<b><i>In The Spotlight: </b></i>Strategies in Tenant Office Lease Renewal Negotiations

As tenants reconsider and update office space needs, it is imperative that they proactively develop a strong renewal/relocation negotiation strategy to maximize their future rights and benefits. Tenants with expiring leases are often faced with enormous improvement costs; concerns about productivity loss; aversion to change; lack of market knowledge/leverage; and unknown out-of-pocket costs of a relocation or renovation of space. Furthermore, as they are considering what space is right for their future, they face serious concerns over planning for what could be a five- or ten-year financial commitment. Unfortunately, many tenants wait too long to focus on space needs and assume their lease will be renewed on reasonable terms. If a tenant waits until its notice period is upon it before it assesses its needs and develops a strategy or looks at the renewal rights in its current lease, it may become a 'captive tenant' forced to negotiate from a weakened position in the market.

Tenants need to avoid the captive tenant syndrome by considering a real estate strategy well in advance of their lease expiration. Hiring a tenant broker and focusing on possible leverage with a landlord is the best strategy in defense of becoming a captive tenant. Landlords are concerned with lease-up time, high tenant improvement costs, credit risk, their ability to refinance and any impact on liquidity that results in losing a tenant in their buildings. A tenant's ability to leverage these concerns effectively in a negotiating strategy will benefit them financially as well as mitigate future risk. Below are four essential considerations for companies tackling a real estate renewal.

Start Early:
The Process Yields Beneficial Results

Don't miss your option. First, as already mentioned, start early. Time is leverage in any office lease negotiation. Typically, a 15,000-20,000 Rentable Square Feet (RSF) tenant needs to begin addressing its real estate situation at least 18 months in advance of its move/renewal date. This amount of time allows for a thorough process of understanding how the real estate will play into and foster the firm's business strategy, evaluating all available options to stay or relocate and negotiation of economics and lease language. Furthermore, it allows for the opportunity to plan for back-up options if a deal cannot be made for the firm's top option. In a renewal negotiation, it benefits the tenant to speak to the landlord early on in the process. In most cases, the tenant should push for the landlord to give it a proposal as soon as possible to identify where the landlord will start on economic terms. This will allow the tenant to get a 'sneak peak' at what the landlord considers to be market for rental rates and the landlord's thoughts on the strength of the tenant's renewal option. In addition, if the tenant has any operational issues with the current building, this is the time to bring such matters to the attention of ownership; at this point the tenant has the leverage of a potential relocation to get things changed for the better.

Know the Landlord's Position/
Identify Leverage Points

Second, it is important to understand what drives the landlord and what are its motivations. Tenants usually encounter three types of owners with different motivations and decision-making criteria.

Real Estate Investment Trusts (REITS) are publicly traded companies that are concerned about their stock price and paying regular quarterly dividends. They are driven to maintain a certain level of occupancy and mitigate any potential vacancy. They make market deals; they prefer deals that yield quick occupancy and cash flow and are typically more prone to compromising in negotiations. Their decision-making criteria are based on an analysis of what the market is telling them to do. If market comparables are showing that tenant improvement packages are at a certain level, they make the decision to match the market.

Large privately controlled entities and institutional investors with strong financials make up the second type of landlord. They are driven to increase the value of the asset, tend to care less about vacancy and will take risks in deal making. These investors 'buy rate up' in that they defend the valuations of their buildings by strictly adhering to face rental rates. In order to maintain high asking rates, these investors will offer high levels of concessions in the form of free rent and tenant improvement dollars. They are generally selective in making deals and tend to be the force pushing rates up in all markets. They will not make deals that undermine the long-term value of the property. They are tough negotiators.

Small privately controlled entities with less experience, and weaker financials comprise the third type of landlord. They are driven to survive in a competitive marketplace by maintaining cash flow, increasing the value of their asset, and showing progress to their investors. These entities will make market deals as long as they are able to. They are competitive and able to react quickly to the market.

Get Representation; Create Competition;
Be Proactive; Evaluate Market Alternatives

Third, make sure you have a broker representing you. Without representation, landlords believe that tenants are not in the market looking at alternative options and creating a competitive environment ' and they are usually right. A tenant's broker will assist in creating leverage just by being at the table. Letters of Intent to tenants renewing without representation are usually very short documents that lack key economic and other terms that can save tenants considerable sums, such as sublease and assignment clauses, renewal clauses, and non-disturbance agreements to name a few. Furthermore, when a landlord initially develops or purchases property, it builds the brokerage commissions into its pro-forma as part of the rental rate and not an additional fee. More often than not, the landlord's broker will keep the tenant's representative's fee if the tenant is unrepresented.

Negotiate an Effective Renewal Clause

Fourth, understand and use any existing renewal clause for leverage; in new leases, negotiate a favorable renewal provision that provides your company with future leverage. While tenants rarely exercise the renewal right in the lease, the renewal clause itself is a shield against being displaced by a larger tenant in the building. Moreover, a well crafted renewal clause with beneficial options for the tenant is extremely advantageous in any renewal/extension discussion with the landlord. Below are some of the major issues that a good renewal/extension option provision should address.

Exercise of Options to Extend: The tenant should request two five-year options to extend that can be exercised simultaneously for 1 ten-year term or separately for two five-year terms. The notice period to exercise any option should be with as little lead time as possible to ensure the tenant's flexibility and not be limited by how early it can be exercised.

Measurement: The tenant should include language in the lease and in its renewal provision that its space will not be subject to re-measurement upon renewal. Too often, a new landlord will buy a building and re-measure it or an existing landlord will adopt a more landlord-favorable measurement standard and the tenant must renew for more space than it currently leases.

Base Year: Frequently, tenants will exercise their renewal option without considering the effect of the existing base year (in a full service/gross lease) and adjusting it for the new lease term. For example, in 1998, operating expense and real estate tax pass-throughs amounted to $15.00 RSF in Washington, DC, for Class A office properties. In 2008, operating expense and real estate tax pass-throughs amount to $22.00 RSF for Class A office properties. A tenant that is not careful could potentially end up paying $7.00 in pass-throughs alone due to an old base year.

Fair Market Definition: The lease should be as detailed as possible on the definition of Fair Market, and attempt to negotiate a renewal rate as a percentage of the full market rate (often 95%), which many argue accounts for the lack of landlord vacancy in a renewal. The following is an example of a clear and advantageous clause:

As tenants reconsider and update office space needs, it is imperative that they proactively develop a strong renewal/relocation negotiation strategy to maximize their future rights and benefits. Tenants with expiring leases are often faced with enormous improvement costs; concerns about productivity loss; aversion to change; lack of market knowledge/leverage; and unknown out-of-pocket costs of a relocation or renovation of space. Furthermore, as they are considering what space is right for their future, they face serious concerns over planning for what could be a five- or ten-year financial commitment. Unfortunately, many tenants wait too long to focus on space needs and assume their lease will be renewed on reasonable terms. If a tenant waits until its notice period is upon it before it assesses its needs and develops a strategy or looks at the renewal rights in its current lease, it may become a 'captive tenant' forced to negotiate from a weakened position in the market.

Tenants need to avoid the captive tenant syndrome by considering a real estate strategy well in advance of their lease expiration. Hiring a tenant broker and focusing on possible leverage with a landlord is the best strategy in defense of becoming a captive tenant. Landlords are concerned with lease-up time, high tenant improvement costs, credit risk, their ability to refinance and any impact on liquidity that results in losing a tenant in their buildings. A tenant's ability to leverage these concerns effectively in a negotiating strategy will benefit them financially as well as mitigate future risk. Below are four essential considerations for companies tackling a real estate renewal.

Start Early:
The Process Yields Beneficial Results

Don't miss your option. First, as already mentioned, start early. Time is leverage in any office lease negotiation. Typically, a 15,000-20,000 Rentable Square Feet (RSF) tenant needs to begin addressing its real estate situation at least 18 months in advance of its move/renewal date. This amount of time allows for a thorough process of understanding how the real estate will play into and foster the firm's business strategy, evaluating all available options to stay or relocate and negotiation of economics and lease language. Furthermore, it allows for the opportunity to plan for back-up options if a deal cannot be made for the firm's top option. In a renewal negotiation, it benefits the tenant to speak to the landlord early on in the process. In most cases, the tenant should push for the landlord to give it a proposal as soon as possible to identify where the landlord will start on economic terms. This will allow the tenant to get a 'sneak peak' at what the landlord considers to be market for rental rates and the landlord's thoughts on the strength of the tenant's renewal option. In addition, if the tenant has any operational issues with the current building, this is the time to bring such matters to the attention of ownership; at this point the tenant has the leverage of a potential relocation to get things changed for the better.

Know the Landlord's Position/
Identify Leverage Points

Second, it is important to understand what drives the landlord and what are its motivations. Tenants usually encounter three types of owners with different motivations and decision-making criteria.

Real Estate Investment Trusts (REITS) are publicly traded companies that are concerned about their stock price and paying regular quarterly dividends. They are driven to maintain a certain level of occupancy and mitigate any potential vacancy. They make market deals; they prefer deals that yield quick occupancy and cash flow and are typically more prone to compromising in negotiations. Their decision-making criteria are based on an analysis of what the market is telling them to do. If market comparables are showing that tenant improvement packages are at a certain level, they make the decision to match the market.

Large privately controlled entities and institutional investors with strong financials make up the second type of landlord. They are driven to increase the value of the asset, tend to care less about vacancy and will take risks in deal making. These investors 'buy rate up' in that they defend the valuations of their buildings by strictly adhering to face rental rates. In order to maintain high asking rates, these investors will offer high levels of concessions in the form of free rent and tenant improvement dollars. They are generally selective in making deals and tend to be the force pushing rates up in all markets. They will not make deals that undermine the long-term value of the property. They are tough negotiators.

Small privately controlled entities with less experience, and weaker financials comprise the third type of landlord. They are driven to survive in a competitive marketplace by maintaining cash flow, increasing the value of their asset, and showing progress to their investors. These entities will make market deals as long as they are able to. They are competitive and able to react quickly to the market.

Get Representation; Create Competition;
Be Proactive; Evaluate Market Alternatives

Third, make sure you have a broker representing you. Without representation, landlords believe that tenants are not in the market looking at alternative options and creating a competitive environment ' and they are usually right. A tenant's broker will assist in creating leverage just by being at the table. Letters of Intent to tenants renewing without representation are usually very short documents that lack key economic and other terms that can save tenants considerable sums, such as sublease and assignment clauses, renewal clauses, and non-disturbance agreements to name a few. Furthermore, when a landlord initially develops or purchases property, it builds the brokerage commissions into its pro-forma as part of the rental rate and not an additional fee. More often than not, the landlord's broker will keep the tenant's representative's fee if the tenant is unrepresented.

Negotiate an Effective Renewal Clause

Fourth, understand and use any existing renewal clause for leverage; in new leases, negotiate a favorable renewal provision that provides your company with future leverage. While tenants rarely exercise the renewal right in the lease, the renewal clause itself is a shield against being displaced by a larger tenant in the building. Moreover, a well crafted renewal clause with beneficial options for the tenant is extremely advantageous in any renewal/extension discussion with the landlord. Below are some of the major issues that a good renewal/extension option provision should address.

Exercise of Options to Extend: The tenant should request two five-year options to extend that can be exercised simultaneously for 1 ten-year term or separately for two five-year terms. The notice period to exercise any option should be with as little lead time as possible to ensure the tenant's flexibility and not be limited by how early it can be exercised.

Measurement: The tenant should include language in the lease and in its renewal provision that its space will not be subject to re-measurement upon renewal. Too often, a new landlord will buy a building and re-measure it or an existing landlord will adopt a more landlord-favorable measurement standard and the tenant must renew for more space than it currently leases.

Base Year: Frequently, tenants will exercise their renewal option without considering the effect of the existing base year (in a full service/gross lease) and adjusting it for the new lease term. For example, in 1998, operating expense and real estate tax pass-throughs amounted to $15.00 RSF in Washington, DC, for Class A office properties. In 2008, operating expense and real estate tax pass-throughs amount to $22.00 RSF for Class A office properties. A tenant that is not careful could potentially end up paying $7.00 in pass-throughs alone due to an old base year.

Fair Market Definition: The lease should be as detailed as possible on the definition of Fair Market, and attempt to negotiate a renewal rate as a percentage of the full market rate (often 95%), which many argue accounts for the lack of landlord vacancy in a renewal. The following is an example of a clear and advantageous clause:

The term 'Fair Market Rental Rate' shall mean the annual amount per rentable square foot that landlords of comparable buildings (age, size, location, class, vacancy) have accepted in current transactions between non-affiliated parties from new, non-expansion, non-renewal and non-equity tenants of comparable credit-worthiness, for comparable space, for a comparable use for a comparable period of time ('Comparable Transactions'). In any determination of Comparable Transactions appropriate consideration shall be given to the annual rental rates per rentable square foot; the standard of measurement by which the rentable square footage is measured; the ratio of rentable square feet to usable square feet; the type of escalation clause (e.g., whether increases in additional rent are determined on a net or gross basis; and if gross, whether such increases are determined according to a base year or a base dollar amount expense stop); the extent of tenant's liability under the lease; abatement provisions reflecting free rent and/or no rent during the period of construction or subsequent to the commencement date as to the space in question; brokerage commissions, if any, which would be payable by landlord in similar transactions; length of the lease term; size and location of premises being leased; the existing conditions of the space; the floor the space is on and its views (alley versus street); building standard work letter and/or tenant improvement allowances, if any; and other generally applicable conditions of tenancy for such Comparable Transactions.

The intent of this language is that the tenant will obtain the same rent and other economic benefits that the landlord would otherwise give in Comparable Transactions and that the landlord will make, and receive the same economic payments and concessions that it would otherwise make, taking into account 100% of prevailing market concessions received in Comparable Transactions.

Downtime: Downtime is defined as the time it will take the landlord to place a new tenant into a now vacant space. If the renewal clause is not at a percentage of market, the tenant should look to lower its renewal rent such that the net present value of its deal equates to what the landlord can attain for a new tenant after suffering downtime and other market concessions it will incur in a new deal.

For example:

RSF Leased: 20,000 SF
Lease Term = 60 months
Full Service Rental Rate = $65.00SF
Annual Escalator: 3%/annum
Tenant Improvements for a New
Tenant: $50.00
Downtime = 3 months to market + 3 months to build-out = 6 months total
Non-Variable Operating Expenses incurred on vacant space: $12/SF

The net present value of this income stream to the landlord is $6.8M dollars. Solving for this same net present value, assuming no vacancy or non-payment of operating costs for an existing tenant, and using the same $50/SF required for tenant improvements, means the tenant's rent should be no more than $60/SF. Even if the landlord and tenant split the difference such that the tenant's rent is $62.50/SF, a renewing tenant with the same allowance as would be given a new tenant should have a lower face rental rate.

Arbitration: Typically, a renewal clause will grant a 30-day period for parties to attempt to agree on the rental rate. If the parties cannot agree, the tenant should have the right, not the obligation, to proceed to a three-broker binding arbitration. If the tenant proceeds to a three-broker arbitration, it is imperative that the guidelines for determining the rent are spelled out. One accepted method is that the mean of the two closest determinations governs, and if there are no two closest, the middle of the three governs.

Use Brokers, Not Appraisers: It is important for tenants to have accurate numbers in the determination of fair market rent. Appraisers call brokers for information on a regular basis because they are at the vanguard of market activity. Therefore, a strong renewal clause will stipulate that licensed commercial brokers are used to arbitrate the rental rate. Additionally, the particular agent/broker selected by each party should not have worked with or for either party in the past three years.

Rescission Rights: Larger tenants with more negotiation strength are able to achieve a right to withdraw completely from the strict renewal process and break off negotiations to pursue an alternative course of action should the parties not agree on the renewal rent before the arbitration provision kicks in. Sometimes large tenants may even be able to secure the right to rescind after the rental rate is determined.

No Conditioning of Renewal Rights: Moreover, landlords will attempt to condition the renewal clause in multiple ways to diminish this right of the tenant. The landlord will argue that if the tenant occupies less than 75% of the space, the renewal right is waived. The tenant should strive for language stipulating that leasing (not occupancy) of no less than 50% is required. Moreover, a tenant should be careful that other lease provisions do not negate the renewal right by stating that certain subleasing or an assignment voids the right. A previous default or a current non-monetary default that is not material also should not forfeit a tenant's right to renew. Last, some landlords will attempt to negotiate a condition where the tenant loses its right to renew if a renewal amendment is not signed within a period of days (usually ten). A tenant should never agree to this provision.

Tenants can avoid the 'captive tenant' syndrome by starting the renewal process early on with their landlord, identifying possible leverage points, hiring a tenant broker, and performing a detailed analysis of their renewal clause during negotiations. Renewal/extension provisions are valuable rights that should be carefully crafted in the lease, and if used appropriately, these clauses can provide substantial leverage for a tenant in any renewal/relocation discussions.