Incorporating flexibility into long-term leases
Lease agreements are typically fairly long-term contract arrangements, often 3 to 15 years. Predicting longer term business cycles beyond 2 to 3 years makes planning future space requirements for office tenants a difficult proposition.
Why aren’t short-term leases more prevalent?
There are multiple reasons why building owners shy away from shorter-term leases. This includes securing stable predictable cash flow in order to maximize the value of their asset. Secondly, there is typically a significant amount of capital invested by the landlord up-front in terms of leasehold improvements, architectural costs and leasing commission required to secure new tenants and make the space ready for occupancy. This requires a longer-term lease in order to recoup these up-front costs and secure an acceptable return on investment.
The tenant often wants a longer term lease to lock in rental costs over a longer period of time and secure adequate capital investment from the landlord to design and build out space for specific use rather than use the tenant’s own capital for improvements. Shorter-term leases are typically much less cost-effective, particularly in an improving market.
In today’s economy, where business cycles can be more volatile, shorter-term leases provide the best flexibility to react to changing business conditions but don’t make sense in the long run for established businesses. What options do office tenants have to structure more flexibility into their longer-term leases and avoid less cost-effective short-term leases?
Renewal and extension options
A renewal option or the right to extend the lease beyond the current term when it matures is critical for office tenants. There are significant costs associated with relocating. And while more economical comparable options may be available, you don’t want to be displaced because the building owner has a more attractive tenant when your term expires. There is a good chance your existing location still serves your needs well.
Right to assignment and sublease
Business conditions sometimes dictate vacating your current premises with time left on the lease. You may be expanding staff rapidly without expansion capabilities in your building due to a tight market or suddenly faced with an unreasonable volume of costly unoccupied space or no longer need the space due to a merger or acquisition. In order to mitigate the risk associated with unforeseen business conditions or events, it is critical to structure a flexible assignment and sublet provision in your lease agreement.
Termination and contraction options
A termination option gives the tenant the right to terminate the lease at a specific point during the lease term prior to the maturation of the lease. A termination option will require definitive notice to the landlord in advance of the termination, typically 6 months to a year. There is also a penalty typically assessed to the tenant in the form of some combination of a rent penalty and unamortized leasing costs (i.e. tenant improvement allowance and leasing commissions).
Larger tenants can also typically structure contraction options similar to a termination option for predefined space at various points in the lease — giving the ability to give space back and downsize before the end of their lease term.
A growing tenant or a company that anticipates expanding staff often negotiates expansion options into the lease agreement. There are several common variations of expansion options granted by building owners. These rights enable tenants to expand into additional or contiguous space that is currently or may come available.
- Hold options or fixed expansion options: The tenant has a defined period of time to exercise the option on a defined space or a predetermined “must-take” expansion at some point in the lease term.
- Right of first offer: If any space or a predefined becomes available in the building, the landlord is obligated to present it to the tenant before marketing it as available to third parties.
- First right of refusal: This provision obligates landlords to present any deal that they are willing to sign with a third-party tenant for a predefined space. If there is interest from the existing tenant with the expansion option, the tenant may elect to match the deal and preempt the transaction with a third-party tenant.
In some cases, these expansion rights for specific space have already been granted to existing tenants of the project, but it is also feasible to negotiate subordinate rights to another tenant in the event the option is declined, expires or the first right holder should vacate the building.
Flexible office design and alternative work strategies
Today, as the nature of the workplace is rapidly changing, there are new ways to incorporate flexibility in to your real estate with office design and alternative work strategies that require less space. More and more companies are beginning to experiment with hoteling and activity based workplaces. While it remains to be seen how popular these new innovative strategies will become, it is important to structure a lease agreement that supports these new ways of working. Issues such as 24 hour operations, extended building hours and essential services, flexible allocation of tenant improvement allowances and parking arrangements will be critical for alternative work strategies to be successful. The infrastructure in the office buildings of yesterday are often not currently equipped to adequately serve the higher density workplace of today and in the future.
Battle for control and the cost of flexibility
Negotiating flexibility in your lease is a battle for control with the landlord, who desires to maintain as much control of the asset as possible. How much flexibility you are able to negotiate is subject to market conditions, negotiation leverage impacted by a variety of factors and the negotiation expertise of the tenant and the tenant’s real estate representative.
There can be costs associated with creating more lease flexibility. But think of it like an insurance policy whereby there is a cost associated with the premium in exchange for the security of the insurance coverage. Today’s competitive and volatile global economy places a premium on obtaining as much flexibility as reasonably possible in your long-term lease commitment in order to mitigate risk. Don’t overlook your options to do so.
Coy Davidson is Senior Vice President of Colliers International in Houston. He publishes The Tenant Advisor blog.