What do Bigfoot, the Loch Ness Monster and lease “tear ups” all have in common? Many people have claimed to have seen them over the years; however, they all remain largely a myth. While the opportunity to tear up your lease and move to another space or building in your landlord’s portfolio may seem good in theory, it rarely works in practice.
A lease tear up is when the landlord agrees to rip up a tenant’s existing lease (which still has term remaining on it) and enter into a completely new lease. Typically this happens when the tenant needs more, less or perhaps different space but there is too much term left in its current lease to enter the market and right size into a third party landlord’s space. In a true tear up, the landlord forgives the remaining obligation on the original lease when it enters into the new lease. As we will see, these transactions are often difficult to perform and, when they do, they rarely involve the extinguishment of the prior obligation.
Imagine you are currently leasing 15,000sf of office space and now need 25,000sf. Assume you have two years left on your lease term and your existing landlord doesn’t have room in your building for you to expand. Assuming your landlord controls other nearby buildings that can accommodate your larger requirement, is it a slam dunk that he will rip up your existing lease and move you into the other building? In many cases he is actually prohibited from carrying out this strategy. However, even if the landlord is able to relocate you to his other building, you may end up paying a premium for the privilege. Let’s see why.
How Your Landlord’s Ownership Structure Affects a Lease Tear Up
One issue that tenants ought to consider when deciding on a building is whether the landlord has the ability to move it to another building in its portfolio if and when it runs out of space or its needs otherwise change. This is especially true in the suburbs where buildings tend to be smaller. Thus, in a 1,000,000sf Class A building in Center City, it’s likely that at any point in time, the landlord will have 10,000sf of expansion space or even a new 25,000sf suite to accommodate our tenant in the example above. However, this may not be the case in a 60,000sf building in King of Prussia.
While many landlords may tell you that they can accommodate your growth elsewhere within their portfolio if necessary, in reality, only certain types of landlords can actually provide such flexibility. With the exception of the large REITs and perhaps well capitalized institutional owners, most landlords hold each of their properties in single purpose entities (“SPEs”). SPE structures are used in order to (1) isolate the financial risk of each building and owner from the risks of all affiliated properties and owners, (2) allow for different ownership compositions for each asset and (3) enable landlords to finance each asset independently including through CMBS loans. Thus, while to the outside world it may appear that one large real estate company owns and operates a large portfolio of properties, if the SPE structure is being utilized, each asset is effectively a world unto itself. In such case, the real estate company loses the ability to treat these portfolio properties interchangeably.
Lease tear ups, therefore, become virtually impossible when properties are owned in SPEs. In our above example, if the landlord were to take the tenant out of Building A and move it into Building B, the investors and lenders of Building B would secure a windfall but at the expense of the investors and lender of Building A who would lose a valuable tenant. As a result, the owners and lender of Building A would never consent to such a deal even though it makes sense from both a portfolio and client relationship perspective.
Extinguishment vs Spreading of Prior Obligations
Even if the landlord is a REIT or institutional landlord who, directly or through subsidiaries, wholly owns each property and does not separately finance its assets, a lease tear up often becomes a prohibitively expensive arrangement for the tenant.
In our example above, it may seem like good business for a landlord to rip up a 15,000sf short term lease in exchange for a new, 25,000sf long term lease. However, we often find that the landlord is not actually forgiving the rent on the remaining lease term when he rips up the old lease– this old obligation simply gets spread over the new lease term thereby resulting in a premium. In order to determine whether the landlord is truly forgiving the remaining rent obligations when it rips up the old lease or merely shifting those obligations to the new lease, the tenant needs to compare the new lease deal with what it could otherwise achieve in a competitively bid situation.
Thus, let’s assume that there are two full years left on the original lease in Building A at a rental rate of $30/sf (i.e., total remaining rent of $900,000). Despite the fact that the landlord says it is willing to “tear up” the original lease and move the tenant to Building B, it may attempt to recover some or all of that $900,000 in the new deal. If the landlord has been doing new lease deals in Building B for $30/sf rent with a $50/sf tenant improvement allowance and six months of free rent, but he offers the relocating tenant a rent of $32/sf, a tenant improvement allowance of only $40/sf and no free rent, the tenant is effectively paying a premium for the relocation. In this case, the old lease obligations have not been forgiven; they’ve simply been transferred to and spread over the new deal.
Achieving flexibility to grow or shrink your space as your business expands is very important given the long term nature of lease obligations and the rapid change of business today. However, while some landlords may appear to have the ability to accommodate your changing needs within their vast portfolio, it’s rarely that simple. In order to ensure that this promised flexibility is truly viable and cost effective, the tenant must do its due diligence both when selecting a landlord and then again at the time it considers any such lease tear up transaction. Without this careful analysis, the tenant may find that his lease tear up is as illusory as Bigfoot or the Loch Ness Monster.
For more information contact Glenn Blumenfeld