Understanding your options in a commercial lease to create flexibility in an ever-changing economy

Steve Kim, Senior Associate, Transaction Management, Plante Moran CRESA

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 protected]

Insights Real Estate is brought to you by Plante Moran CRESA

How to negotiate the world of commercial real estate

Simon Caplan, SIOR, Partner, CRESCO Real Estate

You’ve found the perfect office or commercial space and you’re ready to commit to a lease. But before you do so, you need to be aware of potential issues so that you don’t make costly mistakes, says Simon Caplan, SIOR, a partner with CRESCO Real Estate. “By the time the tenant and landlord start negotiating a lease, they’ve already agreed to the major lease points, such as what the rent is, the space buildout plan, the amount of tenant improvement dollars, etc.,” says Caplan. “Once you’ve got those together, you’re ready to negotiate the lease, but you need the help of an expert in order to avoid potential red flags.” Smart Business spoke with Caplan about some common red flags for tenants to look out for and issues you need to raise for your own protection. What are the major issues to be aware of in a lease? The normal process for a potential tenant is that you hire a broker to show you the best spaces for your requirements, then you look at spaces and you choose the best space for your needs. From a tenant perspective, you want to know how big the space is and how much you are going to pay and for how long of a term. What is the buildout going to look like? What are the tenant improvement dollars? Is there a period of free rent? Once you have negotiated those major points, the next step is to start negotiating the lease. What are some common red flag issues to look out for? One of the biggest areas tenants should be aware of are pass-throughs, that is what costs the landlord is allowed to pass through to the tenant. Based on that, when the landlord is doing a buildout for the tenant, if it is extensive, the tenant should have the ability to monitor the landlord’s contractors to make sure the work is of good quality. It should be specified in the contract that the tenant is allowed to observe/inspect the landlord’s work When you rent space, the landlord is usually willing to give a tenant a one-year warranty on the space. Then, after a year, the tenant is responsible for all in-suite maintenance. So if the buildout is not done right – or if the existing space is not in good condition – you don’t want to be stuck with a problem down the road. You really need to know what you’re getting into and who is financially responsible for what. Also regarding maintenance, the tenant should agree to maintain the space and do minor repairs and attempt to get the landlord to do major repairs and replacements. This issue needs to be explicitly addressed as to who is responsible for what in areas including roof repairs, the parking lot and common areas. In most leases, the tenant pays for repairs and the landlord pays for replacements, but you need to spell that out. In addition, the tenant should ask for the right to audit common area maintenance reimbursements once a year. At the beginning of every new year, the landlord should have figured out all of the costs for the previous year and submits them to the tenant to justify what the tenant has to reimburse. If the tenant thinks the numbers are high, that right to audit would then allow the tenant to inspect the landlord’s records to make sure that what the landlord is billing them is correct. Are there any issues that tenants should raise for their own protection? If the tenant has a problem such as a leaking roof, there is nothing worse than an unresponsive landlord. To protect yourself, you should try to include a self-help clause. That way, if you repeatedly have to call the landlord to fix things and the landlord doesn’t take care of it, you have the right to take care of the problem yourself, pay for it yourself and then bill the landlord or subtract it from the rent. You will have to give the landlord proper notice, but if the landlord is not responding, you can notify him that if he doesn’t take care of it by a certain date, you’ll do it yourself. In addition, every lease has a ‘Damage and Destruction’ clause. If there is a fire, or major storm damage, what are you going to do? How long will you give the landlord to put the space back together for you? And what will you do in the meantime? What you want to pay attention to is how long will you give the landlord to put the space back together for you. The goal is to get the landlord to fix the building as quickly as possible. But it takes time and, as a tenant, you have zero control over that. The Damage and Destruction clause gives the landlord a certain amount of time to do the work, and if it’s done within that time, you have an obligation to come back to the space when it’s ready. Make sure you have Business Interruption Insurance. Also, for your own protection, include an option to extend the lease. Normally there will be some type of increase in rent, sometimes tied to the Consumer Price Index. This gives you the guaranteed right to stay in the space for an extended term at this agreed-to price. You still have the option to try to negotiate a better rate at the extension time. Finally, ensure that you have the ability to install high-speed Internet, satellite dishes and other high-tech communication systems through common areas such as roofs, halls, etc., to get into your space. Tenants often make the mistake of assuming they’ll have access, but the landlord doesn’t have to grant you access. How important is it to have an outside adviser review a contract or lease before signing? You absolutely need a professional to work with you through the process. With a lease, the tenant, the broker and the lawyer should all go over the lease individually and make comments on different clauses, then compare notes before responding back to the landlord. Landlords expect tenants to make reasonable changes to the lease terms, and when you’re leasing office or industrial space, just about every clause is negotiable. There are many other issues that your professional can advise you on to help save you future grief. Simon Caplan, SIOR, is a partner with CRESCO Real Estate. Reach him at (216) 525-1472 or [email protected] Insights Real Estate is brought to you by CRESCO Real Estate.

Aircraft leases in crosshairs as AMR Corp. restructures

DALLAS ―  AMR Corp., the bankrupt parent of American Airlines, is racing to renegotiate aircraft leases and bag what experts believe could be hundreds of millions of dollars in savings.

The airline effectively has until Jan. 27 to inform a court about its lease plans, thanks to a bankruptcy statute giving a company 60 days to make decisions on such deals. American, which declined to comment about its lease plans, will need to have a working plan for which leases it wants to keep, alter or reject.

The process is fraught with questions about AMR’s future fleet needs. And lease holders, eager to preserve contracts signed in better days, are sure to balk when faced with the prospects of accepting lower lease rates or AMR’s rejection of outdated and unwanted airplanes.

“There’s a lot of negotiation, and some of it is playing chicken,” said Adam Pilarski, senior vice president at AVITAS, an airline consulting company that also works with aircraft lessors and lenders.

Aircraft leases are likely to be the biggest trimmable cost after labor for AMR, which filed for Chapter 11 on Nov. 29 in New York, citing uncompetitive labor costs as a key disadvantage in an industry that wrestles with overcapacity and high fuel costs. American is the third largest U.S. carrier.

Aircraft and equipment leases amount to around a third of AMR’s roughly $30 billion in liabilities.

Airlines often order aircraft from a manufacturer but lease the planes from a third party as a way to spread the risk of owning costly aircraft.

Bankrupt companies can reject leases on aircraft and engines or renegotiate leases with lower rates. AMR stands to save hundreds of millions of dollars by renegotiating leases, several experts said, citing comparisons with what other airlines did with leases in Chapter 11.

The company must renegotiate with lease holders while keeping enough planes — and the right models — in the air. AMR will need to consider factors ranging from the age of its jets to long-term plans for its fleet. That means lease holders with more fuel-efficient planes may hold more leverage.

“You look at age of aircraft, fuel consumption costs, how many miles are on each aircraft, and what your plans are for upgrading your fleet,” said bankruptcy attorney Kris Hansen, who is not involved in the case but worked on Delta Air Lines Inc’s. bankruptcy.

“Each airline has a full team who does a thorough profitability analysis,” Hansen said.

Exxon sues government over lucrative canceled Gulf leases

NEW YORK ― Exxon Mobil Corp. sued the government to reverse a decision by the Department of the Interior to cancel offshore oil and gas leases estimated to yield tens of billions of dollars of oil.

The lawsuit, filed on Aug. 12 in the federal court in Lake Charles, La., said the decision arbitrarily deprived it of rights under three of five leases for what is called the Julia field. It said this took away Exxon’s ability to produce a reservoir believed to hold billions of barrels of oil.

Two other leases have yet to expire. The complaint was reported earlier by The Wall Street Journal.

The lawsuit against the Interior Department and Secretary Kenneth Salazar comes after regulatory scrutiny of drilling activities grew in the wake of the April 2010 blowout of BP Plc.’s Deepwater Horizon well in the Gulf of Mexico.

The government’s initial rejection of the lease extension came in 2009, however.

“Our priority remains the safe development of the nation’s offshore energy resources, which is why we continue to approve extensions that meet regulatory standards,” an Interior Department spokeswoman said. “We are reviewing the complaint in accordance with standard procedures.”

The agency has denied extensions when a company fails to comply with the requirements to obtain them, it said.

Exxon, the world’s largest publicly traded oil company, said the dispute arose after the government rejected its October 2008 request for a “suspension of production.”

The Irving, Texas-based company said federal law allows such suspensions for the purpose of advancing future development in a safe manner.

Following several appeals, the Interior Department concluded in its May 31 decision that Exxon lacked a “commitment” to producing oil at the time the leases expired.Exxon and its partner Statoil ASA spent more than $300 million drilling two “producible” wells on the Julia prospect.

As part of its development strategy, Exxon was planning to drill three to six development wells and join them to a planned production facility operated by Chevron Corp. located about eight miles away, according to the company’s lawsuit.

That initial phase of development was estimated to cost $1 billion, Exxon said.