Unlocking Flexibility in Long-Term Office Leases: A Guide to Smart Negotiation
Lease agreements are typically long-term contract arrangements, often 3–15 years. Predicting longer-term business cycles beyond 2–3 years makes planning future space requirements for office tenants a difficult proposition. Businesses evolve, market conditions change, and unforeseen events can drastically alter the landscape, creating the need for a more flexible office lease.
Why Aren’t Short-Term Leases More Prevalent?
There are multiple reasons building owners shy away from shorter-term leases, including securing stable, predictable cash flow to maximize the value of their assets. Second, the landlord typically makes a sizeable upfront investment in leasehold improvements, architectural fees, and leasing commissions necessary to find new tenants and prepare the space for occupancy. This requires a longer-term lease to recoup these up-front costs and secure an acceptable return on investment.
The tenant often wants longer-term leases to lock in their rental costs over a longer period and secure adequate capital investment from the landlord to design and build out their space for their specific use rather than use their capital for improvements. Shorter-term leases are typically much less cost-effective, particularly in an improving market.
In today’s economy, where business cycles are 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 is important for a flexible office lease. 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, suddenly faced with an unreasonable volume of costly unoccupied space, or no longer need the space due to a merger or acquisition. 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 their 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 them the ability to give space back and downsize before the end of their lease term.
Expansion Options
A growing tenant or a company that anticipates expanding staff often negotiates expansion options into their 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 become available.
Hold Options/Fixed Expansion Options: The tenant has a defined period 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 space becomes available in the building, the landlord is obligated to present it to the tenant before marketing it to third parties.
First Right of Refusal: This typical provision obligates a landlord 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 in 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 spaces have already been granted to existing tenants of the project, but it is also feasible to negotiate subordinate rights for another tenant in the event the option is declined, expires, or the first right holder vacates the building.
Flexible Office Design / Alternative Work Strategies
Today, as the nature of the workplace is rapidly changing, there are new ways to incorporate flexibility into 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 is often not currently equipped to adequately serve the higher-density workplace of today and in the future.
The 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 their asset as possible. The market conditions, negotiating leverage, which depends on several factors, and the tenant’s and their real estate broker’s negotiation skills all affect how flexible you can be.
There can be costs associated with creating a more flexible office lease, but think of it in terms of 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 and mitigating risk. Don’t overlook your options to do so.