In the Spotlight: Lease Restructures

In the current economic environment, everyone wants to save money, and saving money in real estate is no exception. The economy is stagnant and will likely continue to be so through the next election cycle. Therefore, unless a lease is about to expire or a new tenant enters the market, we are unlikely to see positive absorption and/or much leasing activity across the country.

However, a lease is not a stagnant document, and neither landlords nor tenants should think of it as such. Organizations that have downsized or desire to utilize their space more efficiently are eager to “give back” excess space. Although landlords do not want excess space to lease in a down market, there may be benefits to the landlord of a steady long-term income stream that offsets the impact of additional vacancy. In sum, for each side an early lease restructure may make sense.

Key Drivers for a Tenant

Subleasing excess space is a complicated and time-consuming process, and one that rarely results in a profit for the tenant. The goal in most subleasing
scenarios is to recover what the market will bear, which is usually a discount to the tenant's prime lease obligation. Subleasing also entails costly upfront expenses, including demising costs, allowances, free rent and brokerage commissions that dilute any income received. Subleasing space that the tenant has no need for is also a risky proposition as the tenant is relying on a subtenant's credit over a long period of time. So for a tenant, maybe a give-back of excess space to the landlord in exchange for a longer lease term makes sense. At the end of many leases, especially those with a base year for operating expense and real estate taxes, a tenant will be paying “all-in” above market. Therefore, an early restructure may not only help a company “right-size,” but also lower the costs for the space it occupies. Restructuring in a tenant-favorable market, especially, can lead to long-term cost-savings for a tenant.

Key Drivers for a Landlord

Whether a landlord desires to sell the building, has a loan coming due or wants to avoid downtime, a long-term lease restructure with a credit-worthy tenant has many benefits. While the landlord may not want space back or want to reset the rent, avoiding having to re-tenant space, which always requires larger concession packages, may far outweigh what an existing tenant requires to remain in the building. Extending the term of a tenant's lease in exchange for lower rent and/or a take-back of space may take away risk to a prospective buyer or lender, thus yielding additional cash for the landlord. An early lease restructure also provides the landlord with an opportunity to rethink how best to stagger lease expirations and reset expansion options, rights of first refusal and/or rights of first offer to better align the needs of all its tenants. This is particularly true if the landlord has space coming available that it will need to re-lease.

Sample Lease Restructure

A sample financial analysis of a recent early lease restructure appears on page 6. As you can see, in that model, the tenant was able to shed 36% of its office space at a minimal cost ($175,000) in exchange for a two-year extension at the fixed rental rates. The tenant saved $1.2 million on a Net Present Value (NPV) basis for the period between 8/1/2012 -7/31/2015 by shedding the excess space. Even with the two additional years of term, the NPV of the company's existing lease obligation was more than the restructured deal by over $170K, and the restructured deal added two more years of term. From the landlord's standpoint, it lost income by taking back space, but even taking into account downtime (six months) and re-leasing costs, given the belief that it can lease the “give-back” space at slightly higher rents than the tenant was paying, the landlord garnered an additional $1.2 million in cash flow over the analysis term with the two-year extension. In addition, the lease extension permitted the landlord to stagger existing lease expirations to help manage the cash flows of the building, and ensure that a long-term, creditworthy tenant did not vacate the building.

In another example, the tenant restructured its lease to garner significant tenant improvement dollars needed to reconfigure its space, and the landlord was able to use the lease term extension to obtain more favorable financing as well as to reset the tenant's expansion rights so as to not to encumber the entire building, which was hurting the landlord's ability to re-lease a large block of space coming available in the building.

In a third example, the tenant restructured its lease early to give back some unused space and renovate the space it occupied at a time when the landlord was trying to sell the asset or would have had to refinance its debt on the property. The lease restructure transferred a portion of the increased value the landlord would receive in a sale or financing event to the tenant is the form of concessions and a lower rental structure.

Conclusion

In sum, there are advantages to both tenants and landlords to rethink their office space needs even if a lease expiration is not in the near term. Remember that a lease is not a stagnant document, and a company's business strategy needs to drive its leasing, not lease expirations.

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Elizabeth Cooper, a member of this newsletter's Board of Editors, is an International Director of Jones Lang LaSalle. Gregory McCavera is a Managing Director. Both are resident in Washington, DC. The authors acknowledge the help of Kyle Szymanczyk in preparing this article.

In the current economic environment, everyone wants to save money, and saving money in real estate is no exception. The economy is stagnant and will likely continue to be so through the next election cycle. Therefore, unless a lease is about to expire or a new tenant enters the market, we are unlikely to see positive absorption and/or much leasing activity across the country.

However, a lease is not a stagnant document, and neither landlords nor tenants should think of it as such. Organizations that have downsized or desire to utilize their space more efficiently are eager to “give back” excess space. Although landlords do not want excess space to lease in a down market, there may be benefits to the landlord of a steady long-term income stream that offsets the impact of additional vacancy. In sum, for each side an early lease restructure may make sense.

Key Drivers for a Tenant

Subleasing excess space is a complicated and time-consuming process, and one that rarely results in a profit for the tenant. The goal in most subleasing
scenarios is to recover what the market will bear, which is usually a discount to the tenant's prime lease obligation. Subleasing also entails costly upfront expenses, including demising costs, allowances, free rent and brokerage commissions that dilute any income received. Subleasing space that the tenant has no need for is also a risky proposition as the tenant is relying on a subtenant's credit over a long period of time. So for a tenant, maybe a give-back of excess space to the landlord in exchange for a longer lease term makes sense. At the end of many leases, especially those with a base year for operating expense and real estate taxes, a tenant will be paying “all-in” above market. Therefore, an early restructure may not only help a company “right-size,” but also lower the costs for the space it occupies. Restructuring in a tenant-favorable market, especially, can lead to long-term cost-savings for a tenant.

Key Drivers for a Landlord

Whether a landlord desires to sell the building, has a loan coming due or wants to avoid downtime, a long-term lease restructure with a credit-worthy tenant has many benefits. While the landlord may not want space back or want to reset the rent, avoiding having to re-tenant space, which always requires larger concession packages, may far outweigh what an existing tenant requires to remain in the building. Extending the term of a tenant's lease in exchange for lower rent and/or a take-back of space may take away risk to a prospective buyer or lender, thus yielding additional cash for the landlord. An early lease restructure also provides the landlord with an opportunity to rethink how best to stagger lease expirations and reset expansion options, rights of first refusal and/or rights of first offer to better align the needs of all its tenants. This is particularly true if the landlord has space coming available that it will need to re-lease.

Sample Lease Restructure

A sample financial analysis of a recent early lease restructure appears on page 6. As you can see, in that model, the tenant was able to shed 36% of its office space at a minimal cost ($175,000) in exchange for a two-year extension at the fixed rental rates. The tenant saved $1.2 million on a Net Present Value (NPV) basis for the period between 8/1/2012 -7/31/2015 by shedding the excess space. Even with the two additional years of term, the NPV of the company's existing lease obligation was more than the restructured deal by over $170K, and the restructured deal added two more years of term. From the landlord's standpoint, it lost income by taking back space, but even taking into account downtime (six months) and re-leasing costs, given the belief that it can lease the “give-back” space at slightly higher rents than the tenant was paying, the landlord garnered an additional $1.2 million in cash flow over the analysis term with the two-year extension. In addition, the lease extension permitted the landlord to stagger existing lease expirations to help manage the cash flows of the building, and ensure that a long-term, creditworthy tenant did not vacate the building.

In another example, the tenant restructured its lease to garner significant tenant improvement dollars needed to reconfigure its space, and the landlord was able to use the lease term extension to obtain more favorable financing as well as to reset the tenant's expansion rights so as to not to encumber the entire building, which was hurting the landlord's ability to re-lease a large block of space coming available in the building.

In a third example, the tenant restructured its lease early to give back some unused space and renovate the space it occupied at a time when the landlord was trying to sell the asset or would have had to refinance its debt on the property. The lease restructure transferred a portion of the increased value the landlord would receive in a sale or financing event to the tenant is the form of concessions and a lower rental structure.

Conclusion

In sum, there are advantages to both tenants and landlords to rethink their office space needs even if a lease expiration is not in the near term. Remember that a lease is not a stagnant document, and a company's business strategy needs to drive its leasing, not lease expirations.

[IMGCAP(1)]

Elizabeth Cooper, a member of this newsletter's Board of Editors, is an International Director of Jones Lang LaSalle. Gregory McCavera is a Managing Director. Both are resident in Washington, DC. The authors acknowledge the help of Kyle Szymanczyk in preparing this article.