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Leasing Office Space
Leasing Office Space
Leasing office space is time-consuming, complex and can divert attention from the primary functions of the business. Steps in the process of leasing office space include selecting a tenant rep broker, location, researching options, selecting the best options, negotiating the primary business terms, selecting an attorney and negotiating the details of the lease.
Tenant Rep Brokers
Begin your search for office space begin by selecting a tenant rep broker. You may initially wonder, "should I skip the broker, and save the fee?" The reality is the cost of office space will be about the same whether or not you use a tenant rep broker. The landlord's broker is paid 4% if he negotiates a leased directly (with the tenant) and 2% if an outside broker is involved. If a tenant rep broker is involved, he would typically be paid 4% of the gross total payments over the term of the lease. Unless you are quite knowledgeable regarding real estate leases, you are well advised to utilize a broker. (Our firm does not provide this service and in no way benefits if you use a broker.)
Specialized Issues and Terms
There are nuances in the process for which guidance and counsel is invaluable. These include what is and is not negotiable, and the reputations of the landlords and management companies. Even if you negotiate what is perceived to be an incredible deal, is it really a "good deal" if the landlord provides terrible maintenance and service? Is it a great deal if your space is not available until 4 months after the agreed upon date?
Right Tool for the Job
Tenant rep brokers are a great option for your office space search. Their fee is paid by the landlord in most markets. They are office space experts. Every day, they work on finding and negotiating agreements regarding office space. Even if you started the office space search within online search service, using an office tenant rep broker will probably generate the most cost-effective office space for your business. Brokers know which landlords are most negotiable and how to structure the transaction to obtain the lowest cost.
Get an Expert!
If you select a tenant rep broker to help find your office space, find an expert. Do not hire the person who helped you purchase your house. Office space tenant rep brokers are full-time experts. It is a very specialized area.
Identify Tenant Rep Brokers
Ask business acquaintances for office tenant rep broker referrals.
Use a search engine to identify perhaps five or 10 office tenant rep brokers in your area. Do your initial research by reviewing their website. Are they office space experts? Call and interview perhaps five to seven by phone.
In addition to basic information regarding their company, and references, you'll want to ask some of the following questions:
Meet Tenant Rep Brokers
- Do you typically represent tenants or building owners in lease negotiations?
- What other commitments do you have at this point?
- Do you have time to properly represent me?
- What is your experience in leasing office space?
- How many years experience in leasing office space?
- How many transactions have you completed?
- What is the total amount of office space?
- I'm thinking about leasing space downtown. Have you recently done any transactions in that area?
- What is your approach to negotiating? Is it to extract every possible concession? Is it to negotiate a commercially reasonable transaction in an expeditious period of time? (Which of these is more consistent with your approach?)
- What are the market conditions and trends in the area I'm considering? Should I be considering a short-term lease or a long-term lease?
- How are you compensated? If you're paid by the office building owner, what communications with your confidential and which ones will you be communicating to the office building owner? Are you my representative or the representative of the office building owner?
Set up meetings with two or three of the tenant rep brokers if you have not chosen one after the first round of phone calls. The objective is to visit more regarding their office assignments, obtain their thoughts on locating appropriate office space for your business, and determine whether you will feel comfortable working with them.
Obtain Actionable Advice
While you make the final decision when selecting office space, you will want to feel confident the office space tenant rep broker will provide actionable advice.
Paid by Landlord and Advices You?
The compensation arrangement with the tenant rep broker is often not intuitive. In most cases, the tenant rep broker will be paid by the landlord. He has a fiduciary relationship to the landlord. His relationship with the perspective tenant is to provide honest information. Your office space tenant rep broker will go out of his way to accommodate you and help with the search process. However, remember that his client is the landlord. If you discuss your negotiation strategy or the maximum amount you're willing to pay, the broker has an obligation to provide this information to his client, the landlord.
Selecting office space begins by selecting a tenant rep broker. You may initially wonder, "why don't I skip the to broker, and saved the fee?" The reality is see will be about the same whether or not she's use a tenant rep broker. The landlords broker gets 4% if he negotiates a leased directally and 2% is an outside broker is involved. If a tenant rep broker is involved, he would typically be paid 2% of the gross total payments over the term of the lease. Additionally, there are nuances in the process for which guidance and counsel is it invaluable. These include issues such as what is and is not negotiable, and the reputations of the landlords and management companies. Even if you negotiate what is perceived to be an incredible deal, is it really a "good deal" if the landlord provides terrible maintenance and service?
What you have selected a broker, clearly communicate your goals and objectives. (You may not want to disclose your maximum budget.) Discuss the locations you are considering, the number of employees, amenities which are important, the class or quality of space you are considering and any other relevant expectations. A crisp and effective communication with the broker will reduce time necessary to find appropriate office space.
Office space location issues can include proximity to existing and potential employees, clients, vendors, and various third parties. For companies with less than 100 employees, the primary criteria for selecting a location is typically proximity to the chief executive officer's residence. As a company grows, office relocations also consider where both existing and prospective employees live. If a company moves 20 or 30 miles from its current location within a metropolitan area, some employees may decide to the additional commute is not worthwhile. If the company moves to another metropolitan area, it will likely lose many of the lower to middle level employees and a portion of the senior management.
Employee Home Locations
The home location for prospective employees must also be considered. If a company has 10 employees, it probably works fine to have an office on the fringe of the metropolitan area. However, a company with hundreds or thousands of employees must consider drawing its staff from a larger geographic base than is reachable from the fringe of the metropolitan area. For example, if your company is on the southern fringe of a large metropolitan area, prospective employees on the northern fringe would be reluctant to make the commute.
Many tenant rep brokers have a tool to evaluate the centric location of all employees. The home address of all employees is entered into a database. The computer algorithm calculates the centric location.
Appearance and Location Appropriate for Clients
For some companies, office space must be selected based on a location convenient to clients and an appearance that is appropriate for clients. For many businesses, clients rarely visit the office. If they do need to visit the office, they do not expect it to be convenient and luxurious. In this situation, most companies elect to choose office space which is low to moderate in price. Conversely, clients of some firms expect the location to be convenient and the office space to be impressive. Large law firms and trust companies fit this category.
Location of Vendors
The location of vendors and various third parties can be important in selecting the location of office space. Companies which have a strategic alliance with vendors or routinely access parts from vendors must consider the location of their vendors when selecting a location. Attorneys who routinely make appearances in civil court or criminal court often select a location close to the courthouse. Property tax consultants often select a location near the appraisal district office. Consider whether you need to be close to either vendors or other third parties when selecting your office space.
Additional Location Factors
Following are addition considerations that may be relevant for you when selecting the general location for office space:
Evaluate Location Factors
- Is it near highways (to reduce travel time)?
- Is it near the airport?
- Is there abundant parking?
- Is parking free?
- Is the area safe?
- Will female employees feel comfortable walking to their cars and driving through the area after dark?
- Is traffic light or heavy?
Determine which issues are most important for your firm. Consider using a weighted average ranking system to a value at which area works best for your firm. In this system, you assign each factor a relevance index from one to 10 (with 10 being most important). You then evaluate the quality ranking for each factor. For each factor, multiply the relevance factor times your quality rating for each of the general location sure considering. Then total the score for each location. The building with the highest score should be best suited for your business if the quality ranking and scorer were correct. Reflect upon the result and see if it is reasonable. Is this really the best location for your business?
Office Space Requirements
After selecting the general location or submarket for your office space, you need to consider prospective locations that fit your criteria. Make sure both you and your tenant rep broker understand your criteria. For example, if you are seeking the luxurious office space with an incredible view for less than $10 per square foot, it's not likely to happen. Following are some other criteria that need to be determined prior to identifying buildings that are options for your office space:
In most cases, the amount of office space and the amount of contiguous office space will be the same. However, in some cases, the space requirement will exceed what is available in a contiguous block of space. In this scenario, you should select the amount of space which must be contiguous prior to identifying office space options.
- Total amount of office space (square feet)
- Amount of contiguous office space
- Building quality
- Target rent per square foot
- Monthly budget for office space
- Conceptual layout
- Term of lease
- Ingress and egress
- Amount of parking
- Type of rental rate (gross, modified gross, NNN, etc)
Define Budget and Expectations
Define the building quality, price per square foot and total monthly budget for office space. The office space broker will advise you if your expectations are on realistic. Visit with the tenant rep broker to make sure the amount of office space you are seeking is consistent with your current and projected number of employees. The density for most American offices is between three and six employees per 1000 ft.˛ of net rentable space. (The difference between net rentable space and actual space is discussed shortly.)
The conceptual layout is important unless you're planning to completely demolish and rebuild the office space. This is very expensive. (Demolishing and rebuilding office space will likely cost at least $25-$40 per square foot depending on your location.) Determine whether you are looking for space which is mostly open concept, or which has a large number of smaller or larger offices. This will allow you to cull options that do not fit.
How important are ingress and egress during peak traffic periods? The layout of the site will determine the ease or difficulty of peak traffic access.
Is signage important? You may need to consider restrictions imposed by the landlord, local government and subdivision deed restrictions. If signage is important, obtain a written copy of all signage restrictions soon after becoming seriously interested in office space. Obtain candid insights from your tenant rep broker regarding signage for the office building.
Do you require a high amount of parking? (4 or more spaces per 1,000 square feet of space is a relatively high amount.)
Rental Rate Options
Rental rate options include: gross, gross plus expense escalation, modified gross, and triple net. A gross lease simply has a rental rate and no allowance or adjustments for expenses. Gross plus escalations includes a base level of rent and expenses in excess of a defined level. The defined level is often the expenses for the year the lease is signed. In a modified gross lease, the tenant pays rent and some of the expenses directly related to his space. These often include utilities and janitorial. This type of lease can also provide for expense escalations. In a triple net lease (NNN), the tenant pays rent and all operating expenses. Operating expenses include insurance, taxes, maintenance, repairs, utilities, janitorial, etc. In general, a gross lease favors the tenant by providing a fixed level of total payments.
Following is a list of amenities available at many office buildings:
Evaluate Amenities Important to You
- Open parking
- Covered parking
- Garage parking
- A/C access
- Banking / ATM
- Cardkey access
- Computer facility
- Conference room
- FedEx drop
- Food Service
- Handicap Facility
- Health club
- Office supply
- Postal service
- Print shop
- Secretarial service
- Sundry shop
- Travel agency
- Tunnel access
Initially, determine which amenities are essential. Adding a large number of amenities to your criteria may eliminate too many office space options. It might be nice to have a print shop in the building, but it would probably be even nicer to have a rental rate of $15 per square foot versus $19 per square foot.
The term of the lease is often a complicated and contentious issue. You want a very short initial term and a huge number of renewal options. An outrageous extreme of this would be a one-day lease with 3649 one-day renewal options. Needless to say, this is not going to happen. Some landlords have a minimum term of three or five years. Depending upon their level of motivation, they're often flexible with regard to this issue. Reflect upon your preferences for your lease term and address it early in the discussion with the office building leasing brokers. For example, if you are seeking a six-month lease or a 20-year lease (at a fixed rental rate with no rental rate increases during the term), broach this issue sooner rather than later in the discussion with the office building's leasing agent.
Addressing the issue of lease term early in the communication leasing broker is appropriate. However, in most cases, do not automatically eliminate a building because the quoted lease term is shorter or longer than your objective. Lease term is often a negotiated issue.
Office Space Prospects
Next start identifying the office space prospects which generally fit your criteria. These are office buildings that are in the general location or submarket you have identified and which generally fit the criteria described earlier in this article.
After compiling a list of office space prospects, you may need to limit it further or before going to see each building. For example, if there are 36 options which fit the above described criteria, you probably would not want to visit each building. An online office space search service is invaluable in gradually narrowing your criteria. This allows you to "what if" scenarios regarding your criteria. Prior to using such an online service, to confirm that it has a comprehensive inventory of buildings in the area you are considering.
Develop a Short List of Prospects
When you have limited the number of options to perhaps three to seven buildings, discuss the building options with your office rep broker to narrow the options. If you are seeking a short-term lease, is the broker are virtually certain that some of the building owners will not provide the desired lease term? Has he broker expressed reservations regarding the quality of management, maintenance or service at some of the buildings?
Visit the Office Space
The next step is to visit the office space in buildings that appear to be a good fit. Reflect upon the criteria you initially establish and any issues that may have since surfaced. Take detailed notes while visiting each of the buildings. (The details of the buildings will fade quickly if you visit 3 or 4 office buildings a day.) Ask questions regarding fundamental deal points to see if the information verbally provided by the building-rep broker provides further inside into the landlord's negotiating position. Also ask questions regarding security, crime, maintenance and any other issues which concern you.
Issues to Address for Prospective Offices
Once you have identified office space that appears to be a good prospect, research relevant issues prior to committing too many resources to negotiating a lease, and obtaining construction estimates.
Does the Office Space Meet Your Needs?
If you plan to put 25 people in 5,000 square feet of space, have the space planner for the building work with you to see if the space works? Doing due diligence and negotiating a lease are time consuming. Cull options that do not work prior to spending much time on due diligence and lease negotiations.
When office space meets the minimally acceptable standard for the previously discussed criteria, it is time to review the costs to prepare the office space for your business. In broad terms, the costs include signage (if relevant) and the cost of renovating or redoing the improvements within your space.
At this point, you need to know the landlord's policy regarding tenant improvements. (Tenant improvements are construction performed to make space suitable for a business. It can include adding restrooms, demolishing and adding walls, floor coverings, window coverings, signage and virtually anything else related to physically preparing the office for your business.
Will the Landlord Pay?
The landlord is usually willing to fund tenant improvement expenditures provided he is confident the tenant has the financial capacity to pay rent for the term of the lease. For large companies with strong balance sheets, landlords will generally spend as much as is requested on tenant improvements. Of course, the cost of the tenant improvements will be reflected in the rental rate.
It's Up to You
If you're a start-up business with no track record and little capital, landlords will be cautious about expenditures for tenant improvements. They will likely want you to fund tenant improvements for your space. The benefit is your rental rate will be lower. However, you'll have to include the cost of preparing your space for occupancy in your initial capitalization.
Other issues related to tenant improvements include defining the scope of work, and who has financial responsibility for performing the work. National companies sometimes simply provide the landlord with a detailed set of plans for the space. It is the landlord's responsibility to cost effectively provide the required build out. For smaller firms, the landlord may provide a tenant improvement allowance, and require the tenant to interface with contractors to have the work performed.
How Much TI?
The cost of tenant improvements can range from $0 to $100 per square foot for second-generation office space. If you are not completely rebuilding the space, the cost is often $5 to $30 per square foot. Even if the landlord is willing to provide substantial funds for tenant improvements, be cautious about the scope of work for tenant improvements. The landlord's expenditure for tenant improvements is essentially a loan which will be repaid with your rent during the term of the lease.
Who pays for ADA?
If the space requires tenant improvements which require obtaining a building permit from the city, review whether you'll have to replace any restrooms because of ADA. (ADA is the Americans with Disabilities Act). In most cases, changes to provide ADA compliance are not necessary if you not require a building permit. However, a consequence of obtaining a building permit is typically that the space must be revised to completely comply with ADA. Replacing the bathroom so it is ADA compliant can be expensive.
After obtaining information regarding the cost of tenant improvements, you should be able to estimate the cost of occupancy for your office space. This will include rent, expenses you pay and the amortized cost of tenant improvements.
The amortized cost of your tenant improvements will be the cost over the term of your lease. To keep matters simple, if you are spending $60,000 to renovate your space, and your lease term is five years (60 months), include $1000 per month for the cost of tenant improvements. The actual cost will be higher to reflect the time value of money.
Research the possibility of a condemnation proceeding. Visit with the relevant city, county or highway department officials to determine whether there are any plans to widen any of the streets contiguous to the office building. If there are firm plans for roadway expansions, research the details thoroughly.
Office space is often subject to rules established by the landlord, deed restrictions and local government restrictions. Research these issues prior to investing much time or money on a space option.
Finally, research criminal activity in the area for the office space you are considering. In many cases, it is apparent whether an area has a low crime rate or a high crime rate. However, considering the investment of time and capital necessary to build out space and move, it would be very disappointing to learn your office space was near a hotbed for criminal or gang activity shortly after moving.
Crime Data Sources
Options for researching criminal activity within an area include online crime reports, discussions with tenants at the property, and discussions with police officers who are active in the area.
In most cases, the information from the services will adequately address the issue of criminal activity near the office space you're considering. However, the most current and contextual data you'll be able to obtain is from tenants at the property and local police officers.
Speak to Tenants
Tenants at the property where you're considering leasing office space can be a wonderful resource. They can provide information regarding crime in the area, problems with traffic, problems with ingress and egress, problems with parking, and other issues in the office building.
Letter of Intent (LOI)
Office space negotiations are complicated and time-consuming. Once you have located the office space that is ideal for your business, the next step is to negotiate an agreement that protects you and is acceptable to the landlord. Industry practice for office space is to negotiate a letter of intent before negotiating the lease.
Use an Attorney!
Engage an attorney to assist in the letter of intent negotiation. It probably seems that the letter of intent is informal and can easily be negotiated without an attorney. However, there are issues you should address in the letter of intent which may not be obvious if you have not previously negotiated letters of intent for office space.
Wow! This is Complicated
Common factors for a office space letter of intent include: defining the parties (lessor and lessee aka landlord and tenant), defining the space, defining the rent, the initial term, any renewal options, rent for renewal option period(s), the day when lease payments commence, the date of occupancy, the condition of the space when the landlord provides it to the tenant, tenant improvement allowances provided by the landlord, who performs the tenant improvements, whether union labor required for tenant improvements, whether the tenant required to use a general contractor for tenant improvements (TI), who pays for the cost of the ADA compliance, who maintains what (i.e. roof, HVAC, electrical, plumbing, etc), who pays which expenses, calculating the payment for expense escalations, free rent, and identification of the broker and payment of the brokerage fee.
You Mean There is More!
Other issues which you may want to address in the letter of intent include expense escalations, eminent domain, foreclosure, maintenance standards, definition of the amount of leasable space, personal guarantees, purchase option, subleasing, dedicated parking, who is responsible for obtaining variances related to signage and usage of the office space, expansion options, first right of refusal, can the tenant keep the TI allowance not needed for construction, can the landlord relocate the tenant if the space is needed to accommodate another tenant, late payment fees, the mechanics of providing notice of default and any options for the tenant to cure the default, mechanics of dispute resolution between the landlord and tenant, and a right to terminate if your business is not successful.
Complete LOI First
Complete and obtained an executed copy of the letter of intent before beginning on the lease agreement. The primary objective of the letter of intent is to negotiate and agree upon the business issues. The lease documents these agreements. Discuss fees to negotiate the lease with your attorney. Agree upon an hourly rate and estimate of the total fees. Agree the attorney will call it that appears the cost is going to exceed the estimate.
The following sections of the leasing office space article focus upon issues that merit commentary.
Renewal options -- tenants love them and landlords prefer to avoid them. In general, a larger number of shorter renewal options is better for the tenant. In addition, shorter notice periods to announce the tenant's intent to are desirable for the tenant. Landlords prefer as much notice as possible regarding whether or not the tenant plans to renew.
Renewal Option Rental Rates
Renewal option rental rates -- tenants typically want fixed rental rates for renewal periods. Landlords typically want the rental rate based upon market rent. Agreeing upon market rents can be difficult and expensive. Reasonable people can disagree regarding the level for market rent for a office space. For example, should the premium for a great view be 5% or 25% .
When do You Start Paying for Office Space?
Tenants are generally provided time to prepare the office space for occupancy prior to the date when they must begin paying rent. However, in hot markets and for some very desirable properties or spaces, landlords will be able to require that tenants pay for office space beginning at the time the lease is executed. In such cases, it is possible the tenant will pay for space for four to 12 months, or even longer, prior to commencing operations within the office space. However, this is the exception rather than the rule. In most cases, tenants are provided a reasonable amount of time to prepare the space for occupancy.
What Happens if Office Space is Not Ready on Time?
The lease should address the contingency regarding what happens if it is not possible to occupy the office space on the contemplated date. For example, there could be delays in obtaining signage permits, usage permits, construction permits, and in completing construction due to a union strike.
If the landlord is providing a tenant improvement (TI) allowance, what are the mechanics of performing the construction and funding the cost of construction? If the cost of the construction is less than the TI allowance, is the tenant allowed to keep the excess funds? Is union labor required?
More TI Details
Is the tenant required to use a general contractor? Should the landlord be compensated for inspecting construction? Alternatively, is the landlord required to provide space which complies with an agreed-upon set of plans at its own expense?
ADA Compliance Expenses
If the space is not currently ADA compliant, who should pay for the cost of making it ADA compliant?
Operating Expenses for Office Space
Office space expenses are typically paid by the landlord. This includes items such has common area utilities, common area maintenance, insurance, property taxes and management. Tenants often pay an allowance for expense escalations for operating expenses above a defined level. Operating expenses for escalation do not include items such as tenant improvements, leasing commissions and interest.
Non-cash expenses such as depreciation and amortization would not be included. While each lease is negotiable, most office leases utilize a gross rent basis with the tenant paying an expense escalation. However, this varies from market to market.
Who Pays for Repairs and Replacements for Tenant Space?
Repair and replacement of the roof is typically handled by the landlord. However, in some leases the tenant is responsible for this expense. Repair and replacement of the HVAC system can be a negotiated matter. In most offices the landlord pays for HVAC repair and replacement.
Payment of the brokerage fees should be addressed in the lease. If a tenant rep broker has been working with you to find office space, you probably signed a representation agreement prior to working with the broker. This agreement would likely provide your commitment to work exclusively with the broker for a defined period. (Include a 30 day cancellation clause in case you are not satisfied with the work performed by the broker. In many cases, this agreement would still provide a level of protection to the broker if you lease space he suggested.)
Document the Brokerage Fee, Even if You are not Paying
Your agreement with the broker should also document who is responsible for paying the brokerage fee. In most cases, this will be the landlord. However, even if you have already documented your agreement with the broker, it is better to affirm the agreement within the lease to avoid a misunderstanding.
Expense Escalations - Who Pays When Operating Expenses Increase?
Expense escalations are relevant when the landlord is paying a base level of expenses and when the tenant is paying expenses in excess of the base. With a typical gross lease, the landlord pays all expenses and the tenant pays expenses in excess of a base level. (Gross leases are typical for office.) The base level is typically the operating expenses for the year the lease is signed. The "expense escalations" would be expenses in excess of this base level. The tenant pays these expenses, for their pro rata portion of the building.
Caps on Increases?
Some leases also provide a cap on increases in expenses. Expanse caps often address the total expenses. Some expense caps are more detailed and include limits on individual line item expenses. To provide more certainty for the tenants cost of occupancy, the tenant may request that property tax increases do not exceed 5% in any year. Property tax increases can be enormous in some states. For example, initial property tax assessments in Texas for office buildings have increased by 20% to 100% for many office building owners. In many cases, these large initial assessments have been successfully reduced to a level much closer to the prior year's value.
However, the property tax assessment process can be arbitrary at times. If the property taxes did increase by 20% or 100%, the landlord would be responsible for the increase in excess of 5% for the example given. There are also sometimes expense escalation caps for utilities, insurance, total expenses and other items.
Eminent domain is the right of government to take private property. Historically, eminent domain was limited to taking private property for public purposes. However, the US Supreme Court expanded eminent domain to include taking private property for private uses. In most cases, property owners are compensated for "takings" through eminent domain.
Eminent Domain Issues
Issues related to leasing office space include who retains compensation for a leasehold estate, what happens if eminent domain takes an amount of parking which makes operation of the office building impractical and if there any rental abatements during construction related to a partial taking of the office building.
A leasehold estate is a tenant's interest in real estate obtained through a lease. A leasehold estate becomes meaningful when contract rent is substantially lower than market rent. Having the right to use office space for a payment well below market rent has value. In the event of a complete taking (when the government takes the entire office building) the lease needs to address proceeds of the tenant's leasehold estate. Do they belong to the tenant or to the landlord?
In any "partial taking", the government only takes a portion of a property. This may or may not include any portion of the building. For the sake of discussion, let's assume a office building with 100,000 ft.˛ and 350 parking spaces. The 350 parking spaces are along the street in front of the building. The current amount of parking is just barely adequate. The condemnation will "take" 200 parking spaces along the street. This leaves the property with only 150 parking spaces, or less than half of what is necessary. The lease needs to define the rights and responsibilities of both the tenant and the landlord in event of a partial taking.
In Event of Foreclosure
Foreclosure of a mortgage typically extinguishes all claims to the property. In other words, if you've negotiated a lease and started a business, your right to use the office space is terminated by foreclosure unless there is a separate agreement.
Will Lender Cancel?
In many cases, depending upon state law, the lender has a defined period of time to reject leases or they are assumed to remain intact. Further, lenders often want to retain the leases and tenants to make the property more salable. However, if the rental rate for a lease is well below market rent, and the tenant is clearly successful, the lender might terminate the lease and require the tenant to negotiate a new lease at market rent.
Negotiating From a Position of Weakness
The tenants negotiating position is much weaker than it was when he first negotiated the lease. The tenant has a successful business at this location. Moving the business takes time and costs money.
Tenants can avoid this dilemma by obtaining agreement that the lease will not be terminated by foreclosure. This is termed a nondisturbance clause. Landlords are reluctant to grant this concession due to the limitation it imposes on the landlord when obtaining financing.
The definition of maintenance standards is often vague. A typical clause may read that "the landlord will maintain the property in a manner consistent with local practice and a prudent owner".
Landlords love personal guarantees since they require the tenant to pay for the space whether or not he needs it. Personal guarantees should be avoided by tenants whenever possible. It is reasonable that the tenant repay the unamortized portion of any tenant improvements and leasing commissions if the lease is terminated early. Further, it is reasonable for a tenant to guarantee a minimal level of performance on a building built to its specifications.
Different Rules for Second Generation Space?
However, for second-generation office space, it is reasonable to request that the tenant only be personally or corporately responsible for paying the unamortized portion of tenant improvements and leasing commissions. Although this is reasonable, it may not be possible. The strength of the local rental market and local practice will dictate whether landlords can extract personal guarantees from tenants.
For single-tenant office buildings, tenants often want a right to purchase the building at a predetermined price. Landlords prefer to avoid this. A compromise is providing the tenant a first right of refusal.
Landlords want the tenant to make rental payments throughout the lease term, but don't want the tenant to profit from subleasing the office space. In some cases, the tenant has the right to sublease the space subject to the landlord's approval. There's often a clause that the landlord's approval shall not be withheld unreasonably. There's also often a clause limiting the types of businesses which can sublease from the tenant. Sublease payments in excess of payments on the primary lease can be an intensely negotiated item.
Dedicated parking is another issue where interests diverge. Tenants love to have parking dedicated to their employees and clients. Landlords try to avoid having parking dedicated to any one user or business. Peak traffic for a business may occur in a short period of time. However, the parking spaces are typically dedicated 24 hours per day.
Expansion Options and First Right of Refusal
Expansion rights and first rights of refusal are negotiable for office space depending on market conditions. Assume you are starting a new firm which is expected to grow quickly. You're initially taking 2,000 square feet of space but hope to expand to 5,000 or 10,000 square feet of space within 18 months. Having the right to take additional space at a previously agreed-upon rental rate and to claim additional space through a first right of refusal is valuable. Once the business is successful and established within the building, negotiating rental rates at a favorable level will be more difficult.
For example, assume your business has been operating successfully for two years and you expect to expand during the next 12 months. Unfortunately, your landlord tells you he just leased the spaces on either side of you. A first right of refusal for additional space can allow you to avoid this problem. Attempt to negotiate a fixed rate, which is determined while negotiating the lease for expansion space.
Many office space leases provide the landlord the option of relocating the tenant at the landlord's expense. For example, consider a local business leasing 2,000 square feet of office space in a 1,000,000 square foot high-rise downtown office building. The landlord is attempting to lease 100,000 square feet of space to a Fortune 500 business. However, to consummate the lease they need the 2,000 square feet of space occupied by the smaller, local tenant.
Even if the landlord pays 100% of the cost to move your business, you will incur a loss. In addition to the time spent planning and executing the move, it will disrupt your business. Relocation clauses are another issue where the interests of the landlord and the tenant diverge.
Event of Default
An "event of default" is when either party does not perform as agreed upon in the lease. In some leases, the landlord has the right to terminate the lease if the tenant defaults. This can include both objective and subjective issues. An objective issue is timely payment of rent. A subjective of issue could be a product or service offered by the tenant which was not initially contemplated.
Non-Financial Event of Default - Example
For example, the tenant put large boxes in the hallway. (Office equipment came packed in the boxes.) However, the lease and / or building rules and regulations clearly prohibit putting trash in the hallway.
Financial Event of Default - Example
Most landlords and most tenants act reasonably. However, some people are unreasonable. Consider the following example. Office space is leased at a fixed rental rate agreed upon 5 years ago. The contract rent is $15 per square foot but the market rent has increased to $22 per square foot. The lease continues for another 5 years at the same rental rate. Due to a clerical error, the tenant forgets to send a rent payment one month. The tenant has an exemplary history of timely payment for the previous 5 years.
However, this is an event of default on the lease. Instead of calling the tenant to inquire regarding the current month's rent, the landlord sends the tenant a notice of default. The notice of default informs the tenant the leases been terminated and demands the tenant vacate the premises within 30 days.
What is Reasonable?
A reasonable solution is for the landlords to provide written notice in the event of a default. The tenant should have a reasonable period of time to cure the default. This issue becomes more complex when it is not possible for either the tenant for the landlord to cure the default.
What if Landlord Can't Perform?
For example, a lease includes an affirmation by the landlord to comply with local laws and regulations. However, city council retroactively increases the parking requirements. (The number of parking spaces required per 1000 square feet of space.) This issue is being intensely litigated by local office building owners. However, final resolution of the litigation is not expected for three or four years. Should the tenant have the right to terminate the lease in this situation?
Most office space leases address the venue for resolving disputes between the tenant and landlord. In most cases, the venue is state district court in either the location of the office property or where the landlord is headquartered. The former is prevalent. There's a growing trend to require binding arbitration for disputes. The advantage it is a less expensive process to resolve differences of opinion. The disadvantage is forgoing some of your rights for a process which can be even more arbitrary than state district court.
Right to Terminate
Finally, tenants should consider providing themselves an escape clause. When starting a business, a high level of optimism and the excitement is typical and understandable. However, the actual business results sometimes fall short of what was expected.
Right to Terminate - Example
For example, assume you had expected sales of $80,000 per month for your business and thought the very lowest level that could possibly occur would be $20,000 per month. Even though the $20,000 per month seemed like a very pessimistic scenario, you were comforted that the business would be profitable at this level. At least you'd be all the pay your expenses and pay yourself a barely adequate salary.
Unfortunately, the pessimistic scenario turned out to be wildly optimistic. For whatever reason, the business is only generating sales of $6000 per month. This is inadequate to pay your cost of operations.
What Rights Should You Require?
Should you have a right to terminate your five-year lease in this scenario? If you do terminate the lease, what is a reasonable amount to pay for expenses incurred by the landlord?
Beware of the Consequences
Although termination clauses and personal guarantees may seem like an arcane nuance when negotiating the lease for your new business, they are critical factors. If you personally guarantee the lease and do not have an option to terminate the lease if your business performs poorly, in a worst-case scenario you are faced with personal bankruptcy or funding an operating deficit for a long period of time.
This concludes the article on leasing office space. By defining your office space criteria, selecting an experienced broker and carefully negotiating the lease, you have reduced the time to find space and negotiate the lease. In addition, you will have mitigated your exposure in the event your business is not successful.