Even as the Coronavirus pandemic has precipitated tremendous challenges to main street, some businesses are leveraging their commercial leases to reap benefits. Here are three ways tenants are getting more out of their leases: by renewing, subleasing, and pivoting to new spaces and new uses.
Businesses that are in a relatively strong financial footing and whose leases are expiring in the next 6 to 18 months may find themselves with greater leverage to negotiate renewal terms. In one recent example, a retailer based in the greater Los Angeles area has a lease expiring in the fourth quarter of this year and the landlord’s broker has been inquiring with the tenant on the status of the renewal. The landlord has offered to increase the rent by 3% however market conditions may enable a negotiation at terms more favorable to the tenant, especially if there is concern about vacancy rates and rental values in that area in the long-term. In another example, just this past month, a Downtown Los Angeles design studio whose lease was expiring was offered a renewal by its landlord at the existing rate (the tenant is doing strong online business). Another area of leverage could be options to renew with “Fair Market Value” rent clauses. These are options to extend where the landlord and tenant did not previously specify the rent during the extended period – and instead provided that rent will be the fair market value existing at the time that the parties exercise the extension option. Expect the language of the “Fair Market Value” lease extension clause to be scrutinized by the parties, including where terms provide that it is based on negotiation and broker determination of value.
There is always the traditional option of subletting or assignment. This may be for the entirety of the space or tenants may right-size downward as they find work can continue to be accomplished from home and that business operations require less space. As more sublease options enter the market (especially in traditional office leasing), tenants may find sublease market rates to be below contract rents; although this could be good news for businesses who have more flexibility and a willingness to become subtenants. According to CoStar Group, which provides information and analytics to the commercial real estate industry, “Prior to the pandemic, the Los Angeles office market was in a favorable position, with vacancies near a decade low. However, net absorption during the past 12 months was, by and large, flat and the area’s vacancy rate, currently just above 10%, had already been going sideways for several quarters.” Retailers on the other hand will need to pay attention to the language in their lease agreement governing subleasing as change of use may require written approvals with the landlord (for example, a sandwich shop that may want to sublease to a coffeeshop). Also according to CoStar, “Retail occupancy rates were already on the decline prior to the virus’ outbreak, and are expected to continue along a downhill trajectory through the rest of 2020.”
A number of businesses have made dramatic changes to operations during the COVID-19 pandemic, for instance, restaurants shifting entirely to delivery and take-out service. While some tenants have only been able to do a fraction of their former trade, we have spoken with a number of business owners who have found success in this pivot. One business, a wine store that has converted entirely to deliveries, has increased sales during COVID-19, increased its hiring and payroll (delivery drivers), and employees are enjoying greater job satisfaction with a reorganized store that is focused on fulfillment and delivery rather than merchandized to appeal to the walk-in customer. The tenant is considering making the shift to delivery-only permanent and moving to an industrial space rather than a storefront. Similarly, the Coronavirus pandemic may hasten the evolution from restaurants (retail sidewalk space) to ghost kitchens (industrial). Businesses will have to determine what is the right type of space for their evolving business model? Industrial space? Retail?
Signing a New Lease in a Post-Coronavirus World
Going forward, expect commercial leasing transactions to follow patterns from the previous market crash and how parties underwrote lease deals from 2009-2012. Securitization of the lease will remain important. This could be in the form of personal guarantees, as well as an increased security deposit and/or letter of credit. Just as before, bankruptcies may become increasingly common. There are also newer FinTech options in the market, for example, one company called The Guarantors offers a sort of rent insurance policy for tenants. While a newer concept for landlords, if the deal terms make sense these sorts of creative options may become increasingly common.
Expect to still see a variety of lease options both short-term and long-term depending upon what the effective rental value will look like after concessions are provided and commissions paid. Tenants that require more build-outs (for example, restaurants, high tech companies, etc.) will still be looking at longer term leases, while those with simplified build-outs (for example, retail clothing stores and basic officer users) can probably manage shorter-term leases. That being said, just as in 2009-2012, if landlords believe this is a temporary market correction, they may not want to be locked into long leases at reduced rents. However, lender requirements especially for larger spaces may also put pressure on landlords to lease for longer-term.
About the Authors
Heather Boren is a commercial leasing broker with Estate Match Realty, specializing in tenant side representation and a professor of finance and real estate at Pepperdine Graziadio Business School.
Laine Mervis is a partner at the Los Angeles law firm Eanet, PC, representing commercial landlords and tenants in litigation and arbitrations.