Establishing Flexibility with Lease Options

May 3, 2017

Jon Glass

Tech Leader Corporate Managing Director, Savills Studley DC/MD/VA Licensed Real Estate Salesperson

Call 202-540-5509

Tips for Aligning Real Estate with Your Evolving Business

 

Quickly, how many people will be working at your company on March 23, 2019? How will revenue, investor relations, industry trends and market share gains evolve over the next 5 to 10 years? Will your location continue to accommodate your company’s needs on December 15, 2024?

Having trouble? Don’t worry, you’re not alone.

Predicting business cycles beyond 2-3 years is difficult for any executive, particularly in the technology sector. Great business leaders are optimistic by nature, but sinking precious dollars into long-term real estate contracts can be unsettling no matter how bright the future looks.

Not surprisingly, most companies, particularly in their early stages, prefer short-term leases in order to stay nimble. Co-working spaces, incubators and subleases are all great solutions for tenants hesitant to commit substantial capital into their second largest expense, real estate.

But what if you find the perfect office space and the landlord is unwilling to agree to a lease shorter than 5-10 years? Or, what if you are midway through a lease and your company goes through a major change, such as an acquisition, consolidation or rapid growth beyond your space capacity?

Fortunately, there are several options that can be negotiated into a lease to protect your business, no matter what obstacle you encounter:

Contraction/Disposition Options

Termination Option: A Termination Option gives a tenant the right to terminate its lease at a predetermined time prior to the lease expiration. Termination Options can be difficult to insert into leases, but if successfully negotiated, they can add tremendous leverage to terminate, relocate or restructure the lease prior to expiration. Termination Options are generally exercisable 2-4 years in advance of the lease expiration depending on the initial lease term, with 9-12 months’ prior written notice to the Landlord. If exercised, the penalty to terminate typically includes the unamortized transaction costs (i.e. construction costs, broker fees, rental abatement, attorney fees). How much, and when the fee is due, is all negotiable.

Assignment & Subleasing: A tenant may need to downsize or vacate its space prior to its lease expiration for a number of reasons. Having subleasing and assignment rights in your lease is critical, but not all are negotiated equally. Consider the following when incorporating into a lease document:

Sublease:
– Tenant should have the right to sublease to other occupants in the building.
– The landlord may restrict a tenant from subleasing to third parties whom the landlord is, or has been, negotiating with to lease space on a direct basis in the building. This is understandable so long as the landlord has comparable space available in the building (they don’t want a tenant to undercut them by offering a substantially discounted sublease to their prospect). A reasonable compromise is to limit the time period in which this restriction occurs, say within 3-6 months from the time the landlord commences negotiations with the prospect.
– Establish a timetable that the landlord must abide by when providing its consent (usually within 30 days).
– The landlord will likely charge an administrative fee associated with granting their consent, which ranges between $1,500 – $2,500.
– Consent by landlord should not be unreasonably withheld, conditioned or delayed.
– Sharing of space (10% – 25%) should not require landlord’s consent.
– A landlord may attempt to limit the profits received by a tenant from subleasing. If so, a market compromise is to split any profits 50/50 with the landlord, net of the costs associated with subleasing.

Assignment:
– Tenant should be able to assign its lease an affiliate, parent corporation, successor entity, or controlled or controlling entity with no prior written approval from the landlord.
– Tenant should also be able to assign its lease to an entity resulting from a merger or consolidation with no approval from the landlord.

Growth/Expansion Options

Fixed Expansion Option: A sizable tenant may require the landlord to offer them additional or adjoining space at a predetermined time in the future. This is the most tenant-friendly of expansion options because it limits the landlord’s ability to market the space to prospective tenants. Landlord’s reluctantly grant fixed expansion options unless the tenant occupies a substantial portion of the building. In such cases, the landlord will make the reserved space available to the tenant typically between the 4th and 7th lease years of a 10 year term. If exercised, the economic terms can be tied to the then-escalated rental rate and up-front concessions, or the then-prevailing market rate.

Right of First Offer: A Right of First Offer (ROFO) obligates the landlord to offer a tenant holding the ROFO additional or adjoining space in the building once it becomes available after initial lease-up. The landlord must notify the tenant of the space availability in writing prior to presenting it to third parties. If the tenant is interested in the space, then the tenant and landlord will engage in negotiations per a timeline determined in the lease. ROFO’s can either be ongoing or a one-time right. Attempt to secure an ongoing ROFO in order to maximize flexibility for future expansion as the time frame in which space becomes available in the building may be unknown.

First Right of Refusal: A First Right of First Refusal obligates the landlord to present a deal to a tenant holding the First Right of Refusal that they are willing to sign with another party for additional or adjoining space in the building. If there is interest from the existing tenant with the First Right of First Refusal, then the tenant may elect to match the offer from the third party in order to secure the space. This is less favorable than a ROFO because it limits the tenant’s ability to negotiate with the landlord. A tenant holding a First Right of Refusal must match the offer made by the third party or decline the space altogether.

Other Flexible Options to Consider

Renewal Option: A Renewal Option is often negotiated to protect a tenant from having their space leased out from under them. This option protects the tenant’s rights and acts as future negotiating leverage. A Renewal Option may shield a tenant from another party willing to pay a higher rental rate, or from a larger tenant in the building needing expansion space. Focusing on a predetermined rent for the renewal rather than Fair Market Value will most likely yield the most favorable results. Renewal options that allow a landlord to raise rents based on fair-market rates can result in large rent increases, especially in a tight market or if the building is in high demand.

Burn-Down in Security Deposit: A landlord may require a sizable security deposit from a tenant with little history or financials that do not meet their standards. For such companies, security deposits can be as high as 6-12 months. A “burn down”, or gradual reduction in the security deposit, can often be negotiated into a lease. The burn-down will take effect at a predetermined time in the lease, often after the first or second year, and continue periodically so long as the tenant is not in default.

If you have any questions, comments or are in need of space, please fill our questionnaire or contact us directly!

 

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