Hidden Value of Long-term Leases

Some companies favor short-term leases to compensate for bad timing. Rather than apply a strategic approach to their real estate, they tend to be reactionary, taking space in times of growth and disposing of it in times of contraction.

Examples of this abound as a result of the latest real estate cycle. Companies that expanded in 1999 and 2000, taking on space when rental rates were at all-time highs and vacancy rates at all-time lows, suffered the consequences when the Internet bubble burst and the economy fell. As these same companies downsized dramatically a few years later, they were faced with surplus space at a time when rates were low and demand nearly non-existent.

To counteract the effects of cyclical real estate decisions, many companies take shorter-term leases. Companies that signed shorter terms at the height of the tech boom counted themselves lucky. However, the experience created a misperception that shorter terms are more economically sound. Although most view a shorter-term lease as the safest strategy, it is often the most expensive way to maintain flexibility, especially for strong credit tenants capable of negotiating contraction and termination options.

The Art of Negotiation

A short-term lease is generally defined as a term of less than five years, while long-term leases are 10 years and above. By virtue of their length, short-term leases require the landlord to amortize transaction expenses over a short time. So the expenses — tenant improvements, legal fees, commissions — are usually passed along to the tenant via a higher rental rate.

A more strategic approach, especially in today's tenant market, is to negotiate a favorable rate as part of a longer-term lease that includes cancellation and/or contraction options. Although landlords typically ask for penalties tied to these options, longer leases are still economical, despite the potential for additional cost.

Our example compares a four-year term to a 12-year term, demonstrating the difference in total cost if the tenant only occupies the space for the short term vs. staying for the 12-year term (see chart). Over a 12-year period, the shorter-term lease would have to be renewed twice. The example assumes a reasonable average market-rate increase for each renewal.

The comparison illustrates only a 7% difference in total cost of the long-term lease when cancelled at the four-year mark over the total cost of the short-term lease. However, if the cancellation is not exercised, the potential cost-savings benefit of the long-term lease is 58%. In this scenario, the savings on a 20,000 sq. ft. space would equate to a whopping $2.6 million.

In cases of contraction, this option is desirable even with the penalty because it affords the company the advantage of continuing to pay the lower rental rate on the remaining space without incurring the considerable expenses associated with moving to a new space.

Long-Term Benefits

For strong credit tenants, a longer-term lease enhances the tenant's ability to negotiate favorable terms. Credit tenants in long-term leases offer additional value to the landlord by increasing access to favorable financing, thereby providing higher net cash flow. This quantifiable value-add is powerful leverage for tenants during lease negotiations.

If a company can identify core properties and can plan ahead, ownership or sale-leaseback offers the opportunity to reduce occupancy costs even more than a long-term lease with a traditional landlord.

The same approach can be applied to portfolios spread across multiple locations, provided the companies can identify which locations are core to the business and which should be treated with more flexibility. In some cases, multi-location portfolios may have less essential locations that are so small in relative size to the portfolio that the amount of increased cost for short-term leases has minimal impact. However, the determination to take on short-term leases should only be made based on a long-term plan.

One of the biggest misconceptions that too often leads to costly reactionary real estate decisions is the belief that “long term” equates to “inflexible.” Whether a company has two leases or 200 leases, a long-term strategy that consists of properly structured long-term leases can be beneficial. And, on the whole, having a long-term real estate strategy that aligns with the company business plan can dramatically reduce occupancy costs — over both the short and long term.

Bill Goade is founding chairman of CRESA Partners.

Cost Comparison: Short Vs. Long-Term Office Leases

The following example illustrates the cost difference between a 4-year lease and a 12-year lease at a typical Class-A suburban office building.
4-Year Lease 12-Year Lease
Tenant Improvement/Transaction Fees* $40 amortized over term = $10.20 per sq. ft $40 amortized over term = $6.34 per sq. ft
Rental Rate Per Sq. Ft. $25 $19
Total Cost for 4 years Per Sq. Ft. 4 × $25= $100 4 × $19= $76+31(unamortized penalty)= $107
Total Cost for 12 years Per Sq. Ft. 4 × $25= $100
4 × $30= $120
4 × $35= $140
Total = $360**
12 × $19= $228
* The amortization figure per sq. ft. assumes a 10% interest rate for the cost of financing tenant improvements and transaction fees.
** The $360 cost per sq. ft. for 12 years assumes two lease renewals.

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