Project Manager Whitepaper
Most leasing markets, variously describe the tact of negotiations as either a “landlords market” or a “tenants market.” The market continuously fluctuates between the two, driven by several factors, such as national economic volatility, local economic stability or specific local demographics, to mention a few. The amount of available space and options presented to the participants will certainly affect leasing decisions, but the process itself primarily remains consistent.
Regardless of which party has the advantage at the time, Landlord or Tenant, an extensive list of issues must be considered and resolved throughout and sometimes up to the final moments of completing a transaction. The long-term relationship between the landlord and the tenant is multifaceted; the leasing process itself intricate and arduous.
Selecting the right Real Estate Advisory team for your needs is never done too soon.
If you own or are managing a business that involves the occupancy of Real Estate then the right time to start considering your Real Estate partner is usually sooner than you think. The following gives those involved or tasked with such decisions the high points that each Real estate transaction takes on when assessing your companies Real Estate needs.
The relationship between the landlord and tenant has a few basic principles:
1. The landlord is well-informed of the building’s fundamentals and the properties performance. In most cases, the tenant is typically not fully aware of the properties strengths and financial position which factor into assessing the lease negotiation process when considering the real estate needs of your business.
2. The landlord negotiates leases every day. Only tenants with sizable enterprises and a widespread workforce have ongoing lease experience and separate facilities personnel to address such issues. Even for these tenants, a major leasing transaction and office relocation is uncommon, occurring once in a decade or perhaps even less frequently.
3. The landlord’s team has a history of collaborating on transactions in a particular building; the tenant usually works with a new assembled team of advisors, unfamiliar with their personnel and the process.
4. The landlord controls the leasing process; its team, internally or through a third-party firm acting as the Building’s Leasing Agent. Part of that responsibility is understanding the landlord’s economic structure of the property, including amenities and capital improvements, and having the ability to negotiate and discuss all points of operating the property. Additionally, the Owner / Landlord should be willing to negotiate a lease in a transparent manner to benefit all parties.
5. The tenant’s upfront expense to relocate can be significant. Take, for example, a tenant requiring approximately 100,000 square feet. As a site is being considered, a Work Place Analysis is performed, and a Test Fit of the proposed floor plate configuration, serves multiple purposes. Not only does it highlight capabilities for a tenant’s use and occupancy for head count, but it also can be used to establish a preliminary construction budget. A gross rental of fifty dollars per square foot and a build-out cost of seventy-five dollars per square foot can equate to at least twelve and a half million dollars in the first year, ignoring “free rent” period, landlord contribution or landlord’s commitment to deliver the premises in the agreed condition per the lease. This also does not consider professional fees, moving costs and other miscellaneous expenses; also referred to as Soft Costs.
Regardless of the market, this is not to characterize the landlord as an adversary, it is simply that the landlord begins with certain advantages. To level the playing field, the tenant must approach the transaction with appropriate preparation and solid advice both internally and through the selected Real Estate Advisor. Too often this groundwork is inadequate or overlooked for the added-value. It is not that unusual to find a tenant well into its space search without a clear sense of its needs, such as operational needs, plans for future growth, necessary move dates, and restoration provisions for existing space. Equally important in taking on this endeavor is overall team synergy. Has the organization defined “three-year” growth or contraction expectations? Will a workforce consolidation reduce ancillary space needs? When performing the due diligence of proposed spaces, can the proposed test fits allow the flexibility needed based on these predictions? What infrastructure or base building amenities add value and can be utilized, or do they require improvements? All points to be outlined and managed by an experienced team of professionals to reach one clearly defined goal.
The tenant’s initial team, consisting of the architect/interior designer, a real estate broker or consultant, a project manager, and legal counsel, should assist the tenant in identifying present and future requirements and ensuring that the space selected best accommodates these needs. Others — engineers, contractors and/or construction representatives — will be added as the project progresses. This team
Comparing Proposals & Negotiating the Lease
Once the team is assembled and engaged, the consultants can assist the tenant in interpreting multiple proposals, each highlighting the landlord’s own response to the tenant’s needs. Similarly, to bargain shopping the tenant is not comparing standardized products – the “family size” with 5 free ounces or the “economy size” for a few bucks less – 18,000 usable square feet, representing a portion of one floor with an eighteen percent “loss factor” or two full floors, each 10,000 “rentable” square feet with an interconnecting stair. Each landlord is emphasizing their building’s unique amenities that best accommodate the tenant.
Throughout this process, satisfying the tenant’s needs efficiently and economically, is not simply a matter of finding a common basis for comparison, such as fixed rent per square foot. There are multiple factors to be considered in a significant relocation. Will the company employees be comfortable with the new commute? Is the tenant staking its future on a landlord’s vague promise that the neighborhood is “coming around”? Will the promised twenty-four-hour security materialize? What if Company X relocates to the new waterfront project and its competitors stay behind in the center city, renegotiating their existing leases? Where is the tenant’s own customer base located and, if relevant, will its customers stay where they are? How “smart” are these new buildings? How important are expansions or renewal rights, building identity, ceiling heights, views, or emergency generator capacity?
The architects, space planners, engineers and other team members also must reconcile dreams with reality. Can the building really accommodate the tenant’s high-tech needs? Is there sufficient core depth to accommodate support services efficiently? Will the acoustics in the performance space be as promised, or will they be affected by the proximity of the building’s freight elevator and the odd space configuration? Will an experimental lab — even if it is a “small one” — be permitted in a midtown office tower? Can the landlord or the financial advisors really assure medium-term costs, or will the budget be destroyed by the cost of removing asbestos from the five-year expansion space, or by complying with the Americans with Disabilities Act, or by an increase in real estate taxes when the landlord sells the building or even restructures its ownership interests?
In the ideal world, the business deal would first be struck, and the economic protections agreed to, and then the lease terms would be established. Most of this is done at very broad overview with what is termed, the “Letter of Intent” or LOI. The reality is much different. Almost without exception, the commercial office lease in the United States is a complex document bringing together numerous disciplines to govern what can be typically a ten or fifteen-year, or even longer-term, relationship. The landlord plays a variety of roles to the tenant’s role as the proposed building occupant. The lease document attempts to interweave various relationships and serves, therefore, as part lease, part sales contract, part credit agreement, part construction contract, part service supply contract and so forth. Moreover, the lease form that is used will rarely be varied. As the issues are the same, though perhaps of less consequence, the tenant for a relatively small space and short term will find itself reading the same voluminous lease document.
As if all of this were not daunting enough, the lease negotiation process can itself contribute to the complexity of the task. Issues are rarely tabled and settled in an apparently logical, or even chronological, fashion. Seemingly diverse issues can have significant economic consequences, and ostensibly non-economic issues can rise to an equivalent level at any time throughout the course of a negotiation. When one issue is addressed it may open the discussion to a related or ancillary item which needs to be inserted into a draft or as part of the numerous conversations that will take place. Basic economic terms are often left open until late in the negotiation process and settled as a package. A tenant may be willing to pay a bit more for “non-recourse” protection or broader termination rights. Significant additional issues can arise late in the game, as the tenant refines its space or design requirements or simply learns more about the building. And market forces may intervene. A tenant rumored to be “in play” will present the landlord with a very different risk profile. Or landlords or tenants may find themselves competing against one another for the same transactions.
Significant Lease Issues
With this background, it should be apparent that proper Due Diligence and assembling the proper team in order to advise you on the transaction would extend into several conversations and drafts of the specifics affecting the term of your relationship and potentially beyond.
As noted earlier, little progress can be made in a space search until the tenant’s basic requirements have been identified and refined. This process (called “programming”) is intended to ascertain the tenant’s current and prospective operational needs in a manner which is translatable into both space and service requirements. For example, food service for the tenant’s staff is not only a space issue but, if cafeteria or dining services are required, will involve technical issues such as venting of kitchen equipment, “wet storage” of refuse, life safety and public assembly code compliance, and access issues. Once the tenant’s programming is sufficiently complete, the tenant’s representative can begin to compare various proposals, perhaps including the tenant’s existing premises if a lease renegotiation is possible.
This comparison should proceed on a “usable square footage” basis. The New York market space is almost always presented on a “rentable basis,” allocating various common areas (elevators, stairways, lobbies and the like) among the available premises. By adjusting these allocations, the landlord can moderate apparent increases in base rents, operating expenses and overall size of the building all while maximizing overall return. Landlords generally look for a certain economic return from their vacant space on the basis of the floor or floors involved as opposed to the particular square footage. In addition to the economic differential between “usable”, “rentable” and “carpeted” measurements, the premises will always vary in their design efficiency. For example, a center core floor plate versus a side core floor plate, the presence of building equipment on the floor, such as mechanical equipment rooms, or the size and spacing of the structural columns can reduce the “usable” square footage. A common and rational basis for comparison is, therefore, critical. In New York, the Real Estate Board of New York (REBNY) establishes the regulatory oversight with Landlords of space measurements, as well as, establish the “Loss Factor”. Most other states utilize a more standardized means of measurement under the protocol of BOMA measurement, Building Owners and Managers Association standards.
But square footage is by no means the only relevant consideration in identifying the best available premises. As noted earlier, the tenant’s advisors must confirm that the space is suitable for the tenant’s intended use on a variety of other fronts, including legality of intended use, physical limitations, delivery date, layout efficiency, and availability of required services and amenities.
The examination should also take into consideration the tenant’s future needs. The tenant’s growth projections are, of course, quite fallible. Indeed, it is sometimes said that the only certainty is that growth will be other than as projected. However, the tenant’s team must consider whether future plans for growth, consolidation or even attrition are consistent with available options to expand or contract the premises.
Here, as in so many instances, the negotiation process will have to reconcile the tension between the landlord’s and the tenant’s desire for the utmost flexibility. The landlord will want the tenant’s firm commitment for additional space with little obligation on its own part, known as the “must-take” obligation. The tenant, in turn, will seek to characterize every decision as an “option.” An agreement with a tenant to “take” on additional space, for example, may occur on the fifth anniversary of the lease commencement, assuring the landlord that their tenant will take the space within a narrow timeframe or on a certain date. Now, the landlord knows to market the space for the interim period only. An “option” on the part of the tenant, means that the landlord cannot currently lease the space for more than the interim period but may find itself seeking another tenant in five years. From the landlord’s perspective, the rental for two shorter periods may not equate to that for a single longer period. Substantial tenants may negotiate various “takes” and “options”, and may also seek some limited control over additional space. If, as indicated earlier, the tenant’s growth projections turn out to have been too conservative, it may be in the market for additional space sooner than expected. While the landlord may resist giving the tenant additional options, it may agree to notify the tenant of the availability of additional space on a “first offer” or “first refusal” basis that would necessitate prompt decision by the tenant whether to lease the available space. Here, from the standpoint of the landlord, the “first offer” is less restrictive than the “first refusal”. The landlord can approach its existing tenant before marketing the space rather than participating in substantial negotiations with outside parties.
The rental on the possible expansion space can be acknowledged in the initial lease with the associated market risks to both parties or left to future agreement on a “fair market rental value” basis. An existing and substantial tenant may argue for a discount on the fair market rental value, claiming that the landlord’s savings in “down-time” and their cost to market the space yield a greater net rental to the landlord. For the tenant, the time of agreement on the rental value is critical. In the case of “option” space, can the tenant convince the landlord to delay its decision to lease the space until the rent is determined? This approach may or may not be successful in a given negotiation. At the minimum, however, it necessitates an early determination of rental value than may be prudent. In order for the landlord to have sufficient time to remarket the space if the tenant opts not to lease it, the rental value may have to be determined as much as eighteen months in advance. Significant changes in the interim could render the “fair market rental value” significantly biased to one party or the other. An adjustment to the agreed fair market rental value to reflect interim market swings is possible but, at best, imprecise.
II. Base Rent
We discussed earlier the need for a tenant to be able to compare lease proposals on some rational basis. What is the base or fixed rent on a usable square footage basis? What is the free rent period (and the scope for free rent; i.e., does it include operating and tax expense escalations—see Section III) at lease commencement and upon the exercise of expansion and renewal options?
Beyond this, the tenant should understand the components of its rental obligation. We will discuss escalations in Section III below. As discussed more fully in that Section, the base rental may be on a “net rental” or “gross rental” basis. The former means that a tenant will be paying its pro rata portion of all operating expenses and real estate taxes in addition to the net rental. With a gross rental, a portion of the stated fixed rent includes a base charge for operating expenses and real estate taxes (typically the expenses and taxes at/or about lease commencement, though in many instances simply an arbitrary figure), and the tenant will be paying its pro rata share of increases in such costs over the base charge.
Various other charges may be characterized as part of base rent. Electricity and cleaning are common examples. In some areas, such as New York City, this characterization may lead to the tenant paying a rent or occupancy tax on this amount even though it is more in the nature of a separate payment for services or a product. Generally, a tenant should be wary whenever separate components are included in a base rental calculation. Simply put, inclusion of more components will make it more difficult for the tenant to verify costs and to ensure that no intermediary (i.e., the landlord or its affiliate) will be making a profit on services or products purchased from a third party. The objective is to eliminate the middleman.
Take, for example, electricity costs. A direct meter approach, where the tenant purchases electricity directly from the public utility and consumption is measured by a separate meter, will provide the best means of cost protection. Yet, direct metering may not be available for all tenants, especially in older buildings, without expensive alterations to the building electrical system, and the rate available to the tenant will likely be higher than that charged to a landlord as bulk user. One alternative is sub metering, where the landlord purchases electricity from the utility at a given rate and monitors usage by each tenant on a sub meter. This approach provides a means of monitoring the tenant’s consumption — but not the rate charged. Unless the tenant negotiates for a direct pass-through of the rate charged to the landlord (with perhaps an administrative charge added), the landlord may be making a significant profit.
The third common alternative, “electric rent inclusion,” provides even less protection to a tenant. In this circumstance, the landlord and tenant agree to a fixed increment to the base rental to reflect the tenant’s electricity consumption based upon the tenant’s proposed electrical installations and equipment. The landlord (or, if negotiated, both parties) will then have the right to monitor or survey usage from time to time based upon the actual electrical installations and equipment at the time of survey. But often these provisions assume only an upward adjustment in the rental charge. The tenant may have no way of confirming the propriety of the initial charge and the survey of usage is unlikely to be as accurate as direct metering.
In the case of cleaning services, the tenant’s options may be even more limited. Typically, in a gross rental lease, the landlord will engage a cleaning contractor for the entire building, factoring the cost of cleaning into its base rent, and passing increases through to the tenant under the escalation provisions. The tenant should be concerned about both cost and quality. Is the landlord charging more than the market and making a profit by using an affiliated company? Does the tenant have any control over quality?
Tenants are often able to negotiate some means of assessing cost, but the quality issue is much more difficult. A substantial tenant may seek the right to hire its own cleaning contractor. Landlords can reasonably object to this approach, however, because the presence of two cleaning contractors may impair building security, tax the freight elevators and create labor problems. Even if the tenant is successful in negotiating for a separate cleaning contract, it may find itself with no material change in quality (“the people remain the same, only the uniforms change”) while subsidizing a portion of the landlord’s cleaning contract. When the tenant seeks a decrease in base rent to reflect the fact that the landlord is not providing cleaning services to the tenant, the landlord would be justified in reducing the base rental only by the actual savings on its cleaning contract; those savings are likely to be less than what the tenant is paying under the separate contract.
III. Tax and Operating Escalations
In a so-called “triple net lease” (commonly where the tenant is leasing an entire building), the landlord is largely a passive owner and the tenant assumes the responsibility for property maintenance and direct payment of the various costs associated with the building’s operation, including real property taxes. More typically, the landlord retains several of these responsibilities and seeks to be reimbursed by the tenants for its costs. This is often referred to as a “gross” or “full service” lease. As noted above, gross lease rentals may be on a “net rental” or “gross rental” basis. In either event, the tenant will be reimbursing the landlord for some or all operating expenses and tax charges.
In some gross rental situations, landlords seek to account for increases in these costs through use of a formula, rather than a direct accounting. One such formula increases rent by the same or a stated proportion of the percentage increase in the consumer price index. This approach is, at best, a rough approximation of increases in the landlord’s costs. Increases in the cost of consumer goods may have little relevance to the cost to the landlord of maintaining its building. In New York, some landlords use a so-called “porter’s wage” formula, which is based upon the labor cost for a category of building employees. Here again, the porter’s wage would have no relation to the cost of fuel and many other operating expenses. Formula approaches have an appeal because of their relative simplicity and thus may be suitable for a modest size tenancy. In such a circumstance, the tenant should carefully review the formula with its advisors to evaluate its fairness.
More commonly, especially for medium to larger tenancies, the landlord will utilize, and the tenant will expect a direct cost approach. In gross rental markets, such as New York, larger tenants should consider whether to seek a net rent or to accept a gross rental and, if the latter, how the base amount incorporated in the rental will be calculated. In theory, there should be little or no difference between the actual rental amounts paid under the net rental and gross rental approaches, except, perhaps, in the initial year or two of the base term. If a gross rental is used, the bases for operating cost and real estate tax escalations must be established. These can be based upon estimates, especially for buildings under construction or which have not been fully leased, or upon the actual costs and taxes for a specified year, such as the first year of the lease term.
A tenant needs to understand not only how the base amounts will be derived for a gross rental lease but, whether it takes a net rental or a gross rental, the relative efficiencies of prospective buildings and landlords. Projected efficiency is not a matter of precise calculation. Rather, it is mostly judgmental and is subject to change for example, if the landlord or managing agent changes.
If the direct cost escalation method is used, the review and negotiation of the actual provisions is one of the most critical aspects of the leasing process. In the commercial arena, lease provisions are construed, for the most part, in accordance with their terms. Thus, even if actual results vary significantly from projections because an unintended charge was allowed, or an obvious charge not properly considered in formulating base amounts, the fact of the increase alone, however “excessive”, will not be sufficient reason for a court to “cap” or otherwise modify the express terms of the lease agreement. The protections must appear in the lease itself.
The potential scenarios are, of course, without limit. For example, the tenant may have agreed to pay tax escalation based upon the real property taxes for a specified year. Later, the landlord may contest the taxes for that year and obtain a reduction, resulting in a lower base amount than the tenant expected. With a lower base amount, the tenant may find itself paying additional taxes for subsequent years under the escalation provisions. Similarly, the tenant may have agreed to pay its fair share of operating costs but did not expect to be subsidizing the landlord’s capital improvements late in the term of its lease.
If the landlord’s definition of operating expenses is properly drafted and could not be read to include specious items, such as art work in the lobby, then counsel need not engage in a lengthy discussion about exclusions. On the other hand, if the definition of operating expenses is broad (as it usually is), the scope of the included costs as well as the counterpart exclusions must be carefully defined. To give but one illustration, in the face of an exclusion for leasing costs which did not refer to the tenant’s lease, one landlord attempted to charge the tenant for the costs, amortized over the term, of procuring that tenant’s lease.
IV. Landlord’s and Tenant’s Work; Alterations
In rare instances, a tenant may select space that is ready for occupancy, either because the tenant can adapt its requirements to a standard office configuration provided by the landlord or because the prior tenant’s build-out fortuitously accommodates the new tenant’s needs. In almost all cases, however, the tenant will find itself with a significant design and construction job at hand. Perhaps the premises are raw space consisting of concrete slabs and columns and exposed wiring or, even more costly, an existing build-out that must be gutted and rebuilt. In these instances, the lease document will become in part a construction contract, a credit instrument, or both, as the landlord and tenant negotiate the costs of, and the responsibilities for, demolition and build-out.
In the past, landlords often forced tenants to engage the landlord or one of its affiliates to build out the premises. The risks to tenants of such an approach may seem evident but often were not fully fathomed. Today, many landlords see the role of contractor as presenting more risks (delays in rent commencement, liability and the like) than rewards. Institutional owners (especially foreclosing lenders) may simply not have the capacity to offer any significant construction services. For all of these reasons, most landlords prefer to shift build-out responsibility as much as possible to the tenant. The outcome is most likely something of a hybrid—some landlord work and the balance tenant work, with the financing provided in whole or in part by the landlord.
The tenant’s design team will want ample opportunity to inspect any premises under consideration. Can any of the existing build-out, perhaps interior stairways, be salvaged and incorporated into the proposed design? Are there existing conditions that will make a build-out more expensive to inhabit or add construction time constraints? Among such issues is the presence of asbestos or hazardous containing materials. What are the conditions of the Base Building MEP systems along with proper and current code compliance of those existing systems ? The goal of the tenant’s design team will be to identify (and, if necessary, negotiate lease terms that will result in) space that will be delivered by the landlord in a safe and hazard free condition, as well as satisfying the tenants timeline to construct without unknown inference or delays. The tenant may require that the landlord assume the responsibility for (and the risks associated with) demolition of existing improvements, asbestos removal and the like. The tenant will also want the landlord to perform any agreed upon work to the base building or base building systems, as this work essentially involves matters outside of the tenant’s prospective premises and presents more of a risk to the tenant because of the potential impact on other tenants or the building and its systems. The landlord is likely to accept these responsibilities, and it may extend its involvement in the tenant’s build-out to be responsible for, or at least to have significant control over, any portions of the tenant installation that will affect its basic building systems. For instance, the landlord may require that its contractor complete any installations affecting the life safety, electrical or air-conditioning systems. And, from the tenant’s perspective, this may be best for all concerned so long as it can control the cost and timing of the work to be undertaken by the landlord.
Delays, by landlord or tenant, will figure prominently in these lease negotiations. The landlord will be seeking the assurance of a fixed rent commencement date. Any delays could pose significant financial difficulties for the landlord as its operating costs and debt service accrue. From the tenant’s standpoint, little could be more embarrassing for the tenant representative and his or her team than to be forced to present the tenant’s financial officer with a rent bill for space not yet available for occupancy.
The tenant should also bear in mind that many of the same risks that it faces in completing its space may reappear from time to time throughout the lease term as alterations to the tenant’s space become necessary. Expansion of the premises, periodic refurbishment, changes required by law, and even the installation of new computers can place the tenant and its landlord at odds. Will the landlord attempt to control the work by requiring its involvement or the use of particular contractors? Will the landlord be charging a significant fee for “supervisory” services? Will the tenant be permitted to perform the work at times of its choosing, or only during overtime periods? Will the tenant have necessary access to portions of the building outside of the premises? Will the tenant be able to bring additional electrical service to its premises or connect computer networks on non-contiguous floors? In the best scenario, tenant’s operations personnel should be able to coordinate any such work with building management, leaving the lease document in the bottom drawer. But disputes do arise, and the tenant should not simply rely on a present air of good will.
V. Compliance with Current Local Laws; Repairs
Aside from rental disputes, perhaps the most frequent disagreements between landlords and tenants are those over responsibility for legal compliance costs and necessary repairs. Anticipated costs are rarely an issue; rather, the parties to the lease (or at least one of them) may forget the long-term nature of the lease contract and how quickly the social and legal environment changes. It is endemic to the American legal system that nearly every catastrophe begets a new set of laws. In New York, a substantial fire begot Local Law 1973-5, requiring wide-ranging upgrades of building systems in most Manhattan office buildings. The First Interstate fire in Los Angeles, followed more recently in 1990 by the fire at the Health Services Building, spawned a host of sprinkler and other fire safety ordinances. Falling bricks from a crumbling facade begot New York City’s Local Law 1980-10. And with each enactment, landlords and tenants were forced to review responsibility for the unforeseen requirement.
Another topic of certain importance is the Americans with Disabilities Act. The tenant’s architect will presumably factor into its design compliance issues arising strictly from a pre-inspection of the space for such issues. But what of the base building? Will the tenant’s installation trigger compliance requirements in public areas, and, if so, who will bear the cost? The Act does not clearly delineate responsibility for leased premises and current regulations leave the matter to negotiation between the parties to a commercial lease — an unusual approach in the U.S. regulatory scheme.
Landlords typically retain responsibility for compliance and repair costs relating to common areas of the building and to structural portions of the leased premises.
This is an overview of the array of issues when considering your Real Estate needs. Selecting the right Real Estate Advisor well versed in these disciplines is a worthy investment that allows a client or firm to conduct business knowing that then major investment of time and dollars is being closely monitored by a team and firm of individuals well versed in providing such services.
Cresa is that team. Please feel free to inquire further how we might be of service here, nationally or abroad to assist with any aspect confronting your firms Real Estate needs.