Not long ago, commercial real estate tenant space decisions followed a predictable formula. Lengthy lease terms, fixed square footage and often heavily amortized tenant improvements were typical components to agreements. These variables benefitted tenant and landlord alike. However, whether office, industrial or other commercial asset class such as medical/life sciences, occupiers now expect some degree of optionality in their lease agreements.
“The model is evolving,” says New York City based Kenneth Salzman, SIOR, and Principal at Cresa, the global commercial real estate advisory exclusively representing occupiers. “From a tenant representation standpoint, the central focus has moved away from simply what the market rent is to figuring out ways to build flexibility into the commitment without undermining the business’ economics, credit or capital access.”
Brokers specializing in occupier services point to one defining moment in time when optionality not only became more desirable, but critically important.
“A lot of this focus on flexibility took hold during the pandemic years,” says Street Jones, SIOR, SIOR Board Member and Principal with Rich Commercial Realty, a North Carolina-based commercial real estate brokerage firm. “A curveball of that magnitude couldn’t have been predicted. However, after experiencing it, companies now understand anything is possible and are thinking about worst case scenarios when they negotiate for space.”
With contingency planning front and center, numerous contract options are now widely desired. These include phased commitments, shorter lease terms, expansion and contraction flexibility, termination rights, and the ability to sublease space.
“Occupiers are aligning commitments with capital events, supply chain restructuring, regulatory approvals, M&A activity, and headcount volatility,” says Salzman. “One result of Covid is that the traditional leasing model, particularly for office, has been thrown on its head. Landlords unaccustomed to short term extensions, conditional commitments, and phased decisions have been forced to revise their pro-forma assumptions, as occupier demands for flexibility are only increasing.”
Adds Michael Feuerman, Esq., SIOR, SIOR Board Member, and Managing Director-Palm Beach County for Berger Commercial Realty / CORFAR International, “Forward thinking clients understand they need to plan for future growth as well as for potential contraction if that becomes necessary. Unless you’re in an industry where employee headcount is highly predictable, then you’ll always need to plan for these scenarios.”
Not all contract options are as easy to negotiate and secure, however. They impact a landlord’s risk, profitability and finance agreements with their lender.
“Landlords must balance tenant optionality with debt covenants, tenant improvement amortization schedules, WALT stability, and refinance risk,” says Salzman. “As lease durations compress, underwriting assumptions tighten.”
While shorter-term leases are certainly ‘en vogue’, the market has again been more open to longer terms. Jones notes that “Tenants are becoming more agreeable to longer leases, however they want to pair that with termination rights. While we can’t always negotiate those successfully with landlords, we will try to and often have better chances if the property is in a struggling submarket. Still, termination rights always come with penalties.”
The ability to expand is also important. “We have many clients in growth mode,” says Feuerman. “When negotiating expansion rights for them, it’s not enough to just secure the right to expand. You need to tie the cost of the expansion space to the economics of what the client is paying on the original space, if possible, and secure concessions and improvement allowances ahead of time as well.”
Subleasing options are another common point of negotiation, and Feuerman speaks to some of the challenges. “The simple right to sublease isn’t the only thing to consider and ask for,” he says. “It’s critical to negotiate all terms and conditions surrounding subleasing upfront. This includes how profits will or won’t be split, how long a landlord gets to review and approve a sublease request, as well as how stringent a landlord can be in approving a subtenant.”
Jones has found success with his clients going the spec space route. “This can be an ideal option for companies who want to eliminate the additional cost and timeline uncertainties involved with an upfit,” he says. “With spec space, you can avoid surprises associated with completion timing, construction costs, and any complications working with municipalities. We have found this option to be popular with local and corporate tenants alike.”
Many agree, a lot of these options discussed are most important today to occupiers of office real estate, noting one still present challenge for these tenants – the tension between employers and workers regarding the prospects of working from the office, from home, or some mix of both.
“There’s still an imbalance that hasn’t been fully worked out between employees who want to work from home and the employers wanting their workforce back in the office,” says Feuerman.
Says Jones of how likely owners are to agree to some of these options, “It really depends. Owners that are well capitalized, as well as those planning to hold the asset, may be more willing to play ball during negotiations.”
Lenders also play a pivotal role. “The lender is often behind the scenes with control over what decision ultimately gets made,” Jones adds.
Regardless of what the situation may be during negotiations, time can be saved by being upfront about the tenant’s goals. “In the current environment, we are encouraging more open dialogue between parties from the start so that nobody wastes the other’s time going down a path that is not viable,” he says.
Adds Salzman, “Commercial real estate leasing conventions are evolving; however, the bottom line is the transaction structure must align with the occupier’s needs.”
