Space Considerations And Lease Negotiations In A Down Market

Sunday, March 1, 2009 - 00:00

Introduction

The year 2008 marked a significant decline in office leasing activity with downward trends expected to persist through 2009, as evidenced by growing amounts of vacant space, a decrease in rental rates and an overflow of available sublease space. The commercial vacancy rate in Manhattan jumped from 7.9 percent in 2007 to 11.3 percent in 2008, with 2009 projections leaping to as much as 17 percent, which translates into approximately 15 million square feet of vacant space coming onto the market by the close of 2009. (CBRE predictions published in Real Estate Weekly, January 21, 2009; Report by Property and Portfolio Research, Inc., Crain's New York Business, November 3, 2008). Half of the available space flooded the market in the fourth quarter of 2008 (CBRE predictions published in Real Estate Weekly, January 21, 2009), with Midtown experiencing the highest vacancy rate jump. (Jones Lang LaSalle report published in Real Estate Weekly, January 7, 2009). Manhattan vacancies include both office vacancies resulting from the closure of firms in the financial, banking and legal services industries and rising unemployment rates, as well as retail vacancies as demonstrated by the 25 vacant storefronts on Madison Avenue by the end of 2008. (Grub & Ellis predictions published in Real Estate Weekly, January 21, 2009). In addition, commercial rents started to fall in Manhattan for the first time in years during the summer of 2008 and continued through the end of the year with similar projections for 2009. The fourth quarter of 2008 saw an overall drop in asking rents by four percent from the previous quarter. (FirstService Williams report published in Real Estate Weekly, January 7, 2009). Such decreasing rental rates have been caused by the significant growth in the sublease market, vacancies due to unemployment rates and financial uncertainty, and the new construction of various buildings in the city that was completed last year. All of these factors contribute to the decrease in demand at a time when supply is on the rise. Because sublease rental rates are often less than direct lease rates landlords seek, a large sublease market drives rents down not only because of more available space on the market but also because of such lower sublease rates. Almost 2.4 million square feet of sublease space entered the market in the fourth quarter of 2008. (FirstService Williams report published in Real Estate Weekly, January 7, 2009).

Over the past several years, landlords across the country, but especially in New York City, have experienced a thriving and robust leasing market. During such bull markets, businesses grow along with space needs, and in turn rental rates increase due to the high demand and lower supply of available space. A robust leasing environment provides landlords with leverage to dictate the terms of the deals and control the negotiations, and interested tenants must move fast or risk losing the space to another tenant. In 2009, it is predicted that the commercial leasing market will follow a bearish trend enabling tenants to stand on more equal footing in lease negotiations. Landlords need to meet ownership financial obligations (i.e., making mortgage payments and paying real estate taxes and operating expenses), so carrying large quantities of vacant space can mean that the building's cash flow does not cover building costs. In such a climate, landlords have ample incentives to make deals even if that means being more flexible in lease negotiations. Viable tenants will benefit from a smaller tenant candidate pool and a slowdown in leasing activity.

Space Decisions

During a recession, companies explore options to cut expenses, such as downsizing, and thus must evaluate their space and location needs. If the tenant's current lease is set to expire, then in deciding whether to stay or move, the tenant must analyze its current situation, long-term needs and goals, growth projections and general market trends.

Tenants may want to negotiate with their current landlords to remain in their current premises for a short, extended term. This option is most desirable for companies with uncertain long-term prospects who are more focused on short-term cost reduction. However, the tenant who desires to stay put and enters a short-term extension of his lease should consider the consequences of a rising market when the lease term expires, as the economic landscape will likely look quite different.

Tenants who have the financial capability to incur leasing expenses and are comfortable with long-term projections should take advantage of the lower rents and incentives that landlords are offering by relocating to a new, possibly larger and more suitable space. Typical costs associated with signing a new lease include moving expenses, building out the new space, legal fees and paying the first month's rent and security deposit. In a tenant friendly market, landlords often agree to cover some of the tenant's upfront construction and moving expenses. For example, the landlord may offer to pay for the tenant's build-out or even agree to perform the work required for the tenant's occupancy. In this environment it is important for the tenant to be comfortable with the financial strength and level of commitment of the landlord.

Lease Negotiations (Why It's A Good Time To Be A Tenant)

Creditworthy tenants can leverage their status in making good economic deals knowing that landlords are dependent on cash flow from rent payments in order to fulfill their own financial obligations. Because there is a smaller pool of available tenant candidates, landlords should and are going the extra mile to accommodate tenants' reasonable requests. Landlords want to work quickly to negotiate and complete the deal for fear a tenant will change his or her mind or go to other available space. This section will highlight some key negotiation demands and strategies for tenants capable of taking advantage of a soft leasing market.

Discounted Rent And Free Rent

A reaction to a decline in leasing activity requires building owners to offer flat or reduced rents to remain competitive, as they must retain or find tenants in a market that is overflowing with available space. Landlords are not only waiving the first month's rent to be paid upon lease execution, but tenants are getting longer free-rent periods. Various free-rent models can be negotiated, such as a free-rent period at the beginning of the term, or mixed throughout the initial few years of the term (i.e., free rent for a portion of each of the first three years of the term). Free-rent periods are particularly useful for new businesses that do not have the capital to begin paying rent until the business is up and running.

Initial Build-Outs And Work Allowances

Tenants are receiving money from landlords to prepare the new space for the tenant's occupancy. Work allowances may be paid to the tenant in one lump sum, as needed as the work progresses, or even as a credit towards rent. Tenants should consult their architects and engineers to gather cost information about their build-out and then negotiate a payment method that most suits the tenant's particular needs. Some landlords are even agreeing to perform the initial build-out up to a pre-negotiated cap or based on a plan attached to the lease.

Flexibility Of The Term

In these unprecedented times, the exit strategy is often a key item driving the lease negotiations. Tenants may be able to get the right to terminate the lease early upon reasonable advance notice to the landlord (typically, 12 months). In prospering markets, landlords do not readily allow tenants the right to terminate early because this would affect the landlord's ability to maximize its refinancing amount or sales price. But, in order to compete in today's market, landlords may be more amendable to early termination rights.The right to terminate the lease is not completely cost free, as the tenant should expect to pay the landlord's unamortized lease expenses incurred in the initial transaction (such as the unamortized brokerage commission, rental concessions and work allowance or build-out costs); however, the costs associated with an early termination are far less than the cost of paying for unnecessary space.

Due to the uncertainty of the economy, some tenants are favoring leases with shorter initial terms coupled with renewal options. Tenants may also be able to negotiate for shorter renewal notice periods, which will allow for better positioning when assessing what the fair market rent should be at the commencement of the renewal term. Tenants may also want the right to surrender a percentage (and not all) of their space, in the case of a downsizing, which they can do at a set point during the term or prior to the renewal term. Again, tenants should be cautious when signing a short-term lease because the market will rise again and when it does, the tenant would prefer to be locked into a lease at a lower rent than searching for new space at a time when rents are higher and concession packages less favorable.

Flexibility In Assignment And Subleasing

Another crucial provision when negotiating an exit strategy is the right to sublet all or a portion of the premises or assign the tenant's interest in the lease. Historically, landlords controlled the transfer process, restricting the tenant's right to transfer its interests by having unfettered rights of approval in who the transferee is, what the transferee will use the premises for, when the tenant can assign or sublet and the rent the tenant may offer to the transferee. Today, tenants should negotiate greater flexibility in the assignment and subletting section of the lease. The tenant should seek to limit the landlord's approval conditions and other possible impediments to the tenant's ability to shed space.

The items in this section are all important areas the tenant should focus on during lease negotiations, along with other ways to minimize ancillary occupancy related charges.

Conclusion

Although the United States' economy has slipped into a prolonged and painful recession, the current market will not be here forever (maybe not even next year), so this may be a good time to take advantage of the unusual opportunities for affordable prices with reasonable overall lease terms.

Mark E. Maltz is a Partner and Brooke E. Richmond is an Associate in the Real Estate practice group of Davis & Gilbert LLP.

Please email the authors at mmaltz@dglaw.com or brichmond@dglaw.com with questions about this article.