In the last episode, we started interviewing Reuben Torenberg, a commercial real estate broker with CBRE in San Francisco, he specializes in helping startups, technology companies, and venture capital firms find and manage office space in the San Francisco Bay Area and beyond. We discussed what do startups look for when leasing an office, as well as what are the current price points for all kinds of offices in tech hubs. In this episode we are covering what does the base year mean in office leasing, what are specific things that startups want to negotiate on a lease, what happens when a startup goes out of business, we will also cover LOI’s, lease negotiation & TI’s (also called lease concessions), and lastly, we will cover what makes for a good office landlord.
For offices, are the leases typically NNN?
No. It’s typically what’s called a “full service lease” where you pay your rent, and it’s pretty much in all in rent. The landlord covers the utilities, the janitorial, the operating expenses, and real estate taxes. The way that it works is you get what’s called a base year. So let’s say we completed our lease in 2019 and we do a three year term. You get a “base year” and 2019 is your first year, you don’t need to pay any real estate taxes and operating expenses. But in the following year you are responsible for paying your proportionate share of the increase in operating expenses and real estate taxes. So let’s use round numbers, for example let’s say that you occupied 10% of a building. The operating expense in real estate taxes were $100 in 2019 and they went up to $200 in 2020, a $100 increase. All you need to pay is your proportionate share of $100, in this case $10, it’s usually a nominal number. But as you do a long term lease, 7-10 years, it’s growing every year, and that number can become significant. So a lot of companies will renegotiate their lease, they will do what’s called an extension, or they’ll expand and renegotiate the lease to get a brand new base year so that they don’t have to incur those costs. The original base year is pre-negotiated, but if you want to renegotiate your deal, that part is not.
Who wants to renegotiate? The startup?
The startup would come to the landlord and say that they would like to renegotiate after the lease expires in order to get a new base year. And there will be other terms involved such as the rent, and if they need any tenant improvements such as a new carpet, flooring, paint, adding conference rooms, adding phone rooms, redoing the kitchen, security deposit, subleased rights, free rent. Usually when negotiating a lease, we’ll try and get an option to renew (also called an extension option) where you’ll have the right to exercise by a certain date, usually 12 months or 9 months before a lease ends. So there are other terms that get negotiated at the beginning which can also be renegotiated when you’re coming back to the landlord to extend your lease.
Has it ever happened that a startup went out of business, and what happened to that contract? What are the recourses for the landlord?
They go into what’s called a default and the landlord eventually ends up needing to collect their money. This situation has come up numerous times and what we do is find a new tenant to sublease the space. We market it for sublease, and once you come to an agreement on terms, the landlord will say “Okay, instead of subleasing from this company who has gone bankrupt, we’ll wrap up that lease and do a new direct deal with this new tenant”. So we’re able to bring a new tenant into the space and, by doing that, cut our client out of any rent responsibility moving forward.
How often does this happen?
One out of fifty, so very rare. Breaking a lease is rare. Subleasing a space is very common. Last year, over 50% of all our deals where subleases, for the most part because the startups were expanding.
What are some specific things that startups want to negotiate in a lease that we haven’t covered yet?
The few things that we’ve covered so far are the big items such as rent, term, free rent, tenant improvement allowance, and the security deposit. Things we haven’t talked about yet are: let’s say a landlord is forcing us into a five year deal, but we know we’re not going to be able to make it for the full five years. We try to negotiate a termination option where after three years we can terminate with no penalty, or a very small penalty such as two months rent. Another item is sublease rights, a landlord will generally give you the right to sublease, but any profit that you get for that sublease is split 50-50 between the tenant and the landlord since they want to discourage tenants to take space and sublease for a profit. When you’re in rapid expansion mode and there’s only so much availability on a certain building, for example in San Francisco office spaces are at a 4% vacancy right now, we try to negotiate what’s called a right of first refusal, where if a space becomes available in the building, the landlord is required to present it to the startup first at a fair market value, and the startup has the choice to take it or not.
Who determines what is fair under “fair market value”?
It’s determined by the landlord. It’s on the startup whether to agree or disagree. They don’t have to accept the expansion option. They can say that they reject the option, but would still like to negotiate on the lease terms. That’s a little bit more dangerous because in an expansion option you can take it and it’s yours. If you choose not to, the landlord has the right to negotiate with all other parties. And in a market like San Francisco where there’s so much more demand than there is supply, you risk losing the space to somebody else. You need to move very, very quickly in order to secure the space.
Who pays for TI in an office lease?
In office leasing we call concessions. Tenant improvement and free rent are all a function of how much term you take. The longer term you sign the better, for example if you sign a five to seven year lease, the more likely a landlord will be willing to give you a tenant improvement allowance. Or they will turnkey the space completely for you, which means they’ll build it out and just give it to you, which is ideal. In shorter lease situations, like one to two years, or a sublease, the tenant is responsible for everything. They usually don’t get any free rent, and if they want to build anything, it’s on them. They need to go get the permits, they need to hire the contractor, they need to go through the whole process. We really advise our clients against doing their own work and going into construction because it’s much more costly than you think, especially here in San Francisco and in New York. And it takes much longer than you think: you need to go through the whole permit process, so that is a minimum of three to four months.
Do your tenants typically prefer to get more TI and pay higher rent or vice versa?
The answer is vice versa because rent is not appreciating. We always want to minimize rent and maximize flexibility. We advise our clients to do a short term deal, and this is against the ethos of brokers because we are paid based on the amount of term they take, in San Francisco it’s $2 per square foot per year. So on a five year term, you commission will be higher than a three year. But we recommend shorter terms because it’s better for our clients and if you do good by your clients, you keep their business. They go for lower rent as opposed to more TI. We advise our clients against doing TI work until you surpass the 10,000 square foot threshold, because it is going to cost you a lot more than you want, it’s going to be really tedious, this is not your business, you need to run your business, and you need to be in the space within a certain timeframe. When you’re doing construction, almost 90% of the time it gets pushed out. So we really try and advise our clients against TI’s and try and find them the perfect space that they can plug in and play until they’re large enough to design their own space and make it what’s perfect for them, such as the Airbnb’s, the Dropbox’s in, the Coinbase’s, etc.
Does that mean that the landlords also prefer to give less TI?
No, the landlord would probably prefer to give more and to get a higher rent because that will increase the value of their building. They’d prefer to give a higher TI allowance because it gives you the ability to make that space, which is their space, gorgeous. And 95% of the time, the amount of TI they’re going to give you is not as much as you need for the work. So it’s usually going to come out of your pocket, you’ll have to spend your own money to help finish the job. So for them it’s a win win. They’re giving you the money to make their space perfect, they’re getting a higher rent, and they’re getting more term out of it. They’re always going to push you to do more TI, which we can understand. But we prefer that our clients try to stay flexible and nimble and have the ability to move during periods of rapid growth.
What makes a good landlord that you guys like to work with?
A great landlord will be responsive. Sometimes they can be a little bit unresponsive because a lot of the time they aren’t based here in San Francisco. A lot of landlords here are mom and pop landlords who own buildings but live elsewhere, do their own thing, have their own lives, they don’t necessarily understand the process as well as someone who goes through it every day. Sometimes they don’t have much regard for a tenant’s timelines, specifically a startup. Startups generally come up to us and say, “We need space tomorrow, we’re busting at the seams here”. You may need to be in tomorrow and we’re at the whim of a landlord who can take a day or a week to answer. So a good landlord is responsive, a good landlord understands the market, knows where rents should be, and is willing to work with brokers to get to the numbers that they need. Whether it’s conceding free rent, conceding TI, getting a better security deposit, allowing for pets, allowing for bikes. There are many nuances that landlords with experience are able to get through a whole lot quicker than landlords without a lot of experience. They must also have an experienced real estate attorney because they’re very important and are the end negotiators. They give the tenant and the landlord the final sign off.
Is there an LOI that gets signed, similar to retail, and then the lease? And how long does each take to get done on average?
Yes, initially you send an LOI, or what’s called a proposal that just says “We want to lease space in your building. Here are the terms at which we want to lease it.” This usually takes two to four weeks to negotiate. Once that gets signed, it is non binding, but it’s a gesture of good faith that both sides will work exclusively with each other and they won’t continue to tour, market, or accept other proposals. Then the landlord drafts the lease (or sublease) and real estate attorneys are hired on both sides. They review it and go back and forth. Insurance brokers are also hired by the tenant to make sure that they have the proper insurance coverage, general liability coverage, commercial liability, etc. That process usually takes another two to four weeks. So now we’re at four to eight weeks of negotiation. And then once a lease is signed, if you have negotiated well, the tenant has two weeks of early access to install FF&E, which stands for furniture, fixtures and equipment, before they can occupy the space. So far that is six to ten weeks and then add another two to four weeks in the front end for touring, finding spaces, running surveys. On the quick side you’re looking at at least two to three months. As you grow bigger and things get tighter and more competitive, we advise our clients to start looking six to twelve months out. And once you’re bigger, if you have a tenant improvement job or you need to redesign a space, that’s another three to six months that you need to add. That’s why for anything 20,000 square feet and up, we’re reaching out to our clients 12 months in advance to get started, begin the planning from the financial analysis, run the head count projections, etc.
I can see how much work you guys have and how valuable your job is.
It’s a huge decision. And this is probably the top three biggest costs for any company. And we need to earn our client’s trust in order to keep their business, so we take it really seriously. We really care, and we’re going to do everything it takes to make sure that our clients have great outcomes and are happy.
You can reach out to Reuben Torenberg here:
Steffany’s Linkedin: https://www.linkedin.com/in/steffbold/