Choosing the Right Lease Term (Length)
This is one of those subjects that cause a lot of lightbulbs to go on in the minds of tenants attending my seminars. Perhaps it’s because a five or ten-year lease Term has become such a norm in commercial real estate leasing. It rarely occurs to even seasoned tenants that there should be - and actually are – viable alternatives to the traditional five-year lease Term (and five-year renewal option).
Don’t misinterpret what I’ve just said. A long-term Lease Agreement has advantages and disadvantages for both tenant and landlord. For example, the more money you are investing into leasehold improvements the longer your Term should be. This will give you the security of knowing you will recoup your investment before the lease expires. Longer leases are also desirable if the tenant allowance is large, thereby allowing a longer amortization period for the landlord to recoup his investment resulting in low or nominal added rent for the tenant.
It is really not long-term leases that I oppose at all, but the artificial five or ten-year Term. Let me explain - tenants (especially retailers) prefer to open their business going into the peak season. From a sales and cash flow perspective, the optimum time for most shopping centre retailers to open their doors is September or October in anticipation of the forthcoming busy Christmas shopping season at the mall.
Conversely, the worst time for a tenant’s Lease Agreement to expire (or come up for renewal) is five years later just prior to the same peak season. Therefore, rather than a five-year (60-month) Term, I recommend my clients select their optimum lease Term in months - not years. As an example, negotiate for either 56 months or 64 months instead.
The lease Term goal for a tenant should be to open for business going into his or her busy season and to end the Term immediately after the peak season - but prior to the slow season. This strategy will make sense to your accountant purely from a cash flow perspective but more importantly to you from a negotiating perspective too. When your five-year Lease Agreement in a shopping centre comes up for renewal just before Christmas, the landlord has the negotiating advantage. However, if you had taken a 64-month Term or a 56-month Term, for example, your Lease Agreement would be expiring when the space is in less demand.
Consider also that if you occupy a desirable location and your Lease Agreement is expiring going into a peak season there may be a competitor or other tenant trying to lease your space out from under you just prior to the busy season. There is likely to be less demand for the space in a slower January through March season depending on your individual type of business.
For some tenants, other points for considerations regarding your lease Term include the Yellow Pages directory (both the publication date and the deadline for booking space). If your business relies heavily or even moderately on Yellow Page advertising consider coordinating this when selecting the best lease length.
The weather is another factor to consider. If winter is cold and snowy where you operate your business you may wish to consider a lease Term that expires in the warmer months when it’s easier to move. When you plan to retire and sell or wind down the business is also a consideration.
If you are locating your business next to a major anchor such as a grocery store with only 37 months left on their lease Term you may want no more than a 37-month Term yourself in case they do not renew. Alternatively, you could sign a longer lease Term with the right to terminate if the anchor store moves. One franchisee told me he was strategically setting up shop in a building right beside a larger competitor so he could benefit from the traffic they were creating.
This worked fine for about a year until the competitor’s Lease Agreement expired; the competitor moved and took customers and traffic flow away. Don’t make assumptions - do your homework in situations like these. Talk to other tenants and gather whatever information you can.
Frequently, it is not the landlord or the tenant who is hung up about a long-term Lease Agreement. It is often the real estate agent or commissioned leasing representative who potentially stands much to lose or gain from the agreed-upon lease length. Tenants often tell me they have trouble getting a one, two or three-year lease deal. Depending on how the deal is structured the landlord may have no problem with your request but maybe totally unaware of it even if you made an Offer to Lease in writing. Since the realtor will only achieve 60% of his or her commission potential if you sign a three-year versus a five-year lease Term ulterior motives may be at work.
If you are experiencing this type of situation, you may need to speak directly with the landlord or the property manager to get some answers. Tenants wishing to make a month-to-month deal through a realtor often (but not always) get nowhere since the realtor would rather hold out for a long-term tenant that would result in a full five-year commission payment. If the space is taken off the market for a period of months it may be more difficult for the real estate leasing agent to lease it.
When you’re considering the lease Term, you should also negotiate for a generous fixturing period. This is the rent-free period you have to buildout your store or business before the Lease Agreement commences. Thirty days may be enough if there are only minor renovations, but 45 to 90 days will give you more breathing room. So often, tenants underestimate how long it will take to get design plans approved, building permits and contractors on the job - resulting in a rushed or late opening.
Tenants, in general, do not put enough time or energy into negotiating their lease renewal option when negotiating their primary Term. I know it seems like a lot of trouble for something so far off into the future, but bury those feelings and set in place several renewal option periods stating the renewal period as up to three or five years.
The words “up to” are key since you may not want a full five-year renewal option but instead only six more months while you wait for the new building down the street to be constructed so you can move in there.
I recognize that many tenants reading this article will currently be in a Lease Agreement. We can’t talk about lease Terms without touching on the Overholding Period. When a Lease Agreement expires, but you continue to occupy the premises on a month-to-month basis, this is called the overholding period. Most leases state that a penalty will apply to the tenant with an automatic 50 to 100% rent increase. One tenant who ignored this clause was being charged double the rent for three months before I was hired to negotiate a resolution with the landlord. Check your existing lease for this clause and make sure you negotiate a modified overholding period penalty (10 to 20%) if you can’t have it dismissed entirely.
Month-to-month leases have both pros and cons. On one hand, a month-to-month lease provides maximum flexibility for the tenant. Conversely, it provides little or no security. If you are looking for a month-to-month Term (or as an extension/renewal of your existing Lease Agreement), then you may be better advised to sign a one-year short Term Lease Agreement with the option to terminate with 30 to 90 days notice. This way the landlord can’t lease your space to someone else - but if necessary you can still get out, legally and ethically.
For some of my clients with major setup costs who want and need long-term security, I negotiate a primary three-year Term with five more three-year renewal options (18 years total). This lets the tenant legitimately depreciate his or her equipment and leasehold improvement costs over a shorter time period than a standard ten-year Term.
Frequently, we negotiate a set rental rate for both the first Term plus the Renewal Option Terms. This way, there are no unpleasant surprises for the tenant. If the landlord is contributing significant tenant allowance dollars to improve the premises, then the tenant will pre-exercise the first two or three renewal option Terms. With doing this, the landlord is assured of a more permanent tenant, while the tenant will benefit from specific tax advantages. The cost of any leasehold improvements made over the course of a lease Term (eg: new carpeting) is tax-deductible; it is far more advantageous for the tenant to apply the depreciation sooner rather than later. Confused yet?!? Just ask us!
Get creative, think outside the box and get the Term you want!