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Publications
Saving Money When Leasing Office Space in a Tenant's Market
Real Estate Newsletter
The pendulum has swung. Vacancy rates are up, and tenants now hold the upper hand in office lease negotiations. We offer a number of helpful insights for tenants to make the most of current market conditions and obtain a favorable office lease.
Negotiating Strategy
Even when a tenant is happy in its current space and anticipates renewing or entering into a new lease with its present landlord, it is important to select at least one other space the tenant also likes, and to actively negotiate with two or three landlords, leveraging one against the other. While this will create additional stress, it is the only way to fully understand the marketplace, and to find the existing landlord's bottom line. And it may lead to a more favorable transaction in another building!
Key Economic Terms
The key economic terms are rent, and the landlord's contribution toward the cost of building out the tenant's premises (known as the tenant improvement allowance). It is important to remember that there is a direct relationship between the rent and the tenant improvement allowance – the greater the tenant improvement allowance, the higher the rent. Unfortunately, in the current environment in which capital is scarce, many landlords are not willing to offer a meaningful tenant improvement allowance, no matter how high the rent. If the landlord will not provide an adequate allowance, thereby forcing the tenant to come out of pocket for the buildout of its space, the tenant can be made whole by insisting on an abatement of rent for the first few months of the lease term.
Measurement of the Premises
Rent is typically calculated on a per rentable square foot basis, and it is not always a simple and straightforward matter to determine the rentable square footage. The concept is to include within the rentable square footage of the premises a pro rata portion of the common areas within the building. But some landlords seek to increase the square footage beyond a pro rata share of building common areas by adding an arbitrary "load factor" to determine the rentable square footage upon which rent will be based. The tenant should resist an arbitrary load factor.
Commencement Date
The landlord typically prefers that the lease term (and the payment of rent) begin on a specified date. Unfortunately, this leaves the possibility that the tenant could be paying rent before the premises have been delivered with tenant improvements completed. It is therefore important to specify that the term cannot commence until the landlord has completed construction of the tenant improvements (as well as all of the common areas, parking facilities and other building systems, especially if the building is a new one that is under construction when the lease is being negotiated), and has obtained a certificate of occupancy for the premises.
Operating Expenses
In many areas of the country, landlords charge tenants a pro rata share of operating expense increases. These are sometimes called "full-service gross" or "modified gross" leases. The idea is that baseline operating expenses are already built into the rent, and tenants are only charged their pro rata share of increases over the baseline. The baseline amount most commonly consists of the landlord's actual building operating expenses during the calendar year in which the lease commences (the base year). Some landlords, however, use a specified amount, or "expense stop," as the baseline for operating expense increases. A tenant should not accept an expense stop unless convinced it is a fair approximation of the operating expenses during the first year of the lease term.
It is important that the base year provide an "apples-to apples" comparison with subsequent calendar years. This is especially critical if the building is a new one or is otherwise not at full occupancy. To ensure an apples-to apples comparison, operating expenses in both the base year and each of the subsequent comparison years should be calculated on an extrapolated or "gross-up" basis, that is, on the assumption that the building is 95 percent leased and occupied and fully taxed-assessed for the entire year in question. A gross-up provision will ensure a fair comparison between the base year and subsequent calendar years and prevent a windfall for the landlord.
A growing number of landlords nationally are moving away from full-service or modified gross leases, and charging tenants for all operating expenses ("net" leases). Tenants should be vigilant to ensure that certain operating expenses are not passed through, especially under a "net" lease, including debt service, depreciation, executive salaries and above-market management expenses paid to affiliate companies. The biggest concerns for the tenant are substantial one-time expenses for capital improvements to the building. Because the tenant did not reimburse the landlord for the cost of constructing the building in the first place, it is not reasonable to expect the tenant to reimburse the landlord for replacing – as distinguished from repairing and maintaining – significant components of the building.
Repairs and Maintenance
The typical landlord lease form provides that the landlord will repair and maintain structural components of the building and common areas, and that the tenant shall maintain and repair the entirety of its premises. As a practical matter, most tenants are poorly equipped to repair building systems such as electrical, HVAC and plumbing, or to undertake other day-to-day repairs. In fact, many landlords perform minor repairs to the premises, even when the lease allocates responsibility for those repairs to the tenant. When pushed, most landlords will accept a lease provision requiring them to repair and maintain building systems within the leased space.
Service Interruption
The typical landlord lease form gives the tenant no rights or recourse in the event of a service interruption that prevents the tenant from occupying its premises (for example, if the building HVAC system breaks down). It is important to negotiate a provision that provides rent will abate if the tenant is unable to reasonably use the space for a short period of time (for example, two days) due to a service interruption, until service is restored. In addition, the tenant should be able to terminate the lease if the service interruption continues for a longer period.
Permitted Uses
Landlords often attempt to restrict the tenant's use to its specific industry or type of business, even though the tenant is in fact using the premises simply as office space. Such a restricted use then gives the landlord the upper hand if the tenant ever seeks to assign its lease or sublet the premises during the lease term. The tenant should seek as expansive a permitted use as is reasonably possible. For office space, this should include the ability to use the premises for general office purposes.
Assignment and Subletting
As a general matter, landlords will agree that they cannot unreasonably withhold their consent to a proposed assignment or subletting. Reasonable in this context means commercially reasonable, but allows the landlord to fall back on any restrictions contained in the lease. If the lease restricts the tenant's use to an office for a law firm, the landlord might be deemed to be reasonable in disapproving a proposed assignment or subletting to a company in another type of business, even if the office use of the premises would remain essentially unchanged. In addition to ensuring that the use provision is as broad as possible, tenants should also seek the right to assign without the need for landlord consent to affiliates or companies buying their business.
Another approach that landlords often take to restricting assignment and subletting is to include a recapture provision, providing that in the event of a proposed assignment or subletting, the landlord has the option to terminate the lease as to the portion of the premises in question and recapture the space. Such a provision inhibits the tenant's ability to remarket its space and greatly restricts the tenant's flexibility, and should be resisted.
Landlords frequently require that all or a portion of any profit the tenant makes from the assignment or subletting be turned over to the landlord. Most commonly, the landlord will agree to split the profits 50/50, which is generally reasonable. The key is to make sure that only net profits are being split; in other words, that before splitting any profits, all expenses the tenant may incur in connection with the assignment or subletting are deducted.
Insurance and Mutual Waiver of Subrogation
The landlord's form lease may not require the landlord to maintain insurance covering the building against casualty, even though virtually all landlords do maintain casualty insurance. Generally, if a tenant's employees inadvertently burn the building down, the landlord's insurance company will pay to rebuild the building, and under the legal theory of subrogation, be able to step into the shoes of the landlord and sue the tenant to recover the amount of the insurance proceeds paid to the landlord. In order to protect itself, the tenant should require an explicit lease provision requiring the landlord to insure the building against damage and destruction, as well as a lease provision called a mutual release and waiver of subrogation provision, under which the landlord will waive any rights of subrogation it might have against the tenant, thereby preventing the insurance company from recovering from the tenant. This is a critical and often overlooked tenant protection, and is especially important for major corporations with deep pockets.
Non-Disturbance Agreements
In most cases, the landlord has borrowed money to acquire or construct the building, and as a result there is a mortgage or deed of trust encumbering the building in favor of a lender. If a lender that was in place before lease execution forecloses on its mortgage or deed of trust, then as a matter of law, the lease is extinguished, and the landlord can evict the tenant. The only protection for the tenant is to insist that a non-disturbance agreement be obtained from the lender before the lease is executed, requiring that the lender recognize the lease in the event of foreclosure.
Parking
Landlords are always looking for new and increased sources of revenue. As a result, landlords are increasingly charging directly for parking, whenever the local market will allow them to do so. While a reduction in parking rates from the landlord's published rates has a direct economic impact on the landlord, such rates nevertheless are negotiable. A tenant may also want some of its spaces to be marked and reserved exclusively for the tenant's use. Reserved spaces are often available, but it is important that the location of these spaces be agreed upon and set forth in the lease.
Expanding (or Contracting) the Premises
It is important to plan for the possibility of expansion, especially if the lease is for a period of five years or more. Once the size and timing of any expansion options have been agreed upon, the critical items for negotiation are the rent and any tenant improvement allowance. Typically, the parties agree that the rent should be based on the then current fair market rent, or 95 percent of it. Often the tenant improvement allowance for expansion space is negotiated and specified in the lease document, although it could also be subject to a fair market calculation.
The tenant may also want to consider requiring that it have the ability to return to the landlord some of the space at a specified date during the lease term. In industries that are susceptible to rapid expansion and contraction, this may be an important consideration, and landlords will frequently agree to accept such a provision in a longer term lease.
Extension Options
Landlords will often be happy to grant one or more options to extend the term of the lease. Extension options are typically at a fair market rental, although sometimes the landlord will agree to 95 percent of the fair market rental. The critical nuance here is that landlords often try to tether the fair market rental to other lease renewal or extension transactions rather than to lease transactions generally taking place in the marketplace. This has the effect of allocating to the landlord the savings created by the fact that the premises have already been largely built out to the tenant's specifications, thereby increasing the "fair market rent."
Select Qualified Real Estate Professionals
Even when armed with this knowledge, it is best to seek out qualified real estate professionals for assistance. A real estate broker knows the marketplace and will help the tenant identify what is available and how much it should cost. The key is to select a broker with good knowledge of local market conditions and substantial experience in representing office tenants, meaning someone who does not generally represent landlords. A good real estate attorney with extensive tenant leasing experience will turn his or her client's desired space into a reality, and help to avoid costly mistakes that could turn the dream space into a nightmare. Getting both a broker and a lawyer involved at the beginning of a search will help to maximize leverage and get the best deal possible. These professionals can pay for themselves many times over in connection with what is often a company's greatest expense.
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These issues represent some of the highlights in a typical lease negotiation. There are a large number of other issues ripe for negotiation, some more important than others, but virtually all with the potential to impact the tenant in significant ways. Because a lease creates a long-term, ongoing contractual relationship, it is a very complex document with many potential pitfalls. Nevertheless, the current tenant-oriented market for office space creates many opportunities for those tenants willing to do their homework.
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