We hate to say it, but for many tenants, there’s not much you can do now. The time of reckoning is here and if you’re in an existing lease, there’s a 1 in 3 chance that your landlord is at risk of defaulting.
While existing tenants still may get some leeway in renegotiation, if you didn’t have a good representative when your original lease was ironed out, you may be in big trouble. In the case that your landlord defaults or hands their keys back to the bank, you’ll likely be subject to the unique circumstances of the new arrangement.
However, if you are still looking for new space despite the rocky environment, you have a lot to benefit from. Record low vacancies are empowering prospective long-term tenants to drive the best possible deals for their interests. But, this also means that there’s more pressure than ever to skillfully draft leases to protect these deals. Because if something sounds too good to be true, it just might be. In this article we will discuss some of the tactics and safeguards that can protect corporate tenants, even if tragedy strikes.
1. Review Prospective Landlords' Financials
This sounds like a no brainer but, the smartest thing you can do if your looking for new space right now is directing your attention to your prospective landlords’ financials. Because, According to data from research analyst for Goldman Sachs, Randall Zisler, about 30% of U.S. office buildings, which is translated to a collective estimate of $1.1 trillion are at high risk of becoming obsolete.
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“Turmoil in the U.S. office market — which has triggered missed loan payments and foreclosure warnings — has meant prospective tenants are now taking a closer look at the financial health of property owners.” -CoStar |
Many tenants are even refusing to negotiate with landlords until they get some proof that the property owner or their lender has the financial capabilities to carry out a long-term lease.
Working with stronger financial backings will increase the likelihood that the rest of the duties on this list are carried out or accepted by them. But, identifying the state of their finances requires doing your due diligence and conducting research on their current and projected stability.
This also means becoming aware of what buildings are at a higher risk of becoming obsolete. For instance, buildings constructed or last renovated from 1980 to 2009 experience less interest from tenants and investors alike. This means these property owners in the coming years may be less and less able to be maintained, renovated, etc. And just saying...
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“More than 70% of office buildings in markets such as New York, San Francisco, Los Angeles, Boston, Chicago and Philadelphia are at least three decades old.” -CoStar |
Similarly, there is a flight to quality taking place. Premium buildings have higher demand and as a result are more likely to attract a steady stream of tenants. So know that in the future the divide between Class A and Class B buildings will likely widen (and so will the financial state of the landlords who own them).
2. Include Self-Help Clauses in New Leases
Reviewing your landlord’s financial statements is so critical because protections against declining building services are harder to achieve. If your lease is assumed by the bank or your landlord is struggling, there’s a very real chance that you may experience a disruption in your normal services.
That’s why tenants now need to outline safeguards in their new leases before this happens. Tenants can include a “self-help” right clause in their lease. This will empower them to upkeep essential services at the landlord’s eventual expense.
The self-help clause is critical because it will allow you the tenant to take over for the landlord if they can’t (because the building is in receivership) or won’t perform certain key services. For example, if the building is in receivership, office cleaning and/or HVAC maintenance may be diminished to the point of being unacceptable. Keep in mind, once the building is in receivership, the receiver’s first responsibility is to pay the mortgage. All other bills are secondary. Therefore, you can expect a drop in services in a building that is in receivership.
So the solution which landlord’s loathe, is for tenants to have the "right of offset," in which the tenant's out-of-pocket costs related to the landlord’s failure to upkeep responsibilities is deducted from the rent. But to enact this it requires consistent due diligence on your behalf. Keep detailed records of all lease-related documents, including the original lease agreement, amendments, rent receipts, and any correspondence with the landlord. These records can provide valuable evidence to support your rights as a tenant in the event of a landlord default.
Once this is baked in to the lease, this will protect you the corporate tenant even when a receiver steps in. The receiver must abide by the terms of the lease. However, without this, you have no legal leg to stand on to deduct such expenses from the lease. So you may end up paying for additional office cleaning even though you still have to pay your full rent.
Understand, that landlords hate this self help clause because they’re no longer in control. So, in normal market conditions, you can expect significant pushback from landlords or a flat out "no." However, if you're a big fish with a lot of corporate mojo and/or taking significant space, this is something that your tenant rep broker should insist upon.
Now, we are in extraordinary times. Tenants certainly have the upper hand in negotiations. That said, a lot will depend upon the value of your tenancy and the landlord’s overall picture.
3. Put Tenant Improvement Funds in an Escrow or Credit Letter
If it turns out your landlord can no longer reimburse your renovation costs or fails to make promised improvements, you don’t want to be on the hook. As a result, tenants are being advised to put TI allowances into an escrow account.
“Money given by landlords to tenants to customize their office space, generally paid as an allowance over a period of time, could be lost, and in the current market, brokers said that money from landlords could be equivalent to $70 a square foot.”
This is a very real concern because in order to lure in long-term tenants, landlords began offering to cover soft costs. Tenant Improvement Allowances were skyrocketing across the country. So, if you're signing a new lease, you want to ensure that they can fulfill what they promise.
Again, this is more critical for tenants of older buildings. As the standard for office building elevates in conjunction with rapid technological evolution, more renovations will be demanded. Make sure that you don't get stuck in a deteriorating or outdated building if a landlord can't afford to accommodate the cost of renovations.
4. Ensure That You Receive a Non-Disturbance Agreement (NDA)
If you’re signing a new lease, ensure that you receive a Non-Disturbance Agreement (NDA) among yourself, the landlord, and the landlord's lender, which guarantees the your right as a tenant to the leased premises in case of landlord default or foreclosure. The NDA allows the tenant to keep occupying the property according to the existing lease terms, even if the landlord loses ownership.
According to the New York Times, “Though banks would be unlikely to kick out existing leaseholders on taking over ownership of an office building, tenants especially larger ones should get a non-disturbance agreement from a landlord’s mortgage lender as a matter of routine. This means the bank would have to recognize the existing lease of the tenant if it took over the building.”
It is also possible to obtain a subordination, non-disturbance, and attornment agreement (SNDA), which provides additional protection, but it is important to consult with a lawyer to ensure that the SNDA clause is properly worded.
Work With a True Tenant Rep™
In summary, the office market is facing a time of reckoning and existing tenants with leases may face challenges if their landlords default. However, for new tenants, the current low vacancies provide an opportunity to negotiate the best deals possible, with a focus on financial stability of the landlord. To protect their interests, tenants need to include safeguards in their leases, such as a self-help clause, right of offset, and a non-disturbance agreement. They should also consider putting TI allowances into an escrow account. It is important to do due diligence and work with true tenant representatives who can help navigate these complex issues and find the right solutions to meet their needs.
Because, navigating the complexities of commercial real estate leases can be overwhelming, especially during uncertain times. Working with a True Tenant Rep™ can make a significant difference in ensuring that your interests are protected. Unlike traditional brokers who work for landlords and may prioritize their interests over yours, tenant representatives work exclusively for tenants and have a fiduciary duty to represent your best interests throughout the lease negotiation and renewal process.
They have the expertise to help you identify and secure the best possible lease terms, including protections against landlord default and financial instability.
In conclusion, the current state of the commercial real estate market presents significant risks and opportunities for tenants. While existing tenants may face challenges in renegotiating leases with financially unstable landlords, prospective tenants have the opportunity to secure favorable lease terms by carefully considering the financial stability of their landlords and negotiating robust protections for essential services and renovation allowances.
If you're looking for new space in this tenant-favored yet volatile environment, there's certain things you can't get wrong. Learn all the considerations you need to find the right office space for the right price whether there's a recession or not.
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