is not going to work. The major issue for the landlord is that the landlord knows about and permits the use of haz mats in the premises, but wants to get the property back relatively free of haz mat contamination at the end of the term. The tenant needs to use haz mats in the premises, but does not want to be unfairly stuck with the cost of cleaning up contamination by haz mats not caused by the tenant. After lab space has seen a few generations of users, it can be very dicey identifying who caused what level of contamination. So it is often in the interests of both parties to have provisions for doing careful testing of levels of haz mats in the premises at various times, especially at the beginning and end of the term. But what kind of testing?

A Phase I Environmental Site Assessment, the testing real estate lawyers are most familiar with, which tends to focus on the historical uses of a property, is practically useless to the owner or user of lab space. In a lab space lease, the landlord and tenant each needs to have a good environmental lawyer and a capable environmental consultant who is able to do periodic testing for haz mats and advise on the results of testing. Testing the property for the presence of haz mats at the beginning of the lease is helpful in establishing a baseline. Then periodic testing to determine if the property has become contaminated is necessary. It is useful to know what kind of haz mats the tenant intends to use in the premises, and to monitor for contamination by those materials. In addition, invariably a lab tenant will want to install an emergency generator to protect its work product from power outages, which will require a fuel storage tank, which raises issues of liability for fuel spills. Lab space leases raise environmental issues many real estate lawyers, even highly experienced ones, may have never confronted.

3. End of Term Plan: The typical provision in an office or industrial lease about returning the space at the end of the term broom clean and free of the tenant's property does not work for a lab user. Some lab tenants may have special licenses, for the use of radioactive materials, for example. Those licenses can take a year or more to surrender to the regulatory commission, which may be required before the leased premises can be decommissioned and re-let. Both parties benefit if a lease requires the tenant to start thinking about the surrender process long before the end of the term. If the landlord cannot lease the space after the end of the term because the space is still subject to some government regulation of the tenant, then the landlord may argue that the tenant is, in effect, holding over. The landlord may argue that the tenant should have to continue to pay holdover rent until the space is able to be re-let. The tenant may argue that the case in which the space has not been decommissioned is not addressed in the lease (which is probably true), so the tenant has no liability after the term. Some carefully drafted lab leases require the landlord and tenant to prepare an

"End of Term Plan" at least a year before the end of the lease term, identifying what needs to be done prior to the expiration date to turn the space back to the landlord in a condition to be re-let, and the time frame for doing those things. The End of Term Plan gets the parties focused on what will need to happen so that the tenant will not be potentially liable for holding over, or the landlord will not be stuck with real estate it cannot lease to a new user until regulatory compliance is achieved. Also, office space tenants can often be moved out of leased premises during the weekend before the term of the lease expires. By contrast, moving a lab tenant is often not a minor matter. It is not unusual for the tenant who is preparing to surrender lab space to begin relocating to its new lab home many months before the end of the term of its expiring lease. As a result, months before the end of the term of a lab space lease, a landlord may find that a tenant has only a skeleton crew (or no one) left at its property, which usually means there is no one around with authority to address specific concerns or problems with surrendering the space. The End of Term Plan can help keep the parties out of this situation.

4. Ownership of Improvements: In lab space leases, the question of whether the landlord or the tenant owns improvements is almost always a difficult negotiation. The cost of lab improvements is huge, and often the tenant is putting substantial sums of its own money into the improvements in addition to any allowance the landlord contributes. It can be difficult to figure out whose money paid for what. It can also be difficult to determine whether some lab equipment is a fixture of the building or not. Many things in a typical lab can be re-used by the next tenant. A tenant will usually argue that it is paying for the equipment (either through rent or through its contribution to improvements), and should be able to take the equipment when the tenant goes. Unlike leftover office furniture, which often has only salvage value, the lab equipment can be worth significant money. The landlord has a strong incentive to keep all the equipment it can keep, because fully built out and paid for second-generation lab space is very profitable for an owner to lease. The tenant may easily be able to use much of the equipment in its next lab home. The parties should be very specific about what equipment constitutes "Tenant's Personal Property" and what is part of the building (and belongs to the landlord). If possible, the parties should have an exhibit with a detailed list of Tenant's Personal Property, and then provide that the tenant shall take only Tenant's Personal Property at the end of the term. The preparation of that list may be daunting; it can be a very long list. But if the list is prepared carefully, it will avoid conflict between the parties over the question of who owns what.

5. Assignment and Subletting: Because many lab tenants are newly formed companies with big ideas, they often hope to develop something important and then sell the whole company to a major pharmaceutical company, which would involve an inevitable assignment of the lease to the entity acquiring the tenant. Or, they may plan to joint venture with other scientists, and want to be able to let third persons who are not employees of the tenant work in the premises from time to time. As a result, the commonplace lease provision to the effect that the tenant cannot assign or sublet without the landlord's consent does not work for these users. The parties should discuss the tenant's business plan. If the tenant intends to joint venture with other scientists, the lease should contain a provision permitting the tenant to share space with its venture partners without being deemed to have made an assignment or subletting. If the tenant hopes to be a corporate acquisition or merger target, the lease should describe certain "permitted transfers" of the leasehold which do not require the consent of the landlord.

The lease is a critical document for a landlord or a tenant of a life sciences property. Some provisions of a garden-variety office or industrial lease will not work well for the lab space situation. People negotiating these leases should be encouraged to be open-minded in considering provisions for this kind of agreement, no matter how accustomed one may be to seeing "typical" lease provisions. Life sciences space is a permanent part of the landscape of commercial real estate now, and will only continue to grow as a sector of the real estate economy.


Kevin A. Corbett is a partner in the Los Angeles—based law firm of Allen Matkins Leck Gamble Mallory & Natsis LLP, where he specializes in real estate transactions.


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