One of the most important and perplexing decisions for most commercial tenants is deciding upon the duration of a new lease term. Should you lock in a 10-year lease to capitalize on the favorable terms currently being offered over the long term? Or is the flexibility of a shorter-term lease more desirable for your organization? Is there any way to get the best of both worlds?
“While the lease term is one of the more difficult real estate decisions to make, there are effective methods of creating flexibility which can mitigate the risks involved in a long term lease commitment,” says Matt Davis, associate at Guardian Commercial Realty.
Smart Business spoke to Davis about how to best maintain this flexibility in the current economic environment.
What are the risks associated with a long-term lease versus a short-term lease?
First, it’s important to note there are several distinct advantages to most long-term leases (seven to 10 years). Since landlords can amortize their costs over a longer period of time, there is typically a larger tenant improvement allowance, more up-front rental abatement and greater leverage during lease negotiations. And, in a down market, the greatest advantage is locking in lower rent for an extended duration. Given current rental rates are still at their lowest level in years, capitalizing on the market and securing those rents for an extended period can put a company at a competitive advantage should rates increase leaving competitors with higher expenses. Additionally, the security of knowing the space cannot be re-let to a different tenant during the term is also of great value. However, with these advantages come a degree of risk; an unforeseen budget reduction, acquisition opportunity, or corporate restructure could result in significant damages if a tenant is left with too much term and no way out.
If the risks associated with a long-term lease outweigh the benefits, many tenants will simply pursue a shorter term allowing for increased flexibility; however, less apparent are the inherent risks of a shorter-term lease — especially in the current economic climate. There are no caps on rental increases when your term expires, no guarantee the landlord will release the space (e.g., a larger tenant in the building may want the space for expansion) and reduced leverage for renegotiating. To the latter point, there are no loyalty programs in commercial real estate — if a tenant has been in the space for only a year to three years (especially if it has put its own money into improvements), the landlord, knowing full well the cost of relocating, will be less inclined to renew under favorable terms.
How can a tenant balance security and flexibility in its lease agreement?
The best way to maintain the security and extended savings of a long-term lease while retaining a degree of lease flexibility is to secure an early termination option. This option gives the tenant the ability to opt out of its lease at a pre-determined point in time or even at multiple points during the lease term. The risks of a long-term lease are substantially reduced given the ability to cancel the lease mid-term. Conversely, the more common approach of signing a short-term lease with an option to extend may protect a tenant from losing the space or from a reduction in rental rates, but does not protect against a market recovery or secure the additional concessions common with a longer term.
Furthermore, an early termination option can hedge against rental rate reductions by providing mid-term leverage to renegotiate terms. These options can be contingent on the landlord’s ability to provide alternative space that meets the tenant’s needs. Keep in mind securing early termination options can take time to negotiate. Expect the landlord to resist granting this option or propose a significant fee should the option be exercised.
What should the tenant expect to pay for an early termination?
The fee for a termination option is typically contingent on the out-of-pocket costs the landlord incurs when the lease is signed. Landlords typically request a fee reflecting the unamortized portion of these costs (e.g., tenant improvements, free rent and leasing commissions) with an interest rate factor, in addition to several months’ rent as a ‘penalty.’
The landlord’s typical request, however, takes into account far more than the equitable damages to the landlord. With reasonable notice (six to nine months), the landlord should have ample time to release the space, minimizing any interruption in its cash flow. Additionally, the unamortized portion of the out-of-pocket costs should be determined based on the market value of the transaction made at the time of lease execution. For example, if the tenant received at $25 per square foot TI allowance for a seven-year term, but by market standards the same allowance would also be granted for a five-year term, the unamortized costs should be zero if the early termination option is effective month 60.
Securing a reasonable termination fee may require time to negotiate and, when doing so, it’s important to denote its purpose — to reimburse the landlord for costs incurred as a result of providing additional concessions in exchange for the extended term. It’s also suggested to stipulate to a specific amount up front to avoid confusion years down the road if the option is exercised.
Are there other strategies tenants can employ to maximize flexibility?
Depending on a tenant’s particular growth strategy, there are several types of options and, with each, numerous ways to contour them to the tenant’s specific situation. However, these options typically play a greater role when a tenant has a general understanding of its future desire to expand or contract.
Subleasing can also be a viable option for recapturing expenses for unneeded space, but this too can come with its own set of challenges including time, up-front expense and exposure should a subtenant default. An experienced tenant representative can assist in managing a tenant’s expectations when considering subleasing its premises, and is a valuable and cost-effective resource when seeking maximum flexibility in a commercial lease.
Matt Davis is an associate at Guardian Commercial Realty. Reach him at (310) 822-2052 or [email protected].
