What are the top things that you should be aware of when negotiating a retail lease? Bethany Babcock, Founder and Principal at Foresite Commercial Real Estate, reviews some major points for landlords to negotiate with their prospective tenants, large and small.
Tell us a little bit about you.
I live in San Antonio, I work with a group of people here, and we're primarily retail-focused. At that firm, we manage, lease, and sell shopping centers, we manage about 80 of them, we lease about 90 of them and we represent tenants as well as landlords in leasing up their spaces. I've been working in the business for about 20 years, I held positions from accounting to property management, leasing, and sales. I've been able to do a lot of different things, but right now my main focus is running this firm, and also running a training program that we do in the summer for people who are hoping to get into the industry.
You represent both tenants and landlords, what are the main things we should be aware of when negotiating a lease, especially from a landlord's perspective?
This is trying to educate the tenant rep side on why a landlord might be pushing back on certain terms in the negotiations because some of them seem like they're not very important, or that they wouldn't be deal breakers but they carry a lot more weight than they look to have on the surface. That goal is just to understand why a landlord might object to them so that they can come up with more creative solutions, or be able to structure the deal in a way that might make them a little bit more agreeable.
1. Fixed renewal options: this one is something that gets thrown out a lot when people are negotiating the lease, because they've become a given. But in this world where now we're seeing rental rates increase dramatically, especially on retail properties in our area, when you're putting fixed renewal options, which give a tenant the right to renew at a specific price in the future, it's equivalent to putting a cap on the owner’s value. That's important because if the owner wants to sell or do anything, that's the cap, it doesn't get much better than that, so at that point, the value of their property is going to go up and down, subject to the market and the cap rates, but it's not going to go up and down based on rent anymore. That's a bigger ask that I think most tenants realize. A lot of times they'll ask for a five-year lease and then they'll want 20 years’ worth of rent options, that's never a good deal for the landlord.
We're all experiencing a huge inflation that is much more than what the government tells us, how do you recommend a landlord negotiating that?
If I'm on the landlord's side, I try to do no renewal options or options at the market rate. That's one extreme or the other but I'll never let a tenant have more time in their option period than they would in their base rent. If you're doing a 10-year deal, you're not going to get more than 10 years’ worth of options. I don't like deals and they don't make any sense for landlords where you're signing a five-year lease and you get 15 years’ worth of options. That doesn't make any sense but tenants ask for it all the time.
What about national tenants, if they make that a requirement?
They can try but I still would require them to at least have the base year be equivalent to their option period.
2. Free rent upfront versus lower overall base rent:how to maximize the value of the lease? It's really important if a tenant is saying, I need to be at $20 a square foot, and you're thinking, that's tough, I don't think I can make that work, it's not working on my pro forma. One of the better ways to do that and still be able to maximize the value is to tell the tenant, I can't give you $20/square foot, what if I gave you a year's worth of free rent, and the first year is at zero, and then your effective rent over the period will be about $20/sf. But in year two, or year three, it'll be $23/square foot. What that does for the landlord is that when you're capping the value of the property, you're doing it after the free rent period, and they get the benefit of the higher rent, whereas the tenant still gets the same effective rent. That's one way to get a win-win scenario for both parties.
From a tenant’s perspective, that doesn't matter, so it's okay that it helps the landlord, is that correct?
It depends on their business model but a lot of tenants I find like that because it helps them when they need the rent reduction the most, which is in the ramp-up period and the establishment period.
3. Buying up the rent to get more TI: Once you go over market rents, it doesn't help anybody. A really good example of this is Starbucks, back in 2006-2007, when they were expanding fast, they were buying up the rent high by getting a ton of TI and having their buildings just delivered to them. But in 2008, when the market adjusted, suddenly you had all of these little Starbucks that were closing, and the rents they were paying at that time were $50 a foot, and now it's even much higher. They couldn't replace or backfill those locations, even though it was a good real estate with those same rents and so a lot of landlords were in hardship. Sometimes, tenants can think that it doesn't matter if they're getting it back in rent. It matters because it's going to affect the value of their property. After all, the cap rate will reflect the risk.
4. HVAC and plumbing: If you're on the landlord side, make sure that it's a one-time event, or that it has an end date because if those issues go on indefinitely, that means every buyer or lender that underwrites that property is going to have to underwrite that possible event. If you have an end date, within one year or two years, they can put it in and once that period has passed, that risk subsides. But if it's ongoing, then it's going to diminish the value of the building, because it has to get underwritten each year, or conservatively, every few years, however often they think it might occur.
5. Right of first refusal to purchase the property: tenants shouldn't get those because the tenant isn't always the most qualified buyer. When you're doing something to sell the building, the last thing you need is to get permission from someone and to wait. It's going to destroy the value of the building because you're not able to mark it to its fullest. Also, an agent isn't likely going to want to take and spend all the effort to market the property knowing that, at any given time, the tenant might come in and purchase it and their efforts will be mute. Most of the time, I think tenants fail to realize how difficult the qualification processes is to be able to purchase a property. That may work well for single tenants properties but for multi-tenant, it's a very unrealistic assumption that you can get that in your letter of intent. I see it in single tenant and it still creates a problem. There needs to be an end date because it can be used as leverage for the tenant to come back later and say we want to buy it, and then all the other buyers disappear. Then, they reach out again and they try to buy it at a lower price, and that does happen pretty often.
Is that why they normally ask for it?
I don't know, I think a lot of them think that it gives them control, it gives them an option, who wouldn't want it to know that that was a possibility? I think a lot of tenants have the dreams and ambitions to want to own real estate and some of them have more devious plans than others.
Would you recommend an end date of, let's say 30 days, after you decide to sell? What would you recommend?
I would not give them a right of first refusal because that means you're going to have to market it, get the offers, and then they get to counter those offers. That means all your marketing effort and all your things have been wasted and then you have to go through the whole process of trying to market it again if that purchase doesn't pan out. Maybe we could do a one-time purchase option but even that gets difficult to evaluate and determine what the market value should be at that point.
6. Renewal options that exceed the base year in length are a financial instrument for the tenant is a hedge against inflation for them. They cost the landlord more than they gain from the lease and it can limit their value. When we talked about number 1., those were fixed renewal options, any renewal option will do that. It's really important and it means that the tenant has the right to exercise control, and the landlord can't do anything about it. Knowing and understanding that options will always benefit the tenant is important. They never benefit the landlord, but I think that gets confused a lot of times and they get thrown in there. Walgreens is a great example, you'll have a deal where they'll have a 75-year lease, and they'll have 75 one-year options. That's difficult because they can renew one year at a time, you'll never be able to get financing, you'll never be able to sell that deal.
7. Striking out things like the management fee, or the CAM language when they're putting the LOIs: what that does is it creates something that's called slippage, and slippage leads to a lower value of the property. And it's a lot more disproportionate to the share. You may think, I'm only excluding maybe $3,000 in expenses but if you cap that amount at the cap that the property is trading, you're asking for a lot more than you realize. Tenants need to understand how a property is valued. When that little bit of slippage occurs, it creates a giant mess on the ownership side for when they're trying to sell or refinance, because the NOI is affected.
8. Excluding uses, or overly aggressive exclusives: it reduces the marketability of the remaining of the property. I'm working on a deal that was anchored by Target and that particular deal is extremely difficult to lease because it has so many restrictions as to what they're allowed to do and what they're not allowed to do. If you get to the point where they're so burdensome, it's no longer protecting the tenant, it's hurting the center because then your pool of possible tenants gets shrunk so far, and if those aren't a good fit, you end up with a vacant center. What's worse to them, is it that you're next to a bakery that you didn't want to be next to, or that the building is vacant? Sometimes tenants can get a little aggressive without thinking about the holistic view of that.