Office tenants should be wary of the recent advice that has been given regarding how lease flexibility is created in a “tenants’ market.” I have been representing the real estate interests of tenants for many years and there is one rule I always follow in this type of market: in a soft market go long, lock into a low rate and negotiate options in a lease to hedge risk.
In Alex Tarquinio’s March 10th New York Times article, “Appeal of Short Term Leases Grows in Manhattan,”
http://www.nytimes.com/2009/03/11/realestate/commercial/11lease.html
the author makes a decent argument that short-term leases create flexibility in a soft market. His article cites fellow real estate professionals who believe signing a one or two-year lease is a great solution for a tenant to hedge their future business risk. Although Tarquino presents a valid argument, I would like to share an alternative opinion on how office tenants can create flexibility in a soft market by signing a long-term lease at a low rent with options that can hedge their company’s business risk and market risk.
In his article, Tarquinio references several real estate brokers who believe Manhattan has become a “tenants’ market” and as a result “tenants now have the upper hand in negotiations with landlords.” He later goes on to cite a building owner who states “landlords don’t want to tie up space for what they perceive to be a low rent.” Based on this owner’s research, I am led to believe most landlords are optimistic that rents will begin to rise in the short term. I call this fluctuation in rent, market risk and in a soft market a tenant can hedge this risk by signing a long-term lease at a low rent. If the market turns and rents increase, the tenant who locked into a low rent will have successfully hedged their market risk. Therefore, signing a short-term lease does not create flexibility for a tenant nor does it help a tenant take advantage of the soft market; instead a short-term commitment allows the landlord to have the upper hand in the next lease negotiation.
Tarquinio also references a building owner who states “Tenants are saying that they’re just not sure how much space they’ll need in a year or two, so it is hard for them to commit.” This type of uncertainty is what I call “business risk.” In a soft market a tenant can negotiate options into their lease that landlord’s would not otherwise agree to when the market is tight. One of my associates recently negotiated a termination option for a national law firm that relocated their New York office into a small suite, in a Class A building. The termination option can be exercised if the firm fails to maintain a certain level of business in New York. The tenant signed a long-term lease at a low rent and the termination option will hedge their future business risk. That is what I call flexibility.
By signing a short-term lease in a soft market, tenants play right into hands of the landlord. An effective lease negotiation starts with a real estate strategy that meets a company’s future business plan. To hedge economic uncertainty and the effect it can have on business, it is essential to build options into a lease. Landlords are willing to agree to these terms in a “tenants’ market” and also negotiate a favorable rate.
My advice in a soft market, no matter the size of the tenant, is to sign a long-term lease at a low rent and negotiate options to hedge both market risk and business risk. Options create flexibility and signing a short-term lease fails to accomplish this goal. By locking into a low rate today, a tenant will not have to worry about renegotiating at a higher rate when the market becomes landlord favorable. In addition to this, negotiating termination, contraction and expansion options are effective ways for a tenant to hedge their future business risk.
