Michael Webber, Executive Vice President
September 2021
How do I sign a long lease when I’m so unsure about our future needs?
Office leases by their very nature represent a substantial financial, physical, and cultural commitment for tenants. A tenant agrees to pay rent on a set amount of space for a set period of years, regardless of whether the space continues to suit the tenant’s operating needs. Unfortunately, in both good and bad economic times, there is a large element of unpredictability to most businesses. What if the business grows or shrinks dramatically? What if we acquire another business, are ourselves acquired, or merge with another group? More relevant to today’s environment, what if we significantly change the way we do business and utilize office space? Who knows what our company will look like / need in five years? 7 years? 10 years?
What would seem to be the simple solution – a shorter lease term – is difficult to achieve and can be very costly. Aside from the fact that most landlords are not interested in short term leases and many won’t address the possibility at all, the negotiating leverage a tenant wields to affect rental rate, construction allowances and concessions like free rent periods declines dramatically with shorter lease terms.
The best way to deal with uncertainty in lease commitments is to build in as much flexibility as possible. While many forms of lease flexibility are resisted by building owners at every turn, they are worth pursuing and are an important part of any long-term lease negotiation.
Future Expansion
Expansion opportunities are usually fixed options, rights of first refusal, rights of first offer or some hybrid of these. Each is described below.
Fixed Expansion Option – The typical fixed expansion option provides a tenant with the right to expand into a predetermined area at a predetermined time. Ideally, the option will be on predetermined economic terms as well. Landlords are generally averse to fixed expansion options because they limit the landlord’s flexibility and ability to enter long-term leases with other tenants. If Tenant A has the right to expand into a given space in year four of its lease, the landlord cannot lease that space to another tenant for more than that amount of time. It also follows that if Tenant A does not exercise its expansion option, the landlord most likely has a vacant space that must be leased. Fixed expansion options are most common in newly constructed buildings and provided mostly to anchor tenants.
Right of First Refusal – A right of first refusal (ROFR) is somewhat less onerous from a landlord’s perspective, but there is still some reluctance to grant it. With a ROFR granted to Tenant A, a landlord must first find a tenant and negotiate terms. Prior to executing the lease, the landlord is obligated to offer the same terms and conditions to Tenant A. Only after Tenant A rejects the offer can the landlord consummate a transaction with Tenant B.
Right of First Offer – Under a right of first offer (ROFO), a landlord is obligated to offer a predefined space which becomes available to Tenant A prior to marketing such space to anyone else. Generally, the landlord must offer such space on the same terms and conditions that will be offered to others on the same space. If Tenant A does not exercise its right, the landlord is then free to market the space to others. This form of expansion right is the easiest for a landlord to grant, although it is the least attractive from a tenant’s point of view. The tenant is not guaranteed any expansion opportunities, and there is no firm assurance that the offered terms will be reflective current market conditions. To make a ROFO more meaningful and effective from the tenant’s standpoint, often ROFO’s include a provision that requires the landlord to offer the space again after a set period of unsuccessful marketing efforts.
Contraction or Termination
There are many reasons a space may no longer be needed or the amount of space needed shrinks substantially. With a long-term lease, there are three different ways to address this.
Subleasing Rights – Most leases in today’s environment contain a right for the tenant to sublease some or all of the leased space. Landlords will often want to restrict these rights somewhat, and those are the points to be negotiated. Restrictive subleasing provisions often include:
No subleasing to existing tenants in the building.
No subleasing to governmental entities.
No subleasing to a prospective tenant to whom the landlord has shown and/or negotiated for direct space in the building.
A right for the landlord to terminate the lease with respect to the space proposed to be sublet (i.e., recapture provision).
A provision that the landlord is entitled to any profits from subleasing the space.
While liberal subleasing rights can be important, they require the tenant to find its own subtenant and the sublease rent is almost always at a significant discount to the rent the tenant is paying. This results in an ongoing loss for the balance of the lease term.
Termination Options – For longer term leases, the inclusion of a right to terminate the lease is a fairly common practice. For example, a tenant may have the right to terminate the lease six years into a 10-year lease term. Typically, a notice period of perhaps a year is required, and the tenant usually must pay a termination penalty or fee. All the terms are subject to negotiation, but frequently the termination penalty is based on the landlord’s unamortized initial costs of the transaction (i.e., tenant improvement allowances, leasing commissions and rental abatements). Landlords are reluctant to grant termination options because it is a potential disruption to their assured cash flow, and they will negotiate for high termination penalties as a result.
Contraction Options – Similar in concept to termination options, contraction options will apply to only a portion of the leased space. In the case of a tenant who leases multiple floors in a building, a contraction option might only cover one or more floors. The structure is much like that of a termination option, with the tenant giving significant advance notice and paying a penalty based on the landlord’s upfront costs.