As a company weighs its options between signing a short-term and a long-term commercial lease, there are many things it must consider.
“Organizations need to weigh the benefits of locking in historically low lease rates long-term (seven to 10 years) or having the flexibility of a short-term lease,” says Steve Kim, a senior associate, Transaction Management, with Plante Moran CRESA. “Each comes with benefits and risks.”
Low real estate costs can help increase your competitive advantage. However, there are potential downsides to entering into a longer contract that need to be realized and hedged against to create maximum flexibility for your company.
Smart Business spoke with Kim about lease terms and how to negotiate the right conditions to suit your business needs, both today and in the future.
What crucial areas should a lessee consider when choosing real estate for a long-term lease?
When considering a long-term lease, a business should first determine whether the real estate is aligned with its strategic business plan. For example, does the space have room to accommodate your long-term growth plans? Does the building fit with your company’s image and brand? Conducting a space program is essential versus adding a percentage to your current square footage. This exercise will categorize and assign a square footage to all of your space, including conference rooms, executive offices, staff work spaces, common areas and storage, as well as account for future growth.
In addition, with building values at historic lows, purchasing real estate may be a viable option to consider, giving you the ability to lease out space until you need it.
What conditions would signal to a business whether a short- or long-term commercial lease is a more favorable option for a business?
Short-term leases offer a company the most flexibility, but they do have a downside. Lessees often don’t have as much room to negotiate terms and conditions in a short-term agreement as they do in a longer-term one. Also, landlords know all too well the cost of moving a business and could raise your rent at renewal, betting that you will not want to relocate. In addition to potential rate increases, there is no guarantee that you will be able to renew a short-term lease, especially if a large or long-term tenant needs your space.
Long-term leases will typically offer higher tenant improvement allowances, while short-term leases may require out-of-pocket costs by the tenant. But long-term leases also carry risks. Business conditions may change while you are locked into a long-term agreement, making it difficult to expand or contract your business based on a change in your strategic direction. However, an early termination option can be negotiated into a long-term lease to offer some flexibility while maintaining the security and extended savings.
What is an early termination option?
An early termination option allows you to opt out of your lease at a certain point in the contract, which reduces some of the risks that can come with being locked into a long-term agreement. It also offers an opportunity to renegotiate with your landlord midway through your agreement.
A company could work out an option to extend a short-term lease to hedge against losing the space or being hit with a rent increase, but the protections are not guaranteed, as those that accompany a long-term agreement would be.
When trying to negotiate a termination right in a lease, it is helpful to understand the landlord’s potential challenges in providing this option. The situation varies from building to building in regard to ownership structure and the debt situation, for example, and investigating these facts prior to the request is mission critical. Furthermore, the ability to terminate a lease may also be less advantageous if the termination fee is equaled to an amount that is perceivably unlikely to be paid.
Termination option fees requested by landlords are typically for the unamortized portion of the costs based on the market value of the transaction made when the lease was signed, along with an interest rate factor and a penalty equal to the value of rent for a few months. However, if the landlord receives adequate notice that a tenant is leaving, it should allow that tenant to lease the space and head off any loss of income. Termination fees require time to negotiate and ultimately should reward the landlord for offering additional concessions in exchange for extending the term.
What else can a company do to mitigate risk and reduce costs in a lease situation?
Another option to consider is subleasing, which can help a company recoup a portion of its rental expenses. However, expect to invest time and money on the front end to find a tenant and adapt the space.
If the necessary tenant improvements are financially viable for a company to pay upfront, the landlord has a greater ability to accept the termination option because the initial investment in the transaction has been reduced. Furthermore, a lease rate associated with an ‘as-is’ deal is usually below market and can protect tenants with renewal options going forward. Finally, some of the tenant improvements may be depreciated, ultimately lowering some of the company’s potential tax liability for a given year.
Steve Kim is a senior associate, Transaction Management, with Plante Moran CRESA. Reach him at (248) 223-3494 or email@example.com.
Insights Real Estate is brought to you by Plante Moran CRESA