In football, it’s usually pretty obvious when you need to “go long”. If the Eagles are on the 50 yard line, down by six points with five seconds to play, Chip Kelly is going to call for the bomb or “Hail Mary” pass. In real estate, however, it is often less clear to tenants (and many brokers) when to commit to a long term deal or go with a shorter lease term. While there are no hard and fast rules, there are some guidelines companies should consider in evaluating their options. Ultimately, each business is different and the decision will depend on many factors including their growth projections, future prospects, committed capital for the space, uniqueness of the space and forecasts about the general economy.
Here are some of the major factors a tenant should consider before committing to a given lease term:
1. What is the tenant’s near and long term growth or contraction projections and can the building/landlord accommodate these scenarios? If a tenant is growing quickly but already occupies 90% of the building or if there are no near term expansion opportunities, a long term commitment to the building may not make sense. The building needs to be able to accommodate the tenant’s future business projections; otherwise the tenant needs to have the flexibility to extricate itself from its current lease and move to a place in the future that can support its business.
2. Is the space critical to the company’s operations or is it generic space that can be easily and cheaply replicated or replaced? If a distributor is across the street from its major customer’s warehouse and it has a long term supply contract with that client, it may make sense to tie up the strategically located warehouse on a long term basis. This is especially true if the distributor has a lot of capital invested in the building such as racking systems and cranes. Likewise, if a company is building out laboratory space for $350/sf, it probably isn’t economically viable to walk away from this investment in five or seven years. Tying it up long term (or even buying the property) may make more sense. However, if the tenant is talking about generic office space which requires no out of pocket build out costs, that might be a good candidate for a shorter term deal.
3. How much is it costing to build out the new space and how much of that cost is the tenant willing to cover? Although the relationship is not completely linear, generally speaking, the longer the lease term a tenant is willing to commit to, the more tenant improvement allowance the landlord will fund. Thus, it is likely that a landlord will give a significantly larger allowance for a 10 year lease deal than it will give for a five year deal even if it isn’t double the amount. Thus, if the tenant will be required to spend a considerable amount of money to build out its space, it may want a longer lease term.
4. Where is the rental market going? Common sense tells us that, all else being equal, tenants should take advantage of weak market conditions (or weakness in their current building’s performance) by committing to long term leases and minimize their commitments when real estate is relatively expensive. Obviously, there are circumstances which may make these strategies impractical. For example, in a strong real estate market, a tenant whose business is growing and needs to invest significant capital in expansion my require a long term lease in order to economically amortize such costs even though rents are high. On the other hand, in a weak rental market, a company that does not yet feel confident enough about its long term future may not want to commit beyond three years.
5. What is the company’s future business plan? Ultimately, a tenant’s real estate must support its business strategy and not dictate it. Thus, if a newer, fast growing business is funded by private equity money with a three to five year investment horizon, that tenant may not want to commit to a seven year lease. If the company is being positioned for sale within three to five years, a longer lease commitment may deter some strategic buyers who don’t want that lease liability.
6. Is the business changing in a way that could impact space utilization in a major way? If a company is experiencing a trend of employees being secunded by clients, telecommuting from home or otherwise spending considerable amounts of time out of the office, that tenant may want to take smaller bites of real estate as it monitors where the future is taking it. Similarly, if the company has major supply contracts or business relationships that are coming up for renewal in the next few years, it may want the flexibility of being able to re-size itself should it lose this business and, therefore, it would seek a shorter term commitment.
The decision about whether to “go long” in leasing, as opposed to football, is not always clear. Before committing to a lease term, tenants need to think hard about the future and work with their broker to flesh out the issues that will impact their decision. A well thought out strategy will save you a lot of money whereas a poor one may just get you a ticket to Kansas City with Andy Reid.
For more information contact Glenn Blumenfeld