Given the current state of the commercial leasing market, it’s no surprise that leverage in lease negotiations has shifted in favor of tenants, at least the ones who remain solvent. Rent levels have dropped across all commercial asset classes, and landlords are being pressured for economic and non-economic concessions by the few tenants who are pursuing new leases. Even with an existing lease, where a tenant may be legally bound to terms negotiated in sunnier economic times, a landlord’s fear of a new vacancy will level the playing field, and force it to consider mid-term concessions that would have been dismissed out of hand a year or two ago. This article summarizes some of the more common concessions requested by tenants in both new and existing leases.
Issues in a New Lease
In the negotiation of a new lease, the parties will focus first on economic terms such as rental rates. However, a landlord’s ability to decrease rents may be limited by covenants in its own loan documents or commitments to its equity partners. But even if the landlord cannot drop the rent as much as a tenant desires, a tenant may be able to obtain other economic concessions. The most common ones involve “free rent” periods or increases in the landlord’s space upfitting obligations.
Free Rent. In a typical free rent concession, the stated base rent remains at a higher level, but a tenant is granted a “free rent” period during which the base rent is abated. It’s advantageous to the landlord to maintain the higher rental rate, since the fair market value of its property (and hence its ability to refinance or sell) will be driven by the future level of net operating income, without reference to prior concessions. At the same time, the tenant reaps the obvious cash flow benefit of not paying rent for some period of time. Most often a free rent period will occur at the beginning of the lease term, but a landlord may not be able to do so and still meet its debt service covenants. It is also more appealing to a landlord to extend this concession to a tenant that has taken possession, occupied its space, and met its rent obligations for some period of time. A prudent landlord will want to limit the concession to the base rent payable under the lease, so that its tenant remains liable for its pro-rata share of maintenance expenses or other pass-through items. It’s also essential to provide for the recapture of the free rent if the tenant subsequently defaults.
Increased Upfitting. Another common economic concession is for a landlord to offer a more substantial tenant improvement allowance (TIA), which is a cash payment made by a landlord to its tenant to finance the cost of upfitting the leased space. For a tenant, a greater TIA frees up cash that otherwise would have been used for upfitting expenses. For a landlord, a TIA that is spent on leasehold improvements that will be left in place when the tenant leaves is not wasted money. The amount of a TIA may be folded into the calculation of base rent, or the lease may provide for repayment of the TIA (or some portion thereof) in monthly installments, in addition to base rent. Income tax considerations related to TIAs need to be considered carefully.
A landlord must evaluate the credit risk associated with large TIA payments that it hopes to recoup through increased rent. A landlord funding a TIA functions as its tenant’s construction lender, and will want protections to ensure that the allowance is spent in the premises, and also that the amount disbursed to the tenant does not get ahead of the progress of construction.
In lieu of paying a larger TIA, a landlord may want to undertake additional upfitting work itself – for example, by delivering a space that is ready for occupancy in lieu of a shell space with a concrete slab and metal studs. In a new project, a landlord may have access to construction loan proceeds that might not be available for the payment of TIAs. However, from a tenant’s standpoint, particularly where the timing of occupancy is important (such as a relocation from premises covered by an expiring lease), the loss of control over the upfitting process may be a concern.
Non-Economic Concessions. As noted above, a landlord may be financially unable to offer economic concessions, or may be prohibited from doing so by covenants with its lenders or partners. As an alternative, a landlord may be willing to offer a variety of non-economic concessions that do not require a cash payment, do not affect the cash flow from the lease, and do not require funding by its lender.
One common example, attractive to many tenants in these uncertain times, is to grant a tenant more flexible exit strategies. For example, the lease may provide for a shorter initial term with additional renewal options, perhaps with market rent provisions to catch a falling market and caps on increases if the market bounces back. Or a tenant may obtain expanded termination rights, either at pre-established intervals or after the expiration of a certain portion of the lease term, perhaps conditioned on the payment of a termination fee. A retail tenant may request a “kick-out” clause triggered by the failure to meet a certain sales threshold, or an office tenant may ask for more flexible expansion and contraction rights. Other non-economic concessions might include naming or signage rights, parking rights or increased levels of certain services.
Issues in a Current Lease or Workout
It has become increasingly common for tenants to approach their landlords for the renegotiation of existing lease terms, and many of the issues discussed above will arise in that context as well. As noted above, the parties’ relative negotiating leverages may not be as lopsided as one might think. A landlord may be unable to afford to lose another tenant, and thus willing to offer concessions to keep a lease in place, even on less favorable terms. Half a loaf is better than none.
Rent Relief. The most typical request is for rent relief, either in the form of a permanent reduction in the base rental rate, or (more commonly) a temporary reduction or abatement of fixed rent, with a corresponding rent increase later in the lease term. In order to make a wise business decision, a landlord should be monitoring its tenants before issues arise, so that it will be prepared to respond quickly to a tenant’s request. Retail tenants typically provide monthly sales reports, which can provide early signs of trouble, and a landlord also can review other publicly available financial information to monitor its tenants’ financial health. A landlord’s (and its lender’s) approach to a request for rent relief will depend on its judgment as to whether the tenant’s financial prospects will improve during the lease term. In making such a request, a tenant must strike a delicate balance and make a convincing argument that it cannot survive without a concession, but that it might survive with one.
As with a free rent period granted in connection with a new lease, any rent concession should be recoverable in the event of a subsequent tenant default. Also, since the financial strength of the tenant has declined, the grant of rent relief may be coupled with a demand for increased security from the tenant, like an additional lease guaranty from a principal, or a pledge of some of the tenant’s assets.
Early Termination or Partial Surrender. A landlord rarely will be willing to consider a request for an early lease termination, particularly with a solvent tenant (or guarantor). It may, however, be amenable to a request to contract the size of the premises and reduce the rent by some amount (generally not purely pro rata), particularly where the space is easily divisible. In addition to keeping a rent-paying tenant in place in at least part of the space, a landlord may prefer to control the re-leasing of the surrendered space, as opposed to competing with its tenant in the sublease market. The surrendered space may also be capable of being combined with adjacent spaces to increase the landlord’s flexibility with new tenants.
Forbearance Agreements. These typically are agreements of last resort, signed after a tenant default but before the commencement of an eviction action. In certain circumstances, a landlord may find it preferable to accept a promissory note for the delinquent rent, and to keep a defaulting tenant in place on some basis (perhaps month to month), as opposed to pursuing an eviction and being faced with the immediate obligation to re-lease the vacated space in a weak market. A forbearance agreement typically will grant the landlord the immediate right to market the space, and require the tenant to vacate on a short deadline if the landlord is successful in those efforts. At this point, bankruptcy and related debtor-creditor concerns, which are beyond the scope of this article, become paramount to the landlord.
In time, the real estate market will rebound, and the relative negotiating strength of landlords and tenants will adjust, but for now, it’s a tenant’s market - at least for those tenants who are adequately capitalized. A savvy tenant should take advantage of the current market situation to lock in concessions from its landlords that will survive the down