December 7, 2012
This article was published in the Spring 2013 issue of the Real Estate Finance Journal, and appears here with permission. A downloadable PDF is available.
The glut of commercial real estate available in many parts of the country clearly demonstrates the effect of the recession on landlords. Despite gradual improvements in the economy, the commercial real estate market is still a tenant’s market. In this climate, tenants can and should use leverage when negotiating rental rates and other important lease terms that could have a serious impact on their bottom line.
Business owners who have managed to weather the economic downturn are finding that their landlords are quite accommodating in an effort to keep their properties fully leased and revenue flowing in. Landlords are anxious about the current and future state of the market, and consequently are willing to offer more attractive lease terms. As such, especially in our current economic environment, virtually every provision contained in a commercial lease is negotiable. The process of negotiating a lease or lease renewal could take many months, depending on the size of the transaction. Market conditions can change during this period of time; therefore, starting the process during a down cycle is even more crucial.
Many tenants attempt to negotiate their leases on their own. It is important to realize, however, that a lease could account for one of a tenant’s largest operating costs. As such, a potential tenant should consider professional representation. Not only is it important to engage a highly reputable commercial real estate agent to help determine current market rates, the availability of vacant space and what business terms are customary in that area, it is also important to engage an experienced commercial real estate attorney to help negotiate the legal aspects of the lease. A lease is the basis for a long term relationship between a landlord and tenant and if not negotiated properly could create many headaches and a lot of expense down the road.
Rent and Lease Term
The term of the lease and the amount and type of rent, whether base rent, percentage rent and/or additional rent are the first significant points of negotiation. While a short lease term might sound better to a tenant opening a new business due to uncertainty, giving the landlord some certainty with a longer term lease may encourage amenability to deals on other aspects of the lease. With a longer lease term, it is important to factor in and negotiate rent increases over the term. It is also important to try to get renewal options at set rent rates in order to avoid unexpected rent increases.
Most commercial leases are “net leases,” meaning a tenant pays base rent in addition to a share of common area maintenance expenses, real estate taxes and insurance for the property. In our current market, it is possible to either totally negotiate away paying these expenses, or at least exclude certain items such as capital expenditures and other terms that could create sudden large expenses. If these expenses are to be included, the lease should clearly state which expenses are included and which expenses are excluded. A tenant should also insist on a yearly cap/dollar limit on these expenses.
As a side note on existing leases, one way to capitalize on the favorable market, even if the lease renewal date is still some time down the road, is to ask for a “blend and extend.” For instance, if there are two years left of a five year lease, a tenant could ask for free rent for a certain number of months or a lower monthly rate, in exchange for signing a new five year lease. Note that in order to preserve the capitalization rate of their investment, landlords will often opt to grant free rental months rather than cut the stated rental rate.
Condition of the Property and Tenant Improvement Allowance
One of the first terms to negotiate other than term and rent is how the leased space will be delivered to the tenant. This could range from the leased space being delivered in its existing, or “as-is,” condition (with the landlord giving or not giving to tenant a tenant improvement allowance to perform build out work) to the landlord being required to make certain improvements to the leased space prior to delivery. In today’s market, some landlords are offering greater tenant improvement allowances and in some cases will build-to-suit to tenants’ specifications. Renovations, whether to current space or a relocation, require a large expenditure of capital. If a tenant is willing to perform the renovations, landlords are typically willing to reduce the rent and give some free rent periods since they do not have to carry the investment costs. A tenant’s leverage in this regard is relative to the size of the transaction and the tenant’s credit worthiness. Also, and above all, the amount of money the landlord is obligated to spend is going to impact how much rent the landlord expects to receive.
Protecting Your Investment
Another factor for consideration in the current economic environment is the possibility of lender foreclosure on the landlord’s property after the lease is signed. This will most likely render the lease null and void and the tenant will have to vacate its premises. Most lenders are willing to sign what is typically called a “Subordination, Non-Disturbance and Attornment Agreement.” This document keeps the lease in place and enforceable (subject to some exceptions that might be required by the lender) in the event the lender forecloses on the property. The big issues here are which form will the lender agree to sign and whether landlord or tenant pays the lender’s fees to negotiate this document. The bigger investment a tenant has into a space and/or the lack of availability of alternate space makes it more important to get the landlord’s lender to sign this document.
To further protect its long-term business interests, there are several provisions that a tenant should consider. For instance, a tenant should attempt to obtain an exclusive use clause so that the landlord cannot lease other space in the development to a competitor. Additionally, if the development has an anchor tenant such as a known retail brand and that tenant closes, a co-tenancy agreement that allows the lease to be broken or allows the tenant to pay reduced or no rent if the landlord doesn’t replace the anchor tenant in a specified time period should be considered.
Equally important as protecting its interest at that location, is to provide a tenant certain exit strategies in case that location or its business does not work out. For instance, a tenant should seek the flexibility to assign the lease or sublet the leased space in some or all instances without the landlord’s approval. Also, although not favored by landlords, this market makes it easier to negotiate early termination rights, such as the ability of the tenant to terminate the lease in the event its sales should drop below a certain level.
Unfortunately, just as our current market is hitting landlords hard, it is hitting businesses in general hard. As such, it is very important to negotiate up front, and minimize if possible, a landlord’s recourse in the event a tenant defaults under the lease. Tenants may be charged excess late fees and/or interest, the lease may stipulate that the landlord has a lien on a tenant’s property, and some leases allow landlords to accelerate the payment of all rent in the event of a default. Many of these provisions can be negotiated away altogether or otherwise modified to be more palatable.
Ultimately, a tenant’s success in negotiating a favorable deal will depend upon many variables, including, its own creditworthiness, as well as the level of demand for the space the tenant desires to lease. However, knowledge of the market and customary terms, as well as the assistance of qualified real estate professionals will be invaluable tools.
Please note that this article is an overview and is not intended to provide legal advice.
