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The acquisition of commercial real estate in Ontario presents complex legal and financial considerations, particularly where properties are subject to existing leases.

Purchasers must be aware that, under Ontario law, where they have actual or constructive notice of an existing tenancy, they generally assume the role of landlord upon closing and become bound by the rights and obligations set out in the lease. This doctrine is supported both by common law and by statutory provisions, including Section 3 of the Commercial Tenancies Act (the “Act“).¹ In effect, the lease ‘runs with the land’, and purchasers may be exposed to ongoing or unforeseen liabilities or obligations if they do not conduct proper lease due diligence.²

This article outlines critical aspects of lease due diligence that prospective purchasers should address when evaluating commercial real estate transactions. Effective diligence not only safeguards against unexpected liabilities and obligations but also helps to facilitate strategic planning for asset management, redevelopment, and leasing flexibility.

1. The Basics: Who, What, When and Where

A proper due diligence process begins with a comprehensive understanding of the lease’s core components. These fundamental elements form the basis of the contractual relationship between the landlord and tenant. Confirming these details early enables more accurate risk assessment and helps ensure consistency between documentation and reality.

Key items to verify include:

• Parties (Who): Ensure the correct legal names of the landlord, tenant, and any guarantors are used. Conduct corporate searches where necessary to confirm identities and legal capacity.
• Premises (What): Verify that the description of the leased premises matches legal title, survey plans, and actual occupancy. Check for any rights to use additional or common areas.
• Location & Boundaries (Where): Conduct a physical inspection to identify discrepancies between the legal description and the actual space used by the tenant.
• Term (When): Confirm the lease’s commencement and expiration dates, including any options to renew, extend, or terminate early.

2. Rent Roll and Financial Reconciliation

The rent roll is a key financial snapshot of the property. It reflects income expectations and helps the purchaser assess cash flow reliability. However, the rent roll provided by the seller must be carefully scrutinized and reconciled with other documents. Discrepancies can signal side agreements, misstatements, or non-compliance with lease terms.

Consider the following steps:

• Review the rent roll: Ensure it includes all tenancies, rent amounts, escalations, and inducements.
• Reconcile with lease documents and estoppels: Compare the rent roll against the leases and any tenant estoppel certificates for accuracy.
• Identify undocumented arrangements: Investigate any irregularities, such as unusually low rent, inconsistent terms, or absent escalation provisions.

3. Estoppel Certificates

Estoppel certificates are essential tools in commercial property due diligence. These certificates provide a binding summary of the lease’s key terms from the tenant’s perspective and are relied upon by purchasers and lenders to confirm the current state of the tenancy. A signed estoppel certificate generally prevents the tenant from later disputing the facts it contains, thereby reducing the risk of post-closing surprises, although it is not meant to amend the terms of the lease.³

As part of the diligence process, purchasers should:

• Request estoppel certificates from all tenants, particularly major tenants (i.e. those with large premises or long-term leases).
• Confirm material terms, including rent, expiry date, renewal rights, security deposits, defaults, rights of first refusal or offer, and whether there are any undocumented agreements.
• Reconcile information against the lease and the seller’s rent roll, and investigate any discrepancies or omissions.
• Seek alternative confirmations (e.g., statutory declarations or seller warranties) if estoppels are not obtained from a tenant.

4. Tenant Purchase Rights: Rights of First Refusal, First Offer, and Options to Purchase

Certain leases may grant tenants a right of first refusal (ROFR), a right of first offer (ROFO), or an option to purchase the property. These rights can materially interfere with a purchaser’s ability to complete or structure the acquisition of the property, or to freely deal with the property in the future. These rights may also create uncertainty for lenders and investors, particularly if they are triggered by a transfer of control or interest in a broader corporate transaction.

Purchasers should:

• Conduct a comprehensive review of tenant purchase rights, including whether they are one-time or recurring, and whether they bind successors and assigns.
• Secure written waivers of any such rights, or ensure evidence is provided that the tenant has declined to exercise them following proper notice.
• Include representations and warranties from the seller in the purchase agreement confirming that no such rights remain outstanding or unaddressed.
• Evaluate how these rights may affect future divestiture, refinancing, or restructuring, particularly in REIT or fund environments.

5. “Go Dark”

“Go dark” provisions entitle tenants to cease business operations at the leased premises without triggering a default under the lease. Although the tenant may continue to meet rent obligations, such clauses may significantly diminish traffic, the income potential, tenant synergy, and marketability of the asset, particularly in retail or mixed-use developments.

From an asset management and valuation perspective, dark premises can have negative cascading effects on co-tenancy clauses, common area contributions, and overall property perception.

The due diligence review should:

• Identify whether the go dark right is absolute or conditional, and whether it applies only to the original tenant or is assignable.
• Confirm whether base and additional rent continue to be payable during periods of non-operation.
• Assess whether the landlord is granted any remedies, such as recapture or termination rights, in response to tenant cessation of operations.
• Evaluate broader implications, including compliance with anchor tenant co-tenancy clauses or lender covenants.

6. Early Termination and Relocation Rights

The lease should be reviewed to determine if there are any early termination rights in favor of the tenant and the landlord. From the purchaser’s perspective, having early termination rights in favour of the landlord can be advantageous; especially where redevelopment or repurposing of the property is envisioned. Conversely, early termination rights in favour of the tenant could risk sudden vacancy and loss of income. If there is a desire to rearrange tenants in the property to accommodate for new tenancies or as part of redevelopment of the property, purchasers should also consider if the lease provides for any relocation rights in favour of the landlord.

Sophisticated review entails:

• Identifying any termination rights held by either party, including whether they are conditional, unilateral, or triggered by specific events (e.g., failure to meet sales thresholds, redevelopment plans).
• Understanding required notice periods and termination fees and determining whether such costs are commercially reasonable or negotiable.
• Evaluating relocation clauses, including the landlord’s ability to substitute equivalent premises, tenant approval rights, and associated compensation or allowances.
• Assessing whether these rights align with the purchaser’s intended use or redevelopment objectives, or conversely, whether they introduce undue flexibility to tenants at the purchaser’s expense.

7. Operating Costs

Operating costs form a crucial component of a commercial lease, directly impacting the landlord’s net income. These costs typically include property taxes, insurance, maintenance, utilities, and management fees. Understanding how these costs are defined, allocated, and recovered is essential to accurately assess the financial obligations that will be assumed by the purchaser.

Key considerations include:

• Lease Structure: Confirm whether the lease is gross, net, or a hybrid. Net leases often allow landlords to pass operating costs on to tenants as additional rent, whereas gross leases typically do not.
• Definition of Operating Costs: Review the lease’s specific inclusions and exclusions. Some leases exclude capital expenditures or structural repairs from tenant recoveries, which can increase landlord expense.
• Cost Allocation: Understand the basis for allocating costs among tenants – usually by rentable square footage or a fixed percentage – and whether certain tenants (such as anchors) are treated differently.
• Recovery of Capital Expenses: Determine if and how capital improvements are amortized and recovered from tenants, as this can affect cash flow timing.
• Audit Rights and Caps: Review whether tenants have the right to audit operating cost statements and whether there are any caps on annual expense recoveries.

A clear understanding of these provisions ensures purchasers can accurately forecast ongoing expenses and avoid unexpected financial liabilities.

8. Use Restrictions, Exclusivity Clauses, and Competition Law Considerations

Use restrictions and exclusivity clauses define permitted tenant activities and protect tenants from competition within the property. While these provisions help maintain tenant mix and attract anchor tenants, they may limit the landlord’s flexibility in leasing the property.

Key points to review include:

• Permitted use clauses: Ensure tenant uses comply with zoning and align with the purchaser’s plans.
• Exclusivity rights: Identify any clauses preventing leasing to competing businesses, which can affect future leasing opportunities.
• Restrictive covenants: Check for obligations limiting the landlord’s ability to lease other spaces.
• Competition law implications: Recent legislative amendments, including those introduced by Bill C-56, have strengthened the scrutiny of agreements that may substantially lessen competition. Exclusivity provisions that unreasonably restrain trade or limit market competition could be challenged, impacting their practical effect.

A comprehensive understanding of these provisions enables purchasers to anticipate potential legal and operational constraints, facilitating informed decision-making and strategic planning.

9. Tenant Inducements and Outstanding Landlord Obligations

Tenant inducements, such as improvement allowances, landlord’s work, free rent or fixturing periods, or relocation payments, are frequently offered during lease negotiations. If not paid/completed before closing, the purchaser may inherit the responsibility for these financial obligations.

Purchasers should:

• Identify all inducements provided under the lease, including those still outstanding.
• Verify the status of landlord-funded obligations, such as buildout allowances or incentive payments.
• Require appropriate adjustments in the purchase price, escrow arrangements, holdback periods or seller indemnities.
• Confirm inducements with tenants, ideally through estoppel certificates.

Conclusion

Failure to conduct comprehensive due diligence when acquiring commercial properties encumbered by leases can expose purchasers to significant and unexpected liabilities. In Sandhu v Paterson,⁴ for instance, the purchaser sought a court declaration that the tenant was unlawfully occupying the premises after the purchase, asserting ignorance of an existing written lease. The Court rejected this argument, finding the purchaser was willfully blind by failing to make reasonable inquiries despite having notice of the lease. As a result, the lease, and all its terms, were upheld as valid and binding.

This case underscores the critical importance of thorough lease review and diligent investigation during the acquisition process. Meticulous due diligence not only informs sound investment decisions but also protects purchasers from inheriting undisclosed obligations and mitigates potential risks post-closing.

If you are a purchaser looking to further discuss the lease due diligence process or require additional information, please feel free to contact Alex Kolandjian and Aida Nabavi for assistance.

_{This publication is intended for general information purposes only and should not be relied upon as legal advice.}

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1. R.S.O. 1990, c. L.7.

2. Harvey M. Haber & Robert D. Malen, Assignment, Subletting and Change of Control in Commercial Leases (2023), p. 16 [Haber & Malen 2023]; Taylor v Stibbert, (1794), 20 E.R. 713, 2 Ves. Jr. 438 (Eng. Ch. Dv); See also Protective Holdings Ltd. v. M & P Transport Ltd., 1969 CanLII 733 (AB CA) at 726.

3. 6056628 Canada Inc. v. 2350894 Ontario Inc., 2019 ONSC 1329 at para 32.

4. 2016 ONSC 1748.