Options for further terms in your commercial lease provide an excellent safety net for your manufacturing business, but you will lose leverage if you rely on them to secure your next lease term, potentially costing your business significantly more than necessary. Any potential new lease term should be seen as an opportunity to renegotiate. As a tenant you hold all the cards – you just have to know how to play them. By Dylan O’Donnell.
When negotiating a new commercial lease, multiple options for further lease terms are an excellent way of securing a site for a long term, while giving your business the flexibility to relocate or exit the property at regular intervals as may be needed to support future growth, consolidate or respond to merger and acquisition opportunities.
In other words, option periods in your commercial lease provide your business with an excellent safety net. If your business is performing well and the site continues to meet your needs, you have the security of knowing you can stay for at least as long as the option periods last. In a manufacturing context, this long-term certainty is critical for accommodating capital-intensive plant and equipment.
But here is the problem. Far too many businesses treat options for further terms in commercial leases as more than just a safety net and commit to their next term by simply serving the required notice under the lease. This is a significant opportunity lost to renegotiate the lease and reduce your operating expenses, raise capital, remove onerous lease clauses and/or include more favourable lease clauses.
From our experience, most businesses typically begin to think about whether they want to commit to their site for another lease term around 12 months before the date their lease is due to expire or the last date to exercise their option. Then, having made the decision to stay, they serve notice to the landlord exercising the option to lease for a further term in accordance with their lease. If there is a market review provision in the lease, they may have already agreed with the landlord what the new rent will be before exercising the option, or they may be happy to rely on the market rent review provision in the lease to ensure the rent remains at a “fair market rate”.
Here is why that approach costs businesses money they weren’t even aware they could save (especially in today’s environment, where as a tenant you hold even more cards than usual).
A market rent review at the start of your new lease term will never fully reflect the best deals being completed in your local real estate market. First, they will rarely reflect incentives of new leases being entered into (the “effective rent” rate), but rather reflect the inflated, pre-incentive rent rate (or “face rent” rate). Second, even in declining markets where asking rental rates are reducing, there can be a lag between the best deals being completed by tenants and a market rate being determined at that reduced level. A determining valuer will never set a new low benchmark for market rent – this can only be achieved through negotiations between a landlord and tenant. For manufacturing and other industrial tenants, a “ratchet” clause can also often prevent the rent from decreasing by more than a specified amount, if at all.
Therefore, if you intend to stay at your site beyond your lease expiry, you should always seek to renegotiate the lease, even if you have an option to renew for a further term. This should be done well in advance of your last date to exercise the option, when you have maximum leverage in any negotiations with your landlord (and a safety net to fall back on in case your negotiations are not fruitful).
When renegotiating your lease, the landlord should be considering your offer in the right context of what they would have to offer another tenant in the event you left the property at lease expiry (plus the costs they would have to incur to secure that new tenant). Depending on the market, this might include an extended period of the property being vacant and not generating revenue for the landlord, advertising costs and leasing fees to agents, plus large incentives to the new tenant by way of contributing to plant and equipment or extended rent-free or rent abatement periods.
To create the right context for the renegotiation of your lease, timing is absolutely critical, as is the way your future intentions are portrayed. If your landlord believes you are seriously contemplating relocating or exiting at lease expiry, and there is sufficient time remaining on your current lease for you to do so, then you are much more likely to create the right context for renegotiation (remember, you do not have to be seriously contemplating a relocation of your business, your landlord just has to believe it is possible that you are).
By renegotiating with your landlord in the right context, you can create a win-win scenario.
Your landlord can avoid all of the uncertainty and cost associated with losing one tenant and sourcing another. You can access the benefits a new tenant would such as contribution to upgrading plant and equipment or a rent-free or abatement period that you cannot access by exercising your option or by relying on the market rent review provisions to set your new rent.
By simply exercising your option, you can easily end up paying significantly more than you should for your next lease term, after taking into account a lost opportunity to receive landlord incentives such as rent-free, rent abatement or capital contributions, or even through less obvious means such as the removal of onerous lease provisions and inclusion of more favourable items. This is why exercising your option for a further lease term may not be the best option for your manufacturing business.
Dylan O’Donnell is a Director of tenant and occupier advisory group Lpc Cresa.