Read the following three concepts. Explain your interpretation of each, and how you would apply each of the three concepts to real world real estate issues
Concept of Negotiated Lease Provisions
Every clause in a commercial lease can affect the property’s operating income and value. Clauses that address rent payments and the responsibilities of owners and tenants for operating expenses have a direct effect on property income. However, numerous clauses that address the operation of the property and the rights of either the tenant or the landlord can Page 580also have a significant effect on the economics of a lease and, therefore, its risk and value to both the tenant and owner. This section discusses the clauses and provisions that are typically part of a commercial lease negotiation.
Use of the Premises
If a lease does not state a specific purpose for which the property may be used or specifically forbid certain uses, the tenant may use the property for any legal purpose. Typically, however, commercial property leases contain a clause that indicates the purpose for which the space may be used. In addition to ensuring that the space is used lawfully, such clauses prevent uses that may damage the building, detract from its image and prestige, disturb or conflict with other tenants or surrounding neighbors, or expose the owner to potential legal liabilities.
Lease Term
The lease term must be clearly indicated, including the beginning and ending dates. One-year terms for apartment leases are the industry standard. For other commercial property types, however, lease lengths can vary considerably. Longer leases provide more stability for both the tenant and owner and they delay the re-leasing costs faced by tenants and owners when a tenant vacates the premises. For example, owners may face an extended period of vacancy and may incur significant search costs in their attempts to find a new tenant. With the exception of apartment projects, the owner will usually need to pay a leasing commission to the person responsible for securing a new tenant. In addition, the owner will generally need to provide a tenant improvement (TI) allowance to the new tenant. The TI allowance is the amount the landlord agrees to spend to build out or refurbish the space to meet the needs of the tenant’s business. The owner may take care of the improvements him- or herself, pay the allowance directly to the tenant, or pay contractors on the tenant’s behalf.1
When vacating space upon lease termination, tenants face moving costs, including the possible disruption of their business. In addition, tenants frequently make significant improvements to the space when moving in, often in excess of the TI allowance. These improvements may be lost when they vacate the premises because they have become part of the real estate (see Chapter 2). In short, both tenants and owners are negatively affected by re-leasing costs. As a result, both prefer longer-term leases, all else being the same, in order to minimize such costs.
Although longer-term leases delay re-leasing costs and provide rental rate security for both tenants and owners, a significant cost may be paid in lost flexibility. If tenants have reason to believe market rents are likely to fall in the near future, they may prefer shorter lease terms. In addition, many tenants are uncertain about what their space needs will be in the future. If tenants expect their business to grow steadily, or if their business is a risky start-up venture, shorter-term leases may be preferred. In general, the more uncertain a tenant’s future space needs, the greater the value associated with flexibility.
Flexibility is also valuable to owners. For example, landlords may desire a shorter lease term if they believe market rents are likely to rise in the near future. In addition, owners often desire to alter the mix of tenants to maximize the synergies of the property. This is especially true for shopping center properties, as we discussed in Chapter 21. In short, flexibility considerations suggest shorter-term leases are more valuable to both tenants and owners. Therefore, optimal lease terms reflect the trade-offs between the desire for the flexibility inherent in short-term leases and the reduction in risk and re-leasing costs associated with longer-term leases.
Concept of Concessions
Once a lease has spelled out how rents are to be determined over the lease term and how owners and tenants are to share the responsibility for operating expenses, the basic economics of the lease have been established. However, lease contracts may also contain one or more concessions that reduce the lease cash flows. Concessions are usually offered to potential tenants to provide them with an incentive to lease space in the owner’property, but they are not reflected in the quoted rental rate.
A concession often granted to new tenants when the supply of space exceeds demand is a period of free, or perhaps reduced, rent. The owner also may commit to pay a tenant’s moving expenses or penalties incurred by the tenant in breaking an existing lease.
A common concession found in office, industrial, and shopping center leases, are tenant improvement allowances, discussed above. TIs are usually stated as a per square foot amount. If a tenant is moving into an existing space that has already been finished out by a prior tenant and requires little in the way of alterations, the negotiated TI allowance may be $5 per square foot or lower. However, if a tenant is moving into newly constructed “shell” space, the owner may be required to provide a significant TI allowance to permit the tenant, or the owner on behalf of the tenant, to build out the space in an appropriate fashion. The magnitude of the tenant improvement allowance is often a heavily negotiated lease item.
Concept of Subordination and Non-Disturbance.
Banks or other lenders may request—or demand—that property owners include a subordination clause in their leases. Essentially, this clause states that the lease is subordinate to any existing or future mortgages on the property. Thus, if the owner defaults on the mortgage and the lender forecloses, the lender has the right to terminate the lease and evict the tenant, even if the tenant has fulfilled all of its responsibilities under the lease. However, a subordination clause puts tenants at risk of losing their business location, which can be critical to their operations and customer relationships. In addition, they risk losing any investments they have made in leasehold improvements.
One solution is to ask the lender to enter into a non-disturbance agreement with the tenant. This agreement prohibits the lender from interfering with the tenant’s use of the premises, as long as the tenant continues to pay rent and otherwise complies with the lease agreement’s terms and conditions.