What Is a Master Lease Agreement?
A master lease agreement is a contract between a property owner and a tenant (also known as the lessee) for the leasing of real estate, usually on a large scale or for the whole of a property. With respect to multifamily properties, it is an agreement for the leasing of an entire property, such as an apartment building. The property owner, usually an investor or other entity with a sizeable worth, leases the property to the lessee. A master lease agreement is different from other leases in that the lessee may not be a single person living in the leased premises. Instead, a master lease agreement allows the property owner to lease the property to the lessee (tenant) and then, through a sub-lease to another party, permit that party to rent the property directly to residents.
Master lease agreements may be the result of a tradeoff the property owner or investor makes between short-term rental income and long-term rental income. Investors will often lease an entire property to a lessee for a period of 5 to 7 years for a monthly rent of approximately $10,000 per month, or such a rent as may be mutually agreed upon. The lessee then sub-leases the property for a much higher monthly rent, sometimes as much as $1,000 per unit, or such amount as may be mutually agreed upon or permitted under local laws and regulations. Practically speaking, the master lease agreement permits the owner to have a steady cash flow through the lessee , while the lessee can make a substantial profit through sub-leasing rooms in the property for a longer period of time. If local laws and official regulations allow for a full use of the property (as a multifamily residential unit), the lessee may retain the rights to the entire property as agreed under the master lease agreement.
Under all circumstances, however, a master lease agreement will permit the lessee to sub-lease the entire property or fractions of it, usually through a standard lease agreement and terms. The lessee often can control all aspects of the property during the lease term, such as maintenance, repairs, and rent collection. A master lease agreement is often pursued at the beginning of negotiations between a property owner and another party to invest in the property through a substantially high sum of money yet with a low rate of return. Through a master lease agreement, the property can be renovated and/or refurbished to secure higher payments as the property is more attractive to tenants.
As is the case with most investment and real estate deals, the successful completion of a master lease agreement depends greatly on the terms of the lease. Having an agreement drafted, negotiated, and finalized with the parties to a master lease agreement typically follows the negotiation and finalization of a general lease.
Advantages of Master Lease Agreements
One of the most significant benefits of a master lease structure for a multifamily property with an institutional owner is that it provides the ability for granular risk management. While public REITs tend to hold large, diversified portfolios across multiple markets, your large institutional owner does not have the benefit of this portfolio diversification when leasing its property. With a master lease, the owner and its property manager can customize the lease terms – which include standardizing the term for all leases for tenants on site, setting a maximum amount of rent they can charge on each apartment type, establishing a schedule of tenant allowances for apartments that you refurbish, and determining a minimum rent that the owner will accept from tenants. These variations go to risk management in that you can reduce the risk of identified market challenges. For example, if the overall occupancy rate on a property is significantly lower than the market average, this may have an impact on the rents that the owner will accept from tenants, and in those circumstances, the master lease can allow the owner to reduce the yearly rent by a set percentage as a result of this issue.
Tradeoffs to this approach include that the owner may require periodic appraisals to ensure that the master lease rent is reflective of the prevailing market rate. You also trade away some flexibility in lease negotiations with tenants because they will be subject to the terms of the master lease.
Another benefit of the master lease approach is that it provides the owner with a consistent cash-flow expectation. In a traditional model where the property is leased on an individual as-need basis, the owner does not always have a reliable indication of the expected cash flow. With a master lease, the owner knows exactly the minimum rent that will be paid, and this rent is guaranteed no matter how many units are leased or up for renewal during the lease term.
Master leases also allow owners to lock in a certain amount of annual rent increases on a property, which is important from a budgeting perspective. If the owner were to lease each apartment on an indentified lease term, it would have no certainty regarding the amount of rent that will be received in the 12th month of a one-year lease. As a result, it may have difficulty budgeting rent increases from one year to the next. Conversely, with a master lease, while the rent may be formally subject to negotiation on a yearly basis, it is more likely that it will increase on a consistent basis because the parties agreed to a formula for making adjustments.
Components of a Master Lease Agreement
The crucial components of a master lease agreement for multifamily properties are the parties involved, terms of the lease, responsibilities, and renewal conditions.
- Parties. As with any lease or property exchange, the first part of a master lease agreement is the legal naming of the groups involved in the transaction. This includes everyone who has stake in the deal, such as the owner of the property and the parties who will take on the obligations to the tenants. Other individuals or groups that might be included in this designation are the property manager and vendors.
- Terms. Each master lease agreement will have a different lifespan, but terms are important to set out. This means stipulating whether the lease is annual, five years, 10 years or more. Some might even be completely open-ended. The terms should also give specific dates when the parties are able to make changes to the terms or renew the lease. Typically, the terms will also contain information about what actions are not allowed in terms of the rental property.
- Responsibilities. A master lease also needs to describe the responsibilities of all three main parties: the owner, the property management and other third-party vendors who are part of the deal. The document should explain who can collect rent; how long the property owner must wait for payment before taking official action against the tenants; how the property management or other vendors can enter the apartments; and what permissions must be sought from the owner before the property management can make improvements, major repairs or lease changes.
- Renewal. The master lease agreement does not necessarily have to include stipulations for renewing the contract. However, many do set a period for which either the owner or the lessee can renew the master lease agreement. Often, this is a simple process by which the parties simply send a letter notifying the other of their intention to renew. In cases where this does not happen, the master lease can sometimes automatically turn into a month-to-month tenancy that allows for termination on 30 days’ notice.
Common Issues and Solutions
All parties involved in master lease agreements for multifamily properties should remember that challenges always exist, no matter how carefully the lease is crafted. Below are some of the challenges you will face during and after the execution of a master lease agreement:
Allocation of risk. The most common issue is the allocation of risk between the landlord and tenant. There is a reason that master lease agreements are commonly used for multifamily units: Multifamily properties carry some of the highest risks of default due to neighborhood changes, loss of rental income from bad tenants and irregular eviction proceedings. Too high of an allocation of risk to a landlord can leave the landlord vulnerable and sometimes unable to pay on its loan obligations.
Tenant default. If the tenant defaults on the lease, then the landlord must find another person or entity to lease the property, on the same terms, as soon as possible. Depending on how long it takes the landlord to re-lease the property on the same terms, the landlord could lose valuable rental income. A pro-forma analysis is a helpful tool when drafting a master lease agreement, but the landlord should also use it to estimate losses in the event that a master lease agreement is terminated or expires.
Eviction. The landlord has the right to evict the tenant for whatever reason is found in the lease. However, the landlord may not have enough cash to cover the delayed rental income while it is busy looking for another tenant. The longer the period of time between a tenant default and the start of another lease agreement, the more likely it is that the multifamily property tenant will be able to renegotiate the lease agreement.
Renegotiations. A good portion of negotiations over a master lease agreement will be focused on how to handle unexpected events that impact the landlord or tenant’s ability to pay rent. The tenant could want to renegotiate because of fewer tenants or vacancies in the building as a whole. At the same time, the landlord should be prepared to renegotiate if there is an unexpected repair that requires it to stop all non-emergency work on the property for an extended period of time.
Legal Issues in Master Lease Agreements
In addition to each party’s objectives, any specific legal issues associated with the property or the parties should be addressed. The most commonly discussed legal issue is whether the lessor is licensed or registered to operate a multifamily property in that state or municipality. For example, many large multifamily landlords own properties in a number of states. As the operator of a multifamily property, the lessor may be required by the state or municipality to register or obtain a license to operate a multifamily rental business. This registration may not be voluntary, meaning that the landlord cannot own a multifamily property in that jurisdiction unless it has obtained the required registration or license.
The question is whether the lessor’s lease obligations to the lessee under a master lease could include the requirement that the lessor ensure that it is registered to operate a multifamily property and that it is in compliance with all applicable state and municipal laws and regulations as a condition to the lessor being able to perform its obligations under the master lease. The primary reason for this is to ensure that if the property becomes subject to an enforcement action, the lessee will not be held liable for such action so long as the lessor takes the steps required by law and under the lease to operate the property legally.
The landlord of multifamily property needs to pay close attention to other regulatory issues that may be applicable to the property and may be the responsibility of the landlord but not the lessee. For example , there may be health or safety permits required for the operation of amenities or services related to the operation of the property, such as a swimming pool or game room. The Department of Housing and Urban Development prohibits the leasing of units in multifamily rental housing that is not "habitable." Public agencies that have subsidized the construction or financing of a multifamily property can have additional requirements before it is legal to rent the property. There may also be other federal or state law issues that apply. For example, many states have laws prohibiting smoking inside rental properties or the restricting of certain classes of tenants—like families with children—from a unit or a section of a property. If a landlord has similar restrictions on tenants, even if allowed by law, the ability for a tenant to have children can affect the tenancy under a master lease and therefore, those contemplated restrictions, if any, should be included in the master lease.
Lastly, a question that often arises with a private equity firm or lender is whether the lessee needs to be a licensed property manager. The answer is always yes. However, if the lessee does not have the experience or the ability to manage a property and intends to contract with a third-party property manager to actually operate the property, there are often practical considerations that impact each party’s negotiation strategy. Other issues, such as the type of management entity the lessee should be are sometimes tied to state or municipal laws. For example, some states have restrictions of how closely a property management company can be controlled by the landlord of the property.
Successful Master Lease Agreement Examples
To further understand the intricacies and benefits of a master lease agreement, let us examine three different hypotheticals where a master lease agreement has been successfully implemented.
Case Study 1: Single Family Home Portfolio
An investor client has set out to acquire single family homes in an expanding, urban market. The investor has determined this market is ripe for growth due to the urban area’s increased quality of life offerings, job creation, and economic health. The investor’s plan is to acquire single family rental houses at discounted prices, renovate them and subsequently lease them for rental income as well as appreciation of the homes’ value. In order to make the economics of the property work given the high up front costs associated with renovating the home, the investor would need to lease the property at a rental rate that would equal or exceed the anticipated expenses, including debt service, taxes, insurance, maintenance and reserves. In order to secure a guaranteed rental reimbursement equal to such expenses, the investor decides to enter into a master lease with a property management company.
The investor negotiates a market level master lease with a two year term with its property management company. The lease provides that the property management company shall make annual guaranteed payments to the investor in an amount generally equal to the homeowner’s monthly mortgage payment. The property management company, in turn, guarantees the investor on a personal basis that it will deliver gross rents at or above the guaranteed payment obligation. The property management company now owns the master lease and is responsible for determining and collecting the gross rents and turning over the net rents to the investor in an amount no less than the guaranteed payments. For tenant placements, the property management company has three standard options to place a tenant: (i) pay the investor an upfront placement fee, (ii) pay the investor a higher percentage of the monthly rent collected by the management company for the remainder of the lease or (iii) retain the right to keep any additional rent collected above that amount contractually guaranteed to the investor.
Case Study 2: Existing Apartment Complex
An investor client wishes to purchase a large, existing apartment complex with good cash flow and significant required repair and maintenance. According to the investor’s business plan, the investor would like to concentrate on increasing the occupancy and increasing the tenant base for the existing property. Once the property has been stabilized, the investor plans to renovate the units and increase the market rents. Since the investor plans to renovate the property over time and further, until additional renovation and reduced occupancy becomes necessary, he does not want to place significant cash reserves into a property renovation reserve. The investor seeks to lease the entire property to a third-party property management company to continue to operate the property, including paying bills and property repairs and maintenance. The investor desires to realize a higher return on investment during the lease term than the existing property currently produces while providing the third-party management company with the maximum opportunity to increase the rents and tenant base.
The parties agree to a master lease agreement with a five year term and a base rental stream equal to the existing cash flow generated by the property. The management company’s rental obligations increase each year over the term of the lease, providing the investor with an annual increase in cash flow to finance the required repairs and renovations. To further incentivize the management company, the management company may apply $5000 per month of additional rents in excess of the base rentals toward deferred maintenance and major capital improvements to be used on a first out basis. To mitigate the risk of default, the investor requires the management company to lease the property to tenants at or above the then-market rate and maintain occupancy at lease 95%. The management company further agrees to an agent to principal relationship, meaning that any additional cash flow above the rent amounts guaranteed to the investor shall remain with the management company and not be shared with the investor. This, coupled with the per unit maintenance costs the management company agreed to pay for each unit under lease in excess of the guaranteed rental amounts, provides the management company with an opportunity to realize a profit while also increasing the overall value of the property.
Case Study 3: Owner-Occupied Property
As a final example, consider a prospective property buyer client who wishes to acquire multiple apartment complexes located in close proximity to one another in order to consolidate the management of the properties into one apartment management company under a master lease agreement. As the owner of multiple properties, the client needs to ensure ongoing cash flow to fund the acquisition of each property so as to satisfy the client’s existing obligations to lenders and others. The client further needs relief against the loss of cash flow due to vacancies and the required maintenance of the units during an overall down-rental market. Enter in a master lease agreement, which is similar to the examples above, however, in this example, the client is a tenant becoming the master landlord.
The owner proposes to lease the multiple properties to one of its existing management companies to operate the properties and provide tenant placement services. The owner is willing to bear the risk of reduced occupancy, however, would like to secure the cash flow necessary to meet its obligations to lenders. The owner therefore proposes a very long term lease (10 years) with annual increases in the rate and a substantial termination penalty tied to the properties’ fair market value. The management company agrees to pay a market fee for the purpose of managing the properties, which amounts to the lesser of the market fee or 75% of the net rents to be generated by the units under lease in any month. The owner further agrees to retain 25% of the net rents for the properties. The owner has achieved its goal of securing the cash flow to continue to operate and pay debt service on the properties, and the management company has acquired the rights agent to principal, under which they can retain the net amounts in any month in excess of the agreed amounts. This structure achieves a win-win for both parties, whereby the owner secures the cash flow to meet its obligations and the management company has a significant cash incentive to maximize the rents and occupancy of the properties.
How to Create a Master Lease Agreement
The following is a step-by-step guide for drafting a master lease agreement for multifamily properties:
Identify your objectives by conducting an initial analysis of your needs, desires, and goals with respect to the property. For example, if you are a landowner wishing to lease a property, you will want to protect your asset. If you are a property owner in need of financing, you may require the flexibility to encumber the property.
Decide upon the basic structure of the deal. How do you envision operating this property? Consider the lease term and any option to extend. What is the rent structure? Will you need to incorporate profit-sharing provisions as part of any lease payment?
Think about whether an existing lease agreement is providing you with the results you need . Would a new lease be better, or will an amendment suffice? It depends on the terms of your existing agreement.
Consider the pros and cons of assignment. If your deal involves multiple properties and parties, this is especially relevant. How will insurance issues be handled?
Explore whether the offeree is interested in purchasing the property.
Review the property and analyze relevant physical and legal factors.
Understand relevant local laws, regulations, and ordinances.
Involve legal professionals at an early stage of negotiations.
Be in touch with lenders.
Exchange drafts with all parties.
Be prepared to complete all of these steps within a certain timeframe.
Be in touch with lenders.