The window for lowering your rent will be opening soon, and here are the keys to getting it right
By David Marino
When the business community begins to open back up this year, many business owners and executive teams are going to look around at all of their excess space remaining from reductions in force and team members working from home post-Covid and wonder what to do about it. With the business community considering how to rebuild their organizations, there will be anemic demand for new office space. Those office tenants already planning to come back are generally thinking they need 50%-80% of their pre-Covid footprint. As tenants’ leases expire, the commercial real estate market is experiencing “negative net absorption” as tenants with office leases expiring downsize and give space back in droves. At the same time, both sublease inventory and space given back to landlords from tenant defaults is flooding the market. This combination of weak demand and spiking supply is causing commercial rents to crash, and a spiking in concessions such as free rent, moving allowances, parking concessions and shorter lease terms, creating the strongest tenants’ market since the 2000 Tech Wreck.
As companies look to lower their commercial real estate expenses, many companies are going to be putting their space, or a portion of it, on the market for sublease. However, for certain office tenants under the right conditions, “restructuring” of a commercial lease will become a strategy to lower a tenant’s rent, shrink the size of the premises, or even “swap” into a more fitting space with the same landlord. In other cases, we are already planning for relocations to cheaper submarkets, cheaper buildings and less space as new landlords seem to have become more aggressive to grab market share than some landlords are prepared to compete to keep the tenant. Either way, a robust market evaluation is required, and the tenant must be of the mind that they would consider moving under the right circumstances to maximize leverage and optionality.
Having engineered hundreds of these in the last three recessions, the basics of such a transaction involve the landlord providing rent reductions over the remaining lease term, or a reduction in the size of premises itself, in exchange for an extension to the existing lease term. Imagine getting a 20%-30% reduction in remaining rent in exchange for extending your lease 5 years. Or imagine giving back one of your three floors in exchange for a 5-year extension of your lease. While these outcomes might appear compelling to a tenant, this doesn’t happen by just picking up the phone and making such a proposal to the landlord—it all has to be flawlessly executed and communicated. Here are the three factors that simultaneously must exist for a successful lease restructure to reduce the tenant’s rent expense.
1. Market Decline
In order to complete a successful lease restructuring, market rent conditions must have deteriorated substantially such that the rent the tenant currently pays is universally agreed to be well above market. We aren’t there yet as some landlords are still having a tough time understanding how bad the damage is to their tenant base and to the broader market. Also, landlords and their promoting listing brokers are seeing that other landlords are still maintaining their pre-Covid asking rents, and while vacancy is down, the vacancy rate doesn’t include all of the sublease space on the market and space where tenants aren’t renewing but where the space isn’t vacant yet, and the “availability rate” is 40% higher than the technical vacancy rate. There is a general “failure to get it” throughout the landlord and brokerage community. But all office tenants are paying above market right now, and it’s just a question of by how much. Worse yet, the annual rent increases in commercial lease contracts will be going up 3%-4% for every tenant in the next year, while the market rents will be going down 10%-20% annually for at least the next two years. The challenge will be determining what the new market rate should be at the time a tenant engages with a landlord, as assessments and negotiations are sure to vary widely! The old method of looking at recent past market comparables, or “comps,” is utterly useless and deceptive on the way down, as from a tenant’s perspective, yesterday’s good deal will be tomorrow’s bad deal. The best deals will be cut when the market hits bottom, but a tenant might not be able to wait that long due to an expiring lease, but waiting is in the tenant’s interest…and going to the market is as well–there should be no rushing into this too early.
2. Remaining Lease Term
Every company today would love the opportunity to simply tear up their current office lease and negotiate new terms, but it doesn’t work that way. The tenants that are the strongest candidates for a lease restructuring are those with two years or less of remaining term. If your lease doesn’t expire for three years or more, you unfortunately are not likely in a position to restructure your lease until time passes to burn off more of your lease term. Landlords do these restructurings to eliminate the vacancy risk and related costs, which can include a year or two of vacancy, extensive tenant improvements and even demising costs. In a declining market such as today’s, landlords reasonably assume that deteriorating market conditions will persist for a year or two, and the risk of losing the tenant is within their risk intolerant time horizon. But three years or more into the future, landlords and their brokers might feel more bullish about a mid-term market recovery and unlikely to give concessions now for an extension that doesn’t even start for three years or longer in the future.
3. Credit of the Tenant
The hard truth is that no landlord will consider a lease restructuring unless they believe that the tenant’s business is going to be around to pay rent for the extended term. In order to successfully restructure a lease, your company must have “decent” credit. While “decent” isn’t a very technical term, it’s chosen intentionally. You do not need to have investment grade credit or be a Fortune 1000 company to be successful in getting these done. Rather, the tenant needs to be able to demonstrate how it is going to be a survivor, which means being transparent with the landlord about the future financials, the longer-range business plan and the management team’s qualifications to lead it.
These lease restructurings work when there is a win-win for both the landlord and the tenant. We engineer a way for the tenant to creatively reduce their real estate expenses, while at the same time shoring up the landlord’s long-term stability and eliminating their vacancy risk. To be clear, this is not a “blend and extend” as some brokers are referring to them. Rather, consider a lease restructuring more like refinancing your home mortgage. You don’t blend your current home loan rate into a new rate, rather you simply replace the old rate with a new rate and reset the term.
Your landlord is not the enemy, but they aren’t going to voluntarily adjust your rent to market—they are going to have to be pushed and persuaded, and that likely includes going to the market. A properly negotiated result is a complex combination of creating leverage, having the right market information, understanding the lease expirations of other major tenants in the landlord’s building or portfolio, assessing the financial scenarios, optimizing the timing and excellent communication skills. As a firm that represents tenants only, and with our expertise in navigating these storms before, we were built for this. Talk to us and we’ll get through this together.
David Marino is executive vice president of Hughes Marino, an award-winning commercial real estate company with offices across the nation. One of the top commercial brokers in all of Southern California, David possesses unrivaled, comprehensive market knowledge, and writes regularly about San Diego commercial real estate on his blog, Suburban Scoop. Contact David at 1-844-662-6635 or firstname.lastname@example.org to learn more.