Whether to buy or lease is a question real estate professionals hear from business owners all the time. It’s a difficult decision that’s based on several factors.
You should evaluate your needs, as well as your personal and business goals, with a qualified real estate consultant, says Joseph V. Barna, SIOR, principal at CRESCO Real Estate. Also, understand your motivation drivers — are you interested in the bottom-line cost of occupancy, long-term ownership, image or flexibility?
“You need to step back and look at where you’re at, where you want to go, and how important your personal goals on the ownership side are in order to understand the best manner in which to invest your money,” he says.
Smart Business spoke with Barna about what propels owners to buy or lease.
What drives owners to buy?
One example would be if you are in a specialized industry and you’re going to make a significant investment in the space’s infrastructure. You don’t want to be unable to come to terms on a down-the-road lease renewal or expansion and have to reinvest in another building.
Another scenario is that you don’t anticipate long-term future growth and the facility you identify is in a desirable location that meets your projected needs.
Many times, the deciding factor is whether you can buy a building, ‘right.’ If a building can be acquired in the lower range or below market value and/or combined with market-driven incentives, the opportunity is worth serious consideration.
Sometimes it comes back to pride of ownership. In Northeast Ohio, we are fortunate to have a wealth of successful entrepreneurs who want to own their real estate simply for pride or a desired image, even if they have to pay a premium for it.
Why do business owners decide to lease?
One reason would be that your space requirements could fluctuate, so you don’t want to be locked into a building. Often this can be market driven; your business grows when the market’s healthy and contracts when it’s not. Also, many large national or global companies lease space because they don’t want to be in the real estate business and worry about selling a property when they decide to relocate.
You also should look at the return on investment. In real estate, a typical return for a market transaction would be 8 to 13 percent on the property’s value. However, if you have a dynamic business that’s getting a 25 to 30 percent margin on your products, it may be better to put your cash into increasing manufacturing and market share for the higher ROI. In addition, our financial markets have changed over the past five years. In most cases, traditional real estate financing has higher equity requirements, such as 25 to 35 percent down, which could also be a deal killer.
How can a lease-purchase analysis help?
To determine the actual cost of occupancy, bring in a qualified broker or consultant to run a lease versus purchase analysis. On the lease side, you look at your base lease rate, utilities, pass throughs and any other additional costs. On the sale side, you’re weighing your equity requirement, mortgage payment, property upkeep, maintenance, insurance and taxes. The analysis gives you a clear-cut idea of whether you’re better off leasing or buying.
The final decision will not always be the lowest cost alternative, but this analysis will at least let you know where you stand based on the cost of occupancy. Then you can consider other factors, like proximity to your customer base as well as employees, flexibility and personal objectives.
How far out should you start considering whether to lease or buy?
The perfect situation is at least one-and-a-half to two years ahead of when you need to make a decision. You need to understand the current market trends, all of the logical lease and sale alternates and the price of new construction, while projecting where your business will be in five or 10 years combined with personal objectives. You can go into the market and identify the perfect alternative, but it could take a year to consummate a transaction — and even more time if you’re building new, retrofitting or applying for government incentives. If you let that fuse get too short, it limits your alternatives.
Joseph V. Barna, SIOR, is a principal at CRESCO Real Estate. Reach him at (216) 525-1464 or email@example.com.
Get analysis of trends in the industrial and office real estate markets by downloading our quarterly Market Beats report.
Insights Real Estate is brought to you by CRESCO
You’ve been in business for several years and it is profitable. You have a decision to make: Do you want to invest in the business and buy a facility, or will you continue to lease?
With the help of your accountant, you should carefully examine the anticipated capital requirements of your business. Evaluate your ability to obtain capital or loans. Don’t box yourself into being cash poor and unable to meet business obligations or take advantage of opportunities.
“The prevailing reason that businesses fail is insufficient capital. Draining capital to pay for a real estate project could be a cause,” says Howard N. Greenberg, managing member at Semanoff Ormsby Greenberg & Torchia, LLC.
“My colleague, Jeffrey Rosenfarb, a principal in Hart Corporation, a national industrial real estate firm, advises that small manufacturing firms overwhelmingly desire to own versus rent, whereas larger corporations generally prefer leasing.”
Smart Business spoke with Greenberg about some pros and cons of leasing or purchasing industrial real estate.
What issues should be examined when considering purchasing a facility?
First, what’s the nature of your business? Manufacturing that utilizes heavy, difficult-to-move equipment is where purchasing may be desirable, to avoid being at a landlord’s mercy when your lease expires. Or is it light manufacturing or distribution, that moves easily?
Second, can you obtain a facility that will remain adequate for your needs? Plan for potential future expansion. Have your counsel review the local zoning code to determine what can be built, either now or in the future.
Do you contemplate children in the business? Real estate can provide a source of income and inheritance. Counsel will need to prepare an agreement that deals with numerous issues including governance, death, disability, termination of employment and sale of the business.
Where do you want to invest your limited capital? Be sure that you will not need capital to expand your business versus acquiring a building. Lending rates are at historic lows, encouraging acquisition. Consult counsel concerning special types of financing such as tax free industrial development or state-provided financing, as well as tax abatements.
What issues should you consider if you determine to lease?
Check locally to ensure there are adequate reserves of industrial rentals available. With any lease, secure options to: extend the term; terminate early; purchase the building; for a right of first refusal; and for the ability to assign the lease or sublet in connection with your business sale.
If I decide to purchase, what entity should purchase the property, and how should the lease be structured?
Keep the building owner entity distinct from the entity that occupies it. The building owner entity should be a limited partnership, limited liability company or S corporation to enable you to utilize tax advantages like depreciation and amortization, and to permit gifting. Also, you may want to divvy up interests differently in the operating company versus ownership in the real estate company. You could decide to bring a partner into your business, but not into the building ownership.
You will need a lease between the two entities, especially if you’re going to sell the business and not the real estate. As a landlord, limit the tenant’s options and set a reasonable term.
Does new construction make sense versus purchasing and rehabbing an existing building?
With new construction or significant rehab, you must have a reliable contractor and architect. Assume that it’s going to cost at least 15 percent more and take 15 or 20 percent longer than initially estimated. Weigh the aggravation of new construction versus having your building the way you want. However, over the past 15 to 20 years, sale or leasing of existing facilities has far exceeded new construction, per Rosenfarb.
Buying and holding an industrial property usually works out well for the owner. For heavy manufacturing, building ownership, or a long-term lease with renewal options, is the way to go.
Howard N. Greenberg is a managing member at Semanoff Ormsby Greenberg & Torchia, LLC. Reach him at (215) 887-0200 and firstname.lastname@example.org.
Insights Legal Affairs is brought to you by Semanoff Ormsby Greenberg & Torchia, LLC
It’s a common mistake that business owners make: waiting too long to address an expiring commercial real estate lease. Sometimes the time just gets away from them. In other situations, they might even think they can sign a quick renewal and be done with it. Whatever the reason, waiting until the last minute is a sure way to leave money on the table.
“I am often asked by business executives when they should start addressing their expiring leases,” says Robert Chavez, founder and CEO of Guardian Commercial Realty. “While the answer varies depending upon circumstances, the time to start due diligence is much sooner than most expect.”
Smart Business spoke to Chavez about how timing is everything when renewing a lease.
Why is it important to begin early when addressing expiring leases?
I like to use the analogy of buying a new car to illustrate the answer to this question. Suppose you were to walk into a dealership, ask how much the shiny new car in the showroom cost, and then wrote a check for it a few minutes later. You would likely pay a lot more for the same car than your neighbor who visited the dealership several times, asked questions about other automobiles in the same class and then finally arrives ready to purchase at the end of the month when the dealership needs to make its sales quota. By doing some research, making the sales person (and likely sales manager at this point) aware that he has done his homework along with being patient and strategic, the neighbor saves many thousands of dollars purchasing the same car.
On a much larger scale, leasing or purchasing office space is similar. Tenants that wait until their lease is near expiration send a dangerous signal as their landlord realizes they are essentially out of options. They do not have time to negotiate another lease and relocate. Landlords take full advantage of this knowledge and hold to a high rental rate with little or no concessions. They are aware that the tenant has painted itself into a corner. When they are facing an expensive ‘holdover’ tenancy or threat of eviction, the landlord is able to leverage tenants into a bad lease. Waiting too long can easily cost a 10,000-square-foot tenant upwards of $600,000 in lost opportunity over a five-year term.
When is the optimal time to focus on an expiring lease?
My rule of thumb is 18 months on average. Longer for very large leases, and somewhat shorter for smaller leases or building purchases. I find that it generally takes most tenants longer than they anticipate to truly focus on important or sensitive internal issues that will impact their real estate decisions. Multiple parties may be involved in such decisions, which always require additional time. Business circumstances may also change and it is important to have ample time to react. I like to have at least three months, at the outset, to feel comfortable that a client has really come to grips with its strategy and direction. Once a tenant finally does decide what it wants to do, it takes much longer to convince a landlord to agree to an appropriate transaction. Landlord also have their own agenda and timetable, so it is imperative that ample time is allocated for landlords that are difficult and/or slow to respond.
Is there ever a time when due diligence is not necessary?
Many tenants feel that because they want to remain in their existing space that there is no need to conduct extensive due diligence. That is a big mistake. Landlords and their own agents talk amongst each other to understand who is active in the market. They also ascertain important information from furniture vendors, architects and others in the real estate support factions regarding which tenants are in the market. If tenants in their building are not on the radar, then landlords are less concerned about losing them to a competitor and important negotiating leverage is lost.
How can tenants make sure they have a strategic advantage during negotiations?
Astute tenants will take time to interview several real estate brokers. It can be a big mistake to assume that the broker they used last time is still a good choice years later. Once selected, a good broker will assist with:
- Site selections
- Evaluating and interviewing architects
- Touring space
- Drafting and negotiating material business points in proposals and letters of intent
- Reviewing construction budgets
- Aggressively negotiating key sticking points to close a transaction in the tenant’s favor
- Assisting legal with document critiques
There is even more work to do once a lease or amendment is signed, but understand that all these steps take time to properly complete. Once completed, and the tenant is now fully informed with regard to its choices, cost and risk, it is surprising how many do elect to relocate based on the data. I have had many instances where a client has stated firmly at the outset of a transaction that they will not relocate, only to see them jubilant over an opportunity that far exceeds their initial expectations.
As is typically the case, hard work does pay dividends. Fortunately for tenants, they can hire a real estate broker early in the process to do the majority of the legwork. Their brokers can spot changing market conditions that their client may miss, or find a unique opportunity perfectly suited to the tenant before it hits the open market. The sooner you get started, the more time you give your broker to work on your behalf.
Robert Chavez is the founder and CEO of Guardian Commercial Realty. Reach him at Robert.Chavez@guardian.net or (310) 882-2060.
Office buildings cost a lot of money to operate and maintain. The operating and tax expenses (OPEX) for mid-rise to institutional-quality high-rise office buildings in Los Angeles range between $11 to $16 per square foot per annum, or $5.5 to $8 million for a 500,000-square-foot building. OPEX is comprised of management fees, administration and overhead, utilities, janitorial, mechanical system maintenance and fees, window washing, parking maintenance and fees and landscaping along with myriad other taxes, fees and miscellaneous expenses.
“The OPEX section in a lease is typically very long and almost impossible to get through in one read without falling asleep. It is the quintessential boring-but-important topic,” says Robert Chavez, founder and CEO of Guardian Commercial Realty. “A primary responsibility for landlord brokers and property managers is to make certain that all of these operating costs are passed on to the tenants that occupy their buildings.”
Smart Business learned more from Chavez about how tenants can keep operating expenses from getting out of control.
What should tenants look out for concerning their operating and tax expenses?
Landlords employ a very strategic methodology when processing their OPEX. Most commercial office landlords use what is known in the industry as a ‘full service gross’ lease. Gross leases incorporate the rent and operating expenses into one rental rate number. They are either quoted annually or monthly as follows: $36 per rentable square foot per full service gross per annum, or $3 per rentable square foot per full service gross per month, depending upon the marketplace.
The OPEX for the first year of a gross lease is referred to as the ‘Base Year.’ The Base Year becomes the cost basis for OPEX over the lease term. Any cost increases to OPEX over and above the Base Year are passed on to the tenant as a portion of their pro rata share. One would presume that any decreases in OPEX would automatically be deducted from any accrued escalations, but that is not always the case.
How can this type of lease hurt the tenant?
Initially, OPEX may seem like a minor issue because the first year expenses in a gross lease are zero — it’s the Base Year. The second year ‘pass-throughs’ may have some modest increases that show up as additional rent on the monthly rent invoice. They are typically so small that tenants do not pay much attention to them. It’s the same for the second or perhaps even the third year. In or about the fourth year, the magic of compounding begins to take effect and that line item often grows to an alarmingly large number. What started at zero, and then a few hundred dollars per month, often grows to thousands of dollars per month in additional rent.
For example, if a base year OPEX is $15 per square foot, and expenses increase at 3.5 percent per annum, the OPEX will grow to $18.40 by the seventh year of the lease term. That $3.40-per-square-foot increase equates to $1.7 million in additional OPEX costs for a 500,000-square-foot building. Accordingly, a 25,000-square-foot tenant would pay $85,000 in annual OPEX costs given their 5 percent pro rata share of the building. This scenario can be even worse if the building is reassessed due to a change in ownership and increased taxes are passed on to the tenant. These are costs that were not likely budgeted for by the tenant. The OPEX costs were creatively camouflaged years ago when the lease was executed.
Tenants must be mindful that these pass-through expenses will likely continue to grow for the duration of the lease term and there may be very little, if anything, a tenant can do about it after the lease is signed.
How can a tenant avoid excessive escalations?
There are measures tenants can take to mitigate the fiscal impact of OPEX escalations. Action must be taken as part of specific and detailed negotiations before a lease is executed.
The primary areas of focus are i) exclusions from OPEX, ii) expense caps, iii) category protection, iv) audit rights and v) properly quantifying the tenant’s pro rata share. Moreover, the tenant must remain diligent every year to make certain all of their hard-fought exclusions and protections are being followed by the landlord when the OPEX is restated each year. It is often the case that a general OPEX statement is presented to all tenants in a building, and it is up to the tenant to recognize that their exclusions may not have been properly accounted for. Issues like this seem to be more pervasive during recessionary periods when landlords are looking for creative ways to bolster revenue.
Can tenants handle these issues on their own?
Tenants can expect landlords to negotiate very aggressively against the tenant safeguards listed above. Common landlord responses are that it is an accounting nightmare for the landlord to track a different set of exclusions for each tenant, or that the tenant is too small to merit such protection. Some landlords will go so far as to say that they ‘just don’t do it that way.’
As is the case with any important negotiation, understanding concepts is only the beginning of the process. Taking this understanding to a successful conclusion takes time, experience and expertise. Landlords are experts at their craft and practice it every day. Tenants typically sign a lease once every five to 10 years, and even the most sophisticated executive can be outmatched by an expert landlord. There are at least 50-plus exclusions and related protections that commercial real estate experts negotiating on behalf of tenants demand. Truly understanding which are the most important for you, and where to spend your time and focus, is a real challenge for novices.
When it comes to commercial office operating and tax expenses, one bad real estate decision can haunt a company for many years to come. Tenants that do not use a tenant-oriented broker and real estate lawyer often regret it after the lease is signed and the OPEX escalations begin to grow.
Robert Chavez is the founder and CEO of Guardian Commercial Realty. Reach him at Robert.Chavez@guardianusa.net or (310) 882-2060.
Leases are rarely conducted on an entirely level playing field, as the landlord is in the business of real estate and the tenant is not. However, with planning and professional guidance, tenants can wrest away the advantage from the landlord and negotiate more attractive terms for occupancy.
“In today’s market, it is imperative that you identify hidden or unanticipated expenses in a lease,” says Richard Mersman, a partner with The Stolar Partnership. “Having a qualified attorney review the lease can save you tremendous headaches in the future.”
Smart Business spoke with Mersman about lease negotiations, what type of provisions and stipulations should be considered, and when to start the lease renewal process.
Why is it important for an attorney to participate in lease negotiations?
For most companies, lease expenses are one of the highest fixed costs on their balance sheet, second only to payroll. Certainly lease expenses — which include rent, common area maintenance costs, taxes and insurance — can have a substantial economic effect on a company’s overall financial performance.
There are a number of financial and legal issues that a tenant will face when negotiating a lease. You want to put yourself in the most advantageous economic and legal position in order to protect your income stream and your business.
What is the role of the letter of intent in the process?
A letter of intent is a tool that the tenant, and later, the tenant’s attorney, can use to streamline the lease negotiation process. The letter of intent defines the basic business terms between the landlord and the tenant.
Generally, the business terms will include key financial terms such as how much rent you are going to pay, what type of tenant improvement allowance the landlord will provide and whether or not there will be a free rent period. The letter of intent will also outline provisions with regard to expansion space, as well as relocation obligations and requirements.
When the attorney — who generally should not be negotiating the business terms — receives the letter of intent, it enables the attorney to concentrate on the legal issues at hand and not the business terms.
What type of provisions should a tenant fight for in a lease?
There are a number of provisions that a tenant should fight for. Commercial leases in today’s market are complicated, sophisticated documents. Generally, in Class A and Class B office buildings, landlords will have a specific lease form that they will provide to the tenant. Naturally, these lease forms are weighted in favor of the landlord.
The responsibility of the tenant’s attorney is to make sure that the tenant is not subject to additional expenses and/or legal obligations that were not originally contemplated in the letter of intent yet may be customary in the marketplace. Involving the tenant’s attorney early in the letter of intent negotiations can be very beneficial and can help eliminate obvious issues.
What stipulations should tenants avoid in a lease?
Make sure that there is no limitation on the use of the space; if the tenant wants to downsize, it may want to sublease space to a different type of business. Additionally, you will not want to be subject to a relocation provision without providing your prior approval. For example, you don’t want the landlord to move you from prime space in a building to space that is less attractive or desirable.
You also want to confirm the parking allocation for your company and identify where that parking will be, thereby ensuring that you have sufficient parking for your employees at a reasonable cost. Signage may also be a concern. Make sure that you have appropriate signage to identify your company within the building as well as outside the building so your customers and clients can easily find you.
Finally, be very careful about common area maintenance costs. The pro rata percentage charge should be accurate and based upon a formula of no less than 95 percent occupancy. This will protect your company’s share of the common area costs so, in the event that a large tenant moves out of the building, your proportionate share of the building costs does not increase.
How should a business go about negotiating a favorable lease renewal?
Start early. The sooner you find out where the market is and what comparable space might cost, the better off you will be. Most leases provide for anywhere between 60 days’ to one year’s notice of renewal, and 180 days is a common threshold. It is incumbent upon each tenant to determine the market rate prior to the 180-day period.
Currently, we are in a very favorable market for tenants. Landlords don’t want to lose a creditworthy, rent-paying tenant. As a result, tenants are able to negotiate a much higher tenant improvement allowance to refurbish space, as well as garner additional rent concessions.
How can a business find a qualified attorney to represent it in lease negotiations?
Referrals are generally the best method for identifying a qualified attorney, as you will likely have someone whom you respect making the recommendation. You can also turn to the local bar association and other legal directories for assistance in finding counsel.
While conducting your search for an attorney, it is important to look for specific experience in commercial leasing as it is a unique area of law that has become much more sophisticated over the last few decades.
Richard Mersman is a partner with The Stolar Partnership. Reach him at (314) 641-5125 or email@example.com.
Business owners might avoid bringing an attorney to the table when negotiating a lease, but the advantages of having an advocate in their corner far outweigh the cost.
“In my experience, when you see a lease where an attorney was not involved on behalf of the tenant, you get a lopsided, landlord-favoring lease,” says Jesshill Love, a partner with Ropers Majeski Kohn & Bentley PC. “The attorney’s job is to think ahead to what happens if something goes wrong to make sure the tenant will be treated fairly.”
Smart Business spoke to Love about the pitfalls a tenant can avoid by partnering with an attorney before signing a commercial lease.
Why should an attorney be present in the negotiations?
Any smart businessman or woman is going to employ both an attorney and tenant broker, because they have different roles. A broker is going to be more focused on lease rates, market factors, square footage allocations and tenant improvement allowances. An attorney is going to focus on protections for the tenant from the point of view of the ‘legalese’ of the lease. This can include indemnification, attorney fees, arbitration and mediation issues. Sometimes an attorney has to interpret multiple provisions together in order to get to the conclusion that the lease actually pushes more of the obligations and expenses onto the tenant than it should. The role of the tenant’s attorney is to make sure that the tenant is well represented and receives the benefit of the bargain in the negotiation process.
What is the role of the letter of intent?
This is often where tenants misstep: they start talking to the landlord about deal points or even move to a draft lease before considering the letter of intent (LOI). The LOI is what will set the tone for future negotiations, and if you don’t drive a hard bargain at the LOI stage, then you’re leaving money on the table when the lease is signed. Once the LOI is established, it’s going to serve as a framework for the actual drafting of the lease itself.
There’s a tremendous amount of standard language thrown into a lease, such as forum selection clauses, attorney fee provisions and indemnification and insurance provisions. All of this is fairly standardized in the industry, but the framework of the main deal points from the LOI is what’s going to set the tone for the lease when it comes to flexible items like tenant improvements, common area maintenance (CAM) expenses and operating expenses, and how they’re defined.
What are some provisions a tenant should push for in a lease?
These can change every couple of years as the market changes. Also, as new case law is handed down, attorneys on both sides of the negotiation will angle to push off certain costs or obligations on the opposing party. The big ticket items now are tenant improvements, free rent, environmental concerns, termination provisions and risk of loss provisions.
It’s still a tenant’s market, so negotiating for free rent up front is something you want to try to do, if possible. Also, try to negotiate a cap for any structural improvements with an absolution period and landlord indemnification of the tenant for any pre-existing structural or environmental problems. Mediation and arbitration as well as attorneys’ fees provisions are additional issues to look out for.
Landlords on triple-net leases will try to define everything as a tenant responsibility: roof, plumbing, sewer line, heating, ventilation and air conditioning (HVAC) and electrical problems. A tenant attorney should push back in an effort to make a major structural problem involving the building envelope the responsibility of the landlord.
Another thing you’ll definitely want to have is a clear definition of default, particularly if you have a letter of credit. You don’t want the landlord to be able to draw down on the letter of credit for something that’s an immaterial default under the lease. Also, when lease rates start to increase, landlords are going to be looking for any type of breach they can in order to cancel the tenant’s lease so they can lease to somebody else at a higher rate. Landlords will attempt to define default broadly to effectuate this purpose. We have seen multiple over-reaching default definitions, such as violation of local zoning and use laws and operating hour violations. The attorney’s job is to make sure that a breach of a lease for which the landlord can actually terminate is material; this should be limited to non-payment.
What should tenants avoid in a lease?
First, tenants should avoid personal guarantees when possible, as well as excessive security deposits. Relocation provisions should also be avoided or, at a minimum, limited. Relocation provisions are common in leases with multiple commercial tenant or office spaces. They allow the landlord to move a tenant if the landlord wants to incorporate the tenant’s space with adjoining spaces for a prospective tenant. The tenant has no choice but to move upon notification from the landlord. Relocation could result in a tenant being buried in the back of the office building, or the franchise in the shopping mall could end up tucked away in a space with little foot traffic. This is obviously not what the tenant initially negotiated for when the lease was signed. The tenant must negotiate relocation preferences and safeguards prior to signing that lease.
Further, some lease agreements require a tenant to continue to pay rent even if the space is rendered unusable. For example, if there’s a fire in the building, and the tenant cannot continue to operate the business, the tenant is still required to pay rent. Although the tenant’s lost business can be covered by business interruption insurance, it is not in the tenant’s best interests to have an open-ended time period for the landlord’s repair of the premises. Most large commercial leases are drafted that way — even if it’s not the tenant’s fault, the tenant is not allowed to terminate the lease pending the landlord’s repair of the premises. Litigation surrounding these matters between landlords and tenants can be company killers. There have to be provisions in the lease that say, if this can’t be fixed within a reasonable time period, the tenant gets to walk.
Jesshill E. Love is a partner with Ropers Majeski Kohn & Bentley PC. Contact him at (650) 780-1611 or firstname.lastname@example.org.
The proposed changes to lease accounting rules will soon have businesses scrambling to figure out how to comply.
“Although the changes have not yet been enacted, businesses need to act now to determine the potential effect of the proposed regulations in order to minimize the negative effect on the company,” says Tina Salminen, CPA, director in assurance services at SS&G.
“In the current GAAP world, you either have an operating or a capital lease,” says Salminen. “From a financial statement presentation perspective, businesses typically prefer operating leases as they are off balance sheet. However, because of various released and proposed changes, companies are required to disclose off-balance sheet risk in order to increase the transparency of financial statements, including the liabilities related to off-balance sheet leases.”
Smart Business spoke with Salminen about what businesses should be doing now to minimize the impact of the proposed new lease accounting rules.
Why is this change being made?
The goal is to make financial statements more transparent and to promote comparability of financial information.
As a result of this proposed IFRS/GAAP convergence project, there will no longer be an operating or capital lease classification, but instead there will be a ‘right-to-use asset.’ Under existing guidance, companies holding operating leases are not required to record the future liability on the financial statements. Thus, a user of financial information would not easily discern this lease and the associated cash flow risk that may exist.
Under the proposed guidance, it will be very clear that you have debt on your books and the asset associated with the debt will be readily apparent.
How will the change impact businesses?
Businesses that hold leases — either as a lessee or lessor — may have to change the way they account for these leases. The proposed changes affect everyone from the leasing agent who leases buildings to the business that leases operating equipment.
The most critical issue is to assess the effect of this pronouncement on your debt covenants. If you lease equipment and now have to record this equipment on your books, the results may impact your financial covenants and your ability to meet these covenants.
Another important effect of this potential pronouncement is that the resulting bookkeeping could be time and cost intensive.
What can business owners do now to prepare?
Businesses need to review the potential impact based on their current leasing situation. If your company is lease-intensive, talk with your lender now about rewriting covenants as you may be in a position under the new leasing rules whereby you will no longer meet them. Not addressing this now in the current risk-averse lending environment could result in the bank calling the debt or reducing the availability of lending to your company.
Most banks are only now beginning to realize the potential impact this proposed guidance will have. It is the company’s responsibility to plant the seed with the lending institution because it may not be an easy fix.
Another potential issue that may occur upon implementation is a significant short-term effect on expense. With operating leases, you make monthly equal payments and, therefore, you can budget for payments. Under the new guidance, the debt will typically result in much higher interest payments initially as the principle is paid down. From a budgeting perspective, this will result in a more significant financial hit initially due to interest expense.
How will it impact the way companies do business?
If you currently purchase capital assets, this proposed guidance will most likely not have much impact on your current financial position. However, if you are a lease-intensive business, you will need to start analyzing whether you should renegotiate current leases or purchase the related equipment.
One item to consider during this analysis is that when you purchase an asset, you have more flexibility with equipment lives. When you lease equipment, you are required to depreciate the equipment over the lesser of the life of the lease or the life of the related equipment. For example, if a company purchases a piece of equipment that could also be leased over 10 years, and decides to depreciate the equipment over 15 years as this better represents the useful life of the equipment, the annual financial effect to buy could be substantially lower than if the company were leasing the same equipment.
The financial impact of future leasing decisions will require companies to seriously consider purchasing versus leasing.
What will the impact be on building leases?
You may start to see shorter-term leases. A building lease for 15 to 20 years will be recorded as an asset and associated liability valued at its net present value of future minimum lease payments. This could reduce the amount of debt and the associated interest expense recorded on your books. What some companies should consider is negotiating shorter-term leases with more renewal periods. Thus, if renewal terms are not imperative to continued operations, the company would be able to record the future minimum lease asset and associated liability at a lower value due to this reduced lease term.
What would you say to business owners who will wait until this goes into effect to address it?
If you wait, it could be quite costly. I would recommend businesses start their analysis now to determine whether changes to leasing structures will be necessary. Taking a proactive approach may reduce the effect on your financial statement and debt covenants.
That also ensures a realistic budget, because if you want to continue leasing, you need to start budgeting for higher interest costs.
Tina Salminen, CPA, is a director in assurance services at SS&G. Reach her at (440) 248-8787 or TSalminen@SSandG.com.
So you made the big decision to open a new office or extend the term of your existing lease. You have negotiated the material business points, including rental rate, improvement allowance, etc., and the landlord has sent you its “FORM” lease to sign and memorialize the transaction.
Not so fast! While you may believe that negotiations have ended, many important clauses remain in the body of that 60-plus-page lease. They must be carefully reviewed and likely amended before you sign.
“Remember, the lease was prepared by a sophisticated real estate attorney who represents the landlord’s best interests, not yours,” says Robert Chavez, founder and CEO of Guardian Commercial Realty. “Commercial leases are typically five- to 10-year contracts and can cripple a company if not properly negotiated — so proceed with extreme caution.”
Smart Business learned more from Chavez about the important items to review before signing that lease renewal.
What are the main things a business owner should know about a lease renewal?
Understand that landlords are not pleased when tenants make lease comments and they will resist your efforts to do so. It is imperative that you remain tenacious to secure a reasonable lease. Tenants have expectations of occupying habitable premises absent and extraordinary costs. You must look carefully for clauses that shift risk from the landlord to you.
The following three examples are important, but be advised that today’s leases contain dozens of dangerous clauses. Tenants are well advised to seek the assistance of an experienced real estate professional before executing a lease.
1. Premises area. At first blush, this section appears innocuous. If the square footage is correctly stated it may appear everything is in order. However, tenants must first ensure that the square footage has been accurately measured. Astute tenants engage their own architect to verify square footage. This can be accomplished quickly and cost effectively. Misstating square footage by a small percentage can cost a medium-sized tenant upwards of $90,000 in wasted money over a five-year term. Exaggerated square footage can also increase the tenant’s pro rata share of building operating and tax expenses by many thousands of dollars over the entire term.
Second, you must make certain that the landlord cannot unilaterally increase the premises square footage unless you actually expand. Many tenants have been shocked to see their rent statements increase simply because their landlord has implemented self-serving rationale for re-measuring the space. It is imperative that tenants stipulate the verified square footage as fixed throughout the term and option period(s) before signing.
2. Real property taxes. Aside from modest annual increases, California real estate values are reassessed upon a sale or transfer of interest in the property (triggering event). Landlords pass property taxes on to their tenants in various forms over the lease term, depending on the type of lease. If a building has been owned by the same landlord for many years, it is likely to have a very low tax basis, and the tax increase due upon a triggering event can be staggering. For example, if a building was valued at $100 million in 1991, and its current fair market value is $300 million, then tenants with leases in place will likely pay an enormous increase in their pro rata share of property taxes upon consummation of the triggering event and for every year thereafter while their lease is in place.
This may even occur when a privately held property becomes publicly traded. It is baffling why a landlord who sells its building for a gigantic profit would expect to pass the tax increases on to an unsuspecting tenant. Tenants do not profit from such a sale, the landlord does. Tenants should secure what is known as Proposition 13 tax protection to avoid paying these tax increases. If the landlord will not agree, then the tenant is well advised to ascertain the taxable basis for the building along with its current fair market value to estimate what its increased occupancy costs will be upon a triggering event. Then the tenant can at least make an informed decision regarding its election to sign the lease or not.
3. Surrender agreement. This clause addresses the tenant’s responsibilities once a lease terminates and the tenant vacates. It is standard for tenants to return space subject to reasonable wear and tear. Some leases, however, impose additional burdens and costs upon a tenant when vacating. A popular AIR form lease provides an extremely broad definition of ‘utility installations’ in one section of the lease that appears harmless. The definition includes items such as power panels, floor coverings (carpet and linoleum), security systems, fire protection, cabling, HVAC equipment and plumbing in or on the premises. It does not make a distinction as to whether the landlord, tenant or even a prior tenant installed these items. Later in the lease, the same phrase, ‘utility installations,’ is used to boot-strap tenants’ responsibilities in the ‘surrender’ section.
‘Utility installations’ takes on a whole new meaning when incorporated into the surrender clause. Costs as high as $100,000 have been charged to medium-sized tenants simply because the surrender clause is so pervasive. Keep in mind that the existing tenant may be moving to a competing building after negotiations with the current landlord soured. If there is bad blood, landlords have been known to use this clause to extract many thousands of dollars from a vacating tenant. Even though it’s years away from being an issue, pay close attention to the surrender clause before signing a lease.
Robert Chavez is the founder and CEO of Guardian Commercial Realty. Reach him at Robert.Chavez@guardianusa.net or (310) 882-2060.
Leasing space for your business — whether office, retail or industrial — is an important investment for any company. While there are always many factors to consider, it is important to understand what is reasonable for your particular business in the marketplace.
In most areas it is still a tenant’s market, so it may make sense to upgrade, expand and extend leases now. In other markets, the leasing climate has started to change and landlords are able to drive harder bargains. Whatever market your company is in, there are several common leasing issues that should always be considered when negotiating a lease or lease extension.
Smart Business spoke to Sonia Lister and Spring Robinson of Jackson DeMarco Tidus Peckenpaugh about their list of the top 10 most common lease negotiation issues that business owners should address when discussing leasing needs with their landlord.
1. Letter of intent. Depending on the complexity of the lease terms, it is almost always to a tenant’s advantage to have a detailed letter of intent (LOI) as the first step in lease negotiations. The LOI should include all of the business terms of the lease. Even though the LOI is typically a non-binding document, the business terms of the deal are rarely renegotiated after the lease negotiations begin, so all essential terms should be clearly addressed in the LOI.
2. Landlord incentives. Consider asking for incentives from the landlord. A company’s ability to negotiate landlord incentives will vary depending on the vacancy rate in the market, as well as other factors such as the company’s size and financial ability. A long lease term and solid tenant commitment may motivate the landlord to offer generous concessions and incentives. Typical incentives include periods of free rent or discounted rent, landlord contributions to build-out costs or moving costs, limits on future rent increases, free parking and reduced or capped operating expenses.
3. Improvements to the premises. Evaluate which party should construct the improvements to the premises. There are three common options: a) tenant build, b) turnkey (landlord builds the improvements at its expense pursuant to a specific plan), or c) landlord build. The negotiation considerations for each of these scenarios are different and so you should be sure to discuss them carefully with an experienced tenant broker and legal counsel.
4. Condition of the premises. Make certain that the current condition of the premises is acceptable if no improvements are being made to the premises. Taking the premises ‘as is’ exposes the tenant to risk for inadequate or outdated facilities. At a minimum, the landlord should warrant that the space is up to current building, fire, safety, zoning and disability access codes and should warrant the condition of electrical, plumbing, heating and air-conditioning systems (even if only for a limited period of time).
5. Planning for catastrophic events. The lease should provide procedures in the event of any future catastrophic event (i.e. damage to the premises, condemnation, or disruption in utilities). In such events, the lease should clearly provide who is responsible for repairing or restoring the damage, whether the tenant is entitled to abatement of rent, and the right to terminate the lease if such catastrophic event is long lasting or of a significant nature.
6. Limiting the liability of lease guarantors. If a principal of your company is required to personally guarantee the tenant’s obligations under the lease, try to limit his or her potential exposure to liability. The risk to the lease guarantor can be limited by adding provisions that reduce the term of the guaranty to a certain number of months after the lease commencement date, or limit the maximum amount payable by the lease guarantor to a fixed dollar amount.
7. Consider future flexibility or allowances for company growth. Prior to entering into a lease or extending the term of an existing lease, it is important to analyze every aspect of your company’s business plan to make sure that the size of the premises is compatible with existing and future plans for your business, and that there is sufficient flexibility built into the lease in the event that plan changes. Some provisions to include to ensure future flexibility include a lease extension option, space enlargement or reduction option, early termination option and the ability to assign the lease or sublease the premises.
8. Security deposit. Depending on the market and the financial strength of your company, it may be possible to minimize the amount of the cash security deposit. If your company is and has been financially strong, the landlord may waive the security deposit altogether. Furthermore, if it makes business sense for your company, a landlord may accept a letter of credit in lieu of a cash security deposit. If, however, you are required to provide a cash security deposit, consider building into the lease a provision that would allow the security deposit to be decreased over time if the tenant has fully performed its obligations.
9. Hold-over provision. Make certain that any penalty for ‘holding-over’ or remaining in the premises after the expiration of the lease is reasonable. Furthermore, be sure to allow flexibility for negotiations with the landlord at or beyond the expiration of the term to renew the lease without payment of any hold-over penalty.
10. Notice periods and deadlines. All notice periods and deadlines for exercising or enforcing rights should be reasonable. After your company has signed the lease, it is important to periodically review the lease and to calendar all important dates so as not to forfeit or waive any rights, such as an extension option, early termination option or space reduction option.
Sonia A. Lister is a shareholder and member of JDTP’s Real Estate Practice Group. Reach her at email@example.com or (949) 851-7408. Spring M. Robinson is an associate and member of JDTP’s Real Estate Practice Group. Reach her at firstname.lastname@example.org or (949) 851-7474.
Most commercial tenants consider leases to be no more than an administrative hassle. But with real estate overhead the second-most expensive line item for businesses, negotiating leases should not be taken casually, particularly for commercial tenants renewing their commitments for an additional five or 10 years.
New terms driven by market conditions and imposed by aggressive landlords can increase a company’s rent and related expenses by more than 50 percent at each renewal. Landlords attempt to impose all costs, risks and inflated profits to their commercial tenants, and most tenants simply sign on the dotted line.
“Why the haste to sign an agreement that is so clearly weighted in favor of the landlord and not the tenant?” says Robert Chavez, founder and CEO of Guardian Commercial Realty. “Dissecting this phenomenon requires an understanding of the dynamics and relevant issues related to negotiating leases.”
Smart Business spoke to Chavez about five insider tips to successfully negotiating with landlords in a commercial or retail lease.
Why do tenants often end up at a disadvantage in lease negotiations?
Most tenants dread the time and costs related to a corporate relocation. Ironically, in their haste to avoid expense and frustration, they often make the most costly mistake when addressing their lease renewals: they fail to leverage their alternatives.
When negotiating lease extensions, tenants focus on the expenses and logistics that impact their company’s direct profits. They pay close attention to their personal costs related to rent, construction, moving, technology, space planning and lost productivity. Though these considerations should be on the list, most tenants fail to recognize the tremendous cost and risk faced by landlords when a tenant vacates a property. This allows landlords greater leverage to charge inflated rates while offering nominal concessions. In exchange for paying higher rent, tenants accept new carpet, minimal rent abatement and a fresh coat of paint as suitable reasons to avoid moving.
How can tenants approach lease renewal more strategically?
1. Quantify the costs faced by the landlord if the tenant vacates. Consider the time the landlord must expend to lease space to a new tenant as well as the improvement costs necessary to retrofit that space.
Construction costs, including space planning and permitting for a modest retrofit, cost conservatively $20 per square foot. Add the cost associated with the landlord’s time preparing, advertising and negotiating a 10,000-square-foot space, and the immediate cost to the landlord becomes apparent and staggering: it typically ranges from $450,000 to $600,000, or $45 to $60 per square foot. Compare this to the $6 to $9 concession package to which most renewing tenants agree.
A commercial space usually does not produce revenue for nine months after a tenant vacates. The key is for tenants to recognize that landlords are always more nervous about the time, money and risk associated with vacant space than they acknowledge.
2. Ignore bullying tactics. Landlords often approach their tenants early and propose two sets of lease terms: the first proposes a lower rate if the tenant is not represented by a broker; the second imposes higher rent for broker-negotiated deals. The landlord blames the extra cost of the latter on commission fees, but the truth is that brokers can negotiate much better terms than either scenario offered by the landlord.
In fact, hiring an experienced tenant’s broker might save more money than employing legal counsel. Though company lawyers understand the law, they are generally not experts in real estate terms and concessions available in a particular marketplace. Hiring both is best.
3. Conduct due diligence. Even for tenants with no desire to relocate, knowledge of the quality, quantity and cost of relocation opportunities provides leverage for the tenant, as does knowing the length of time commercial spaces generally remain vacant.
Understand the true logistics of your space needs. The intricacies of a floor’s layout can be complicated, so use your broker and architect early in the process to assist in determining which building is most efficient for your needs. In many instances, an appropriate floor size and shape can reduce a tenant’s square footage by 10 to 15 percent. Over five years, this translates to an approximate $180,000 savings for a 10,000-square-foot tenant.
Tenants must also exercise care when selecting a commercial real estate broker to represent their interests. Most firms and brokers derive the bulk of their revenue from representing landlords in the managing, leasing, selling and refinancing processes. True tenant brokers will not accept work from landlords, thereby avoiding a conflict of interests and the appearance of impropriety.
Also, be certain that the broker is more than a marketing expert and will be the broker personally handling your assignment.
4. Consider the true cost. Failure to properly negotiate a lease can cost a 10,000-square-foot tenant $300,000 or more over the course of a five-year lease. In addition to the rental rate, tenants should consider items such as square footage calculations, option language for future expansions and extensions, detailed landlord responsibilities, appropriate base year calculations, tax protection and exclusions from operating expenses. These and other issues can cripple a tenant if not properly negotiated, and are often foreign to most tenants who address leases infrequently.
5. Take the initiative. Conducting the due diligence necessary to effectively negotiate leverage takes at least 18 months. The entire process should be finalized no later than six months prior to lease expiration, which means the tenant should start addressing lease negotiations two years before the expiration date.
Be proactive about negotiating your lease and send a clear message to your landlord: you have committed the time, energy and resources necessary to secure the best terms for your commercial office space needs. This is not the only game in town, and your landlord must consider your needs — or another landlord will.
Robert Chavez is the founder and CEO of Guardian Commercial Realty. Reach him at (310) 882-2060 or Robert.Chavez@guardianusa.net.