Real Estate Yoga

By Ken Ashley

(ATLANTA) October 2nd, 2010

The market opportunities for tenants are great these days. In fact, it almost seems like many ownerships are holding a “Fall Sale;” everything’s marked at 50% off! At the same time, we are beginning to hear many clients and others in industry talk about growth. The challenge is occupiers aren’t ready to lease the space for expansion just yet. Also, if one signs a seven, ten or even fifteen year lease, the needs of the company are bound to change.

Go Long, but Option Up

Of course, there is much more to an agreement with a landlord than just the face rate of the lease. Flexibility in the arrangement is both a hallmark of good representation and a reflection of the current market conditions.

Can your lease do this?

So, if you need to have a little real estate yoga, what kinds of options are available for tenants?

Please Don’t Go

Termination options are the most radical ways to leave a lease. There is a degree of certainty in a termination option that is nice to have. Many a decision maker has told us they hope to never need this kind of option, but they take comfort in knowing the ability to terminate is present in the lease.

These options come in many different flavors. The simplest is to negotiation the right to unilaterally terminate approximately three quarters of the way through an obligation. Most landlords will want notice (period is negotiable but we try for about 6 months), unamortized tenant improvement dollars, commissions and a fee of 1-6 month’s rent.

We sometime discuss a variation of this approach called a growth termination option. Put simply, if the landlord can’t accommodate a predetermined square footage or percentage of growth, then after midpoint in the lease, we have the option to leave. The advantage here is the landlord is usually a little more flexible on exit fees, because if we leave, their building is likely leasing up nicely. The risk or reletting the premises is question is perceived to be less.

The main reason landlords don’t like termination options, is they severely affect underwriting of an asset when they go to market to sell. Most will tell you if a tenant signs a 15 year lease with an option to terminate at the 10th year, investors look at the obligation as only 10 years.

Maybe Yes, Maybe No

So what can you do short of leaving a building if your needs change? Like a good Ray Charles song, the landlord says please don’t go baby – we can work it out! Of course, the key is to negotiate options to grow, contract or move in the initial lease negotiations. The nice thing about these options is you don’t have to do anything and as most landlords will tell you options always inure to the benefit of the tenant.

There are long legal tomes that address all the various iterations of options, but briefly they fall into a Right of First Option, Right of First Refusal and Sublease.

A Right Of First Option is the clearest and strongest right that can be granted to give a tenant flexibility in the future; the option grantee is given the right, but not the obligation, to lease additional space in the future.  To be enforceable, the option should set forth exactly what space is subject to the option, the price and terms on which the tenant can exercise the option, the date or dates on or between which the option is exercisable. Landlords usually won’t give up this kind of right easily because is encumbers their space. Large space users stand a better change of securing a Right of First Option.

A Right of First Refusal is an alternative to an option.  Unlike an option, a right of first refusal does not entitle the tenant to lease the space in question.  Instead, if and when the other party decides to lease the asset to another tenant the holder of the Right of First Refusal can require the space be leased to him or her for the same price and terms that the owner is willing to accept from the third party.  Obviously, a right of first refusal is much weaker from the standpoint of the holder that an option: it does not set the price and other terms for the lease in advance and the tenant is subject to a deal someone else has negotiated for the space in question.

A Sublease simply allows another tenant to step into your space and use it based on terms upon which you mutually agree. There are a number of important issues to deal with in sublease language. Keep in mind that in this market the tenant may have a valuable commodity when lease rates rise. Don’t allow a landlord to recapture the space and cancel your lease just because you request approval of a sublease. Also, make sure the landlord approves or disapproves of a subtenant within a reasonable period of time and fee.

We Can Always Agree to Agree

Finally, keep in mind that you are likely to have market leverage at most points in the future if you are a growing and well paying tenant. Capitalism is a great thing and the ultimate sanity check in all things economic. Real estate is no exception and most landlords will work to keep things fair so they can keep you as a tenant. Good landlords are acutely aware of the cyclical nature of this business and try to create long term relationships, not short term profiteering.

So now that we’ve been through our Real Estate Yoga class don’t you feel better? Now off to work!

5 responses to “Real Estate Yoga

  1. Valuable points for smaller (retail, for-profit schools, non-profits, etc.) operators expanding into larger spaces w/ more sophisticated lease options w/ more explicit lease language and implications.

    Local/ regional tenants have been asking about the above topics but typically will not spend the money to hire a Tenant Advisor — perhaps pieces like this will educate them on the value of hiring one to advocate their real estate needs.

  2. Ken,
    Great info. Question? Without giving away propitiatory details, could you give a specific example of a tenant exercising one of the above options and how it was beneficial for that specific tenant?

  3. Sure Duke. In the case of a right of first refusal, a tenant can have the ability to expand in a vacant space abutting their premises with no commitment up front. Here’s an example: let’s say out tenant leases 10,000 s.f. and has a right of first refusal on an adjacent 2,500 s.f. That space sits there until Newco shows up. Newco offers to lease the space at 5 years for $22 a foot with 6 months free and market TI. The landlord give us notice of this deal and we like it. So, our tenant then takes the space, but they take it under the terms that Newco negotiated.
    The benefit? We have the option, but not the obligation to expand.

  4. Ken,

    Great article. I haven’t played around in the leasing world very much, but I recently ran into a close friend who is in a situation with a tenant looking to expand their business into 5-10 more locations, and fast. Their corporate policy indicates that they are to sign leases of NO longer than a year, due to the nature of their business. The tenant is willing to pay rent upfront, however many owners are still shooting them down, even with several vacant spaces.

    It is interesting to see the balancing act that owners and tenants are trying to find.


  5. David Stejkowski

    Good article. FYI, what I have seen most often when representing landlords is a right of first opportunity when space becomes available for lease. This approach can be a good balance for landlord and tenant from my experience.

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