Tenants

Seven Steps to Lease Renogotiations

Consider These Factors When Dealing With Troubled Tenants.

In a perfect world, all property owners and managers would know and understand their tenants' current economic conditions and future business prospects. Tenants would be able to predict business slowdowns and use that knowledge to accumulate financial cushions to survive hard times. And landlords and tenants would work together proactively to keep lease obligations in line with economic realities.

In the real world, that is not always the case. National and global economic conditions change quickly today and can affect local office and retail tenants unexpectedly. Industry slowdowns, personal crises, or the location of a competitor six blocks away can change tenants' fortunes and prevent ordered lease renegotiations. For a variety of reasons, tenants may not communicate their real or potential problems to their landlords until it is too late.

Because every lease term is open during a renegotiation, the renewal process can be just as complex and time-consuming as negotiating the original lease. In addition to studying the economics of proposed modifications, landlords must consider their tenants' relative economic strengths and prospects, as well as the supply and demand factors of the markets in which their properties are located.

During office and retail lease renegotiations, landlords should consider the following seven issues as they relate to both struggling and stable tenants. In each case, done correctly, renegotiations can lay the foundation for lasting and profitable futures for tenants and landlords.

1. Know Tenants' Businesses. The best thing that landlords can do to ensure successful lease renegotiations is to remain knowledgeable about their tenants' businesses. This process begins with the original lease negotiation. Including, monitoring, and enforcing lease covenants that require tenants periodically to provide financial statements or profit-and-loss reports keep landlords informed.

Moreover, landlords must pay attention to tenants' industries. Understanding the business cycle of a tenant's industry may provide an indication of the health of a tenant's business. If an industry slows down, such as recently happened in the technology sector, the tenant's business also may be in trouble.

Awareness of tenants' financial conditions can help landlords determine whether or not tenants that are renegotiating have a good chance of surviving.

Finally, landlords must ascertain who the decision maker is in a tenant company. Often, this is apparent; for example, if the individual who negotiated and signed the original lease handles the renegotiation, generally it is safe to assume this individual can make the ultimate decision. However, considering the number of mergers that have occurred, landlords may want to begin the renegotiation by asking if the tenant's negotiator has the authority to make a binding decision. If the individual handling the negotiation did not sign the original lease and is unknown, landlords are justified in requesting documentation such as a corporate resolution that shows that the person has the authority and power to conclude a deal.

2. Analyze the Market. Clearly, informed landlords also must know the area in which their properties are located, as well as competing markets. If large blocks of space are becoming available for sublease in the surrounding area or new space is being completed, tenants that are willing to move can exert some leverage on their current landlords.

However, if the market is tight and a tenant can't move to a comparable building for significantly less rent, the landlord maintains a stronger position. But landlords also should remain aware of the possibility of tenants, particularly office tenants, relocating to other cities. Landlords can ask tenants what alternatives they are considering. The best protection against this is knowing what it would cost a tenant in terms of time, money, and disruption to uproot its business and employees to a different city.

3. Consider Decreasing Rental Rates. The most-often renegotiated lease term is the rental rate. The renegotiation of rent, while relatively straightforward, can cover a number of issues.

Since the original lease was signed, rents in surrounding areas either have risen or fallen. A tenant renegotiating a lease already may be paying an above- or below-market rate. If space is tight and replacement tenants are available, decreasing a specific tenant's rent may not be necessary. Conversely, if new tenants don't appear readily available, renegotiating the rate might prevent the space from becoming vacant.

If the current rent is well above the market rate, a landlord may consider compromising to avoid losing the tenant. However, in exchange for this concession, the landlord may insist that the tenant lengthen the lease term. In essence, the landlord trades dollars for stability. This can benefit a landlord looking to stabilize a property's cash flow for a longer period.

With retail tenants, landlords might lower the fixed rent in exchange for an increased percentage rent. To some degree, this ties the landlord's fortunes to the tenant's ability to produce revenues capable of offsetting the decline in fixed rent. An added advantage is that the total rent will increase as the tenant's revenues grow.

But several drawbacks exist for the landlord. These include the possibility that the tenant's revenues never increase to offset the decrease in fixed rent, the discount lenders and investors apply to percentage rent, and the expense and effort necessary to confirm the tenant's revenues.

With tenants paying common-area maintenance charges or a pro-rata share of the property expense, landlords should consider renegotiating these costs. Tenants paying net lease charges may try to reduce their expenditures, or at least cap future expenditures, in an attempt to limit costs. Depending on the future expenses necessary to maintain the property, a landlord may be willing to allow a tenant to adjust this number.

In exchange for decreasing CAM charges, landlords can consider various alternatives. One would be negotiating a new lower base year, usually defined as the amount the landlord spends per square foot to maintain the building in a certain year, in exchange for a higher escalator or higher base year for a lower escalator. Escalators are the amount by which these charges increase yearly and can be tied to objective benchmarks such as consumer price index data or a set flat rate such as 3 percent.

4. Add or Strengthen a Guaranty. Lease renegotiation is an opportunity for landlords either to gain a guaranty of a previously unguarantied lease or strengthen an existing guaranty.

Convincing a tenant to add or strengthen a guaranty can be difficult. However, gaining such a concession is valuable if the tenant fails but its owner retains significant assets. If a tenant's financial condition is precarious, its owner may close the business rather than personally guarantee the obligations of a shaky enterprise. Conversely, if a tenant has a strong financial statement, negotiating a guaranty might be a sufficient exchange for allowing the tenant to remain in the space at a decreased lease rate.

If a lease already is guarantied, renegotiation can provide landlords with an opportunity to strengthen the guaranty. A landlord can insist on an additional guarantor or expand the terms of a limited guaranty by lengthening the time a guaranty remains in place or exposing other assets of the tenant in the event of a default.

In addition to understanding the tenant's finances, landlords also must understand the guarantor's finances. It is imperative that landlords know at the outset how they will collect any assets due under the guaranty and where those assets are if that becomes necessary.

5. Remember Lender Requirements. Landlords who have taken out a loan to acquire or develop a property should consult their loan agreement prior to renegotiating any lease. Financial covenants may restrict a landlord's ability to renegotiate leases.

Commonly, lenders require landlords to maintain certain debt-coverage or loan-to-value ratios. Because both DCR and LTV are functions of the property's income stream, decreases in income can cause the property to violate such covenants.

In addition, some lenders insist on the right to approve lease concessions. In most cases, lenders will not kill a deal, but may impose certain costs on the landlord, such as requiring a principal pay down to maintain the property's compliance with the financial covenants.

6. Consider Tenants' Space Needs. The amount of space that a tenant occupies often comes into play at lease renegotiation time.

A tenant reducing the size of its workforce also may want to decrease the amount of space it occupies. By doing so, the tenant hopes to limit its rent payments as well as decrease its pro-rata share of the building's expenses.

This potentially presents a landlord with two complementary opportunities. A tenant with sufficient assets but foreseeing a need for less space may be willing to buy out part of its lease. For example, a tenant occupying two floors of an office building but reducing its workforce so that it only requires 11/2 floors may be willing to pay the landlord a discounted amount of rent to relinquish its right for the now-surplus space. After receiving a discounted payoff from the reduced tenant, the landlord could try to lease the space to a new tenant.

If a tenant is unable to buy out the surplus space, it might want or need to sublease some or all of its leasehold. The lease language may prohibit subleasing or require the landlord's consent. Many leases reserve a landlord's right to approve any potential sublessee and permit only specific uses of the property by both the original tenant and sublessees. Consequently, the landlord can extract a concessions clause from the original tenant to provide something of value in exchange for permitting the sublease. The landlord should take advantage of this clause if it can negotiate a better deal with the subtenant than the landlord obtained in the original lease.

Some leases permit a landlord to reclaim the space from the prime lessee and re-lease it to the tenant that would have been the sublessee.

7. Understand Exclusive-Use and Co-Tenancy Clauses. Many retail leases contain either exclusive-use or co-tenancy clauses. These clauses can be renegotiated if needed, but they can make the renegotiation process unwieldy because adjusting them often requires the consent of a third party.

Many retail anchors, particularly grocery stores, drugstores, and movie theaters, require exclusive-use provisions in their leases. These provisions provide that only that specific tenant can sell certain types of products in a particular retail center. When another tenant renegotiates its lease or attempts to sublet space, the landlord must ensure no violation of an exclusive-use clause occurs.

Co-tenancy clauses also can hinder renegotiation attempts. A co-tenancy clause states that a tenant may close its store or reduce its rent if another tenant or group of tenants does not occupy space at a retail project or if the occupancy rate of the project falls below a certain level. If this is the case, the landlord is stuck and may lose other tenants because of a co-tenancy clause violation caused by the renegotiation. To avoid this, landlords should understand and monitor the parameters of these clauses so they don't breach their leases with other tenants in an attempt to preserve a troubled tenant.

Many of these lease renegotiation issues complement each other or can serve as alternatives to each other. By surrendering a little on rent, landlords may extend the lease for several more years. By allowing a tenant to sublease space, landlords may be able to preserve a higher lease rate. Thus, by knowing the tenant, the market, and the terms of existing leases, landlords can be ready for any tenant attempting to renegotiate its lease.

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