Long-term leases are common in commercial real estate, but they come with benefits and drawbacks for both landlords and tenants. In this article, we will explore the advantages and disadvantages of long-term contracts in the context of commercial leasing, and how to exit or renew a lease without losing money or opportunities.
Long-term leases offer stability and security for both parties, as they lock in the rental rates and terms for a fixed period of time, usually between three and 10 years. This can help landlords avoid vacancies and tenants avoid rent increases or eviction. Long-term leases also allow tenants to customize the space to suit their needs, and landlords to amortize the costs of improvements over a longer term. Additionally, long-term leases can enhance the value of the property and the creditworthiness of the tenant, making them more attractive to lenders and investors.
For example, should the Landlord / property owner need to refinance, the present value of the guaranteed cash flow of the long term leases adds cash value to the building in addition to the value of the real property value itself, which increases security for the Bank and likely provides better terms on refinancing. From the Tenant’s perspective - a history of successfully meeting the financial obligations of a long term lease offers a Landlord security that the Tenant can meet their financial obligations in a future lease, which provides better opportunities to the Tenant of reduced rates or incentives, as opposed to a Tenant which has shown no such history.
Note that some long terms leases can be set for even longer periods (such as a ground lease for the construction of a building or an agricultural development lease). For example, a vineyard development lease may be for 25-30 years, which allows the tenant enough time to plant and cultivate a wine grape vineyard into a productive and valuable crop, from which both parties reap the benefits and rewards.
Long-term leases also have some disadvantages, especially if the market conditions change or the business needs evolve. For landlords, long-term leases limit their flexibility and ability to adjust the rents or terms to reflect the current demand or supply. They also expose them to the risk of default or bankruptcy of the tenant, which can result in lost income and legal expenses. For tenants, long-term leases reduce their mobility and adaptability, as they may be stuck with a space that is too large, too small, or unsuitable for their operations. They also bear the risk of overpaying or underutilizing the space, if the market rates or their revenue decline.
In a long term lease, the lack of flexibility and ability to adjust rents may be particularly challenging for a landlord in an inflationary environment, like today.
Other costs to landlords resulting from tenant default or bankruptcy include losses from leasing costs that have been paid such as leasing commissions paid as a percentage of the assumed rent to be received over the full lease term, as well as tenant improvement allowance often reimbursed upon completion of tenant construction of the space, and any rent abatement or other concessions granted to tenant in exchange for an assumed long term schedule of rental revenue.
Exiting a long-term lease can be challenging and costly, but there are some options available for both landlords and tenants. For landlords, they can try to negotiate a buyout or a termination agreement with the tenant, which may involve a lump sum payment, a penalty fee, or a release of liability. They can also try to find a new tenant to sublease or assign the lease, which may require the consent of the original tenant and the lender. For tenants, they can try to negotiate an early exit clause or a break option with the landlord, which may require a notice period, a penalty fee, or a rent review. They can also try to sublet or assign the lease to another tenant, which may require the consent of the landlord and the lender.
From the tenant's perspective, it's important to thoroughly review and understand any early exit or break options within the lease agreement before committing. Negotiating these terms at the outset can provide flexibility if business circumstances change. Additionally, tenants should maintain open communication with their landlord to explore mutually beneficial solutions for exiting the lease. Seeking legal advice is crucial to navigate the complexities and potential penalties involved in breaking a lease. Subletting or assigning the lease can be viable alternatives, but it's essential to ensure that all parties, including the landlord and any lenders, consent to the arrangement.
Lease surrender agreements are vehicles used used to remove long term non performing leaseholds as well as offer a defaulting tenant a cap on future leasehold liability
Renewing a long-term lease can be beneficial and advantageous, but it also requires careful planning and negotiation. For landlords, they can try to retain the tenant by offering incentives or concessions, such as rent discounts, free months, or improvement allowances. They can also try to increase the rent or the terms to reflect the market value or the tenant's performance. For tenants, they can try to secure the lease by demonstrating their reliability and profitability, such as paying on time, maintaining the premises, or increasing their sales. They can also try to reduce the rent or the terms to reflect their needs or challenges, such as requesting rent abatement, flexible payment, or shorter duration.
Tenants should review their leases and make sure they are well aware of any renewal options they may have and deadlines for sending notice to their landlord in order to exercise. Some renewal options include fixed rent and dictate a predetermined rental rate upon exercising, which can potentially provide significant value to tenants if the renewal rate is below market.
Assess whether the space and cost meet your future needs, then research market rates and explore other rental options to gain leverage. Begin renewal discussions early, well before the lease expires, and negotiate terms such as rent, lease duration, improvements, and potential incentives. Once terms are agreed upon, draft a detailed renewal agreement and have it professionally reviewed. Finally, plan for a smooth transition to avoid business disruption. Initiating the process 6-12 months in advance and maintaining good relations with your landlord can facilitate a successful renewal.
Long-term leasing can be a complex and strategic process, but there are some tips that can help both landlords and tenants achieve their goals and protect their interests. For landlords, they should conduct a thorough market analysis and a credit check of the tenant, and draft a clear and detailed lease agreement that covers all the essential aspects, such as rent, term, maintenance, insurance, subleasing, and dispute resolution. For tenants, they should conduct a careful assessment of their business plan and budget, and review the lease agreement carefully and seek legal advice if necessary. They should also communicate with the landlord regularly and build a good relationship that can facilitate future negotiations or adjustments.
Long-term leasing is complex but manageable with the right strategies. Landlords should analyze the market, check tenant credit, and draft clear leases covering key terms like rent and maintenance. Tenants should assess their business plan and budget, review the lease carefully, seek legal advice, and maintain good communication with the landlord. These steps help both parties achieve their goals and protect their interests