Many business owners and executive teams may be perplexed by all the extra space they have due to staff reductions and post-Covid team members working from home when the business community starts to reopen this year. There will be a weak demand for new office space as the corporate sector considers how to restructure their organizations thus requiring restructuring commercial lease. Office tenants that have already stated their intention to return typically estimate that they will require between 50% and 80% of their pre-Covid footprint. The commercial real estate market is seeing “negative net absorption” when tenants’ contracts expire because tenants with office leases are downsizing and giving space back in large numbers. The market is also being oversaturated by space returned to landlords due to tenant defaults and sublease inventories. The greatest renters’ market since the 2000 Tech Wreck is being created as a result of the poor demand and rising supply, which is also prompting a spike in concessions including free rent, moving allowances, parking concessions, and shorter lease periods.
Many businesses will put their property, or a portion of it, up for sublease as they try to reduce their commercial real estate expenses. However, under the correct circumstances, restructuring commercial lease will become a tactic for certain office tenants to reduce their rent, reduce the size of the property, or even “switch” into a more suitable location with the same landlord. In other situations, we are already preparing for relocating tenants to less expensive submarkets, less expensive buildings, and smaller spaces as new landlords appear to have become more aggressive in their attempts to take market share than some landlords are willing to compete with in order to keep the tenant. In order to maximize leverage and optionality, a thorough market analysis is necessary, and the tenant must be of the mindset that they would contemplate moving if the appropriate conditions were present.
The fundamentals of restructuring commercial lease, which we have orchestrated hundreds of in each of the last three recessions, entail the landlord offering rent reductions over the remaining lease period or a reduction in the size of the premises itself in exchange for an extension of the current lease term. Consider extending your lease for an additional five years in exchange for a 20–30% rent discount. Or consider returning one of your three levels in exchange for a 5-year lease extension. Even though these outcomes can seem appealing to a renter, this cannot be accomplished by simply picking up the phone and proposing it to the landlord—everything must be done perfectly and explained. These three conditions must all be met for a lease restructuring to successfully lower the tenant’s rent costs.
1. Market Recession
A successful restructuring commercial lease requires that market rent circumstances have significantly deteriorated and that everyone agrees that the rent the tenant is now paying is significantly higher than market. We haven’t arrived yet because some landlords are still struggling to comprehend the extent of the harm done to their tenant base and the overall market. While vacancy is down, it doesn’t account for all of the available sublease space or space where tenants aren’t renewing but the space isn’t yet vacant, and the “availability rate” is 40% higher than the level of technical vacancies. Landlords and their promoting listing brokers are also observing that other landlords are still maintaining their pre-Covid asking rents. A general “failure to get it” permeates the landlord and brokerage industries.
But the amount that every office tenant is currently paying above market is up for debate. Worse still, market rents will be declining by 10% to 20% yearly for at least the next two years, while annual rent hikes under commercial lease contracts will grow by 3% to 4% for each tenant in the coming year. Finding the new market rate at the time a renter meets a landlord will be difficult because assessments and negotiations are certain to differ greatly! The traditional approach of using “comps,” or recent historical market comparable, is completely worthless and misleading on the way down because, from the perspective of a renter, yesterday’s good deal will be tomorrow’s awful deal. A tenant might not be able to wait until the market bottoms out since their lease is about to expire, but it’s in their best advantage to hold out. There shouldn’t be any rushing into something at an early stage, just as going to the market is.
2. Current Lease Term
Today, every business would adore the chance to just break their present office lease and bargain for new terms, but that isn’t how things work. Tenants with a lease that has two years or less left to run are the best candidates for restructuring commercial lease. Unfortunately, until additional time has passed to burn off more of your lease term, if your lease doesn’t expire for three years or more, you are probably not in a position to restructure your lease. These restructurings are carried out by landlords to reduce the possibility of vacancies and the associated costs, which can include a year or two of vacancy, significant tenant upgrades, and even demising fees. Landlords in a down turning market, like the one we currently find ourselves in, logically anticipate that the worsening market conditions will last for a year or two, and the risk of losing the renter is within their risk-averse time horizon. However, landlords and their brokers might be less reluctant to make compromises today for an extension that won’t even begin for three years or longer in the future and more optimistic about a mid-term market recovery.
3. The Tenant’s Credit
The harsh reality is that no landlord will take into account restructuring commercial lease unless they are confident that the tenant’s business will continue to exist and be able to pay rent for the additional period of time. Your business needs “good” credit in order to successfully renegotiate a lease. Although the word “decent” isn’t particularly technical, it was purposefully chosen. To be successful in having them done, you don’t need to have investment-grade credit or to be a Fortune 1000 firm. Instead, the tenant must be able to show the landlord how company will survive, which entails being open and honest about its long-term business plan, projected financials, and management team’s qualifications.
When there is a win-win situation for the landlord and the tenant, these restructuring commercial lease are successful. Design a strategy that enables the tenant to significantly cut their real estate costs while also enhancing the stability and reducing the risk of vacancy for the landlord. This is not a “blend and extend,” as some brokers are describing them. Instead, think of a lease restructuring as being more similar to refinancing your mortgage. You just replace the previous rate with the new rate and reset the term rather than blending your present home loan rate into a new rate.
Your landlord is not your adversary, but they will need to be pushed and cajoled into raising your rent to market rate, which most likely entails going to the market. A successful restructuring commercial lease requires a variety of factors, including building leverage, having accurate market knowledge, knowing when other important tenants in the landlord’s building or portfolio have lease expirations, analyzing financial scenarios, timing optimization, and excellent communication skills.