Feature

posted 15 Jun 2007 in Volume 10 Issue 2

Early lease renegotiation: the right strategy?

The complexity of lease renewal may not be the first priority of a managing partner, but early consideration of the challenges and opportunities could forestall potential problems and bring far greater value to the firm.

By David Gilson, tenant-rep broker, Guild Partners LLC

There are few events in the lifecycle of a law firm that cause more consternation and soul searching within the firm’s leadership circle than the pending expiration of the firm’s primary office lease. Even three or four years prior to the expiration date (depending on the size of the law firm) the issue can start generating spirited discourse at the firm’s management and partner meetings.

There are many reasons for this phenomenon. For starters, the pending lease expiration has broad implications throughout all aspects of the firm’s continuing operation: most obviously financial, but also cultural and generational. In some instances, the very survival of the firm could be at stake. We can all point to examples in our own legal communities where an upcoming leasehold termination precipitated a firm’s dissolution or merger.

Even where the potential implications are not nearly so existential in magnitude, firm decision makers will rightfully fret over a myriad of leasehold-related issues. Should the firm consider a move? How much space should the firm commit to? What about revising office sizes and standards? How should the firm coordinate a technology upgrade with a new lease? And when should the firm initiate the process etc.?

As for the threshold issue of when to commence the project, the conventional wisdom is to allow enough time to: evaluate future needs; search the market; negotiate with outside building owners and the existing landlord; and construct new space (in the event of a move). This could all necessitate starting anywhere from fifteen months (for smaller firms) all the way up to four years (for the largest firms considering build-to-suit relocation options) prior to the expiration date.

However, there is an alternative scenario (and the topic of this piece) which could be more appropriate for some mid-size to large firms. That is to engage the landlord as early as four years or more prior to lease expiration, with the goal of restructuring and extending the leasehold – that is, early lease renegotiation.

Naturally, this strategy can only be considered by those firms that can see themselves remaining in their present space through any such extension term. They foresee no concerns relating to: potential building obsolescence; availability of adequate future expansion space; or the desirability of the building’s location. This profile can apply to a high percentage of (if not most) law firms as, statistically, the majority of law firms end up renewing their leaseholds even after a lengthy process of evaluating market alternatives.

Reallocating the future value inherent in the firm’s renewal rights

Early lease renegotiation can provide substantial economic benefit to law firms both in the near term and over the extended leasehold. At the same time, an early renegotiation of a major law firm’s leasehold can be financially attractive to a landlord – a classic win-win proposition.

What provides the opportunity for this mutually favourable outcome is – conceptually – in the year that the lease expires there is built-in economic value to the tenant and, conversely, built-in economic cost to the landlord. The consequence to both parties is enhanced if the tenant has the standard renewal rights under its lease, and can be quite acute if those renewal rights prescribe a more severe formulation for establishing the applicable rental rate for the renewal term (more on that later).

Taking the concept a step further, once that future value/cost is calculated, the parties would be able to reallocate some negotiated portion of it over the period of an extended lease term. From the law-firm tenant’s perspective, a portion of that value could be brought forward to, say, pay the cost of a much-needed renovation of the existing or expansion space, or provide some near-term rental relief. Or, a portion could be deferred over the extended term so as to provide a discount below anticipated market rents for that same period of time.

Where the law firm’s lease accounts for a substantial percentage of a building’s space, a landlord could be equally motivated to seek such a reallocation of those same amounts (potential costs in the landlord’s view). That’s because it would mean an extension of the lease and a resulting immediate increase in the value of the building. That would be particularly true for an owner with a short-term ownership horizon (increasingly common among institutional owners in the current market) who is seeking the most aggressive cap rate for establishing the building’s value for an upcoming sale or refinancing event.

In this last connection, potential buyers would be reluctant to bid for the building on the basis of the most aggressive cap rate when there’s a major lease coming due within three to four years, and there is a risk the tenant would vacate at that time. By extending out that lease and eliminating the risk of near-term vacancy, the building owner has effectively re-set and enhanced the value of the asset. This would be the case even after taking into account the cost of any concessions granted (rental or construction allowances) in return for the law firm extending its lease.

An example of the rationale for an early lease renegotiation

By way of simple example, assume the following:

A 125 attorney firm with 3.5 years remaining on a 100,000 square foot lease;
The law firm has a ‘right to renew’ for five years at 95 per cent of then market rates “taking into account then prevailing market concessions” (this is a version of the plain vanilla renewal clause found in many markets).

The renewal rental rate would take into account the ‘market concessions’ typically available in this firm’s market of, say:

$25/ft2 of construction allowance for a five-year lease;
Three months of abatement – $11.00/ft2 at $45/ft2 rentals assumed in 3.5 years;
$9/ft2 (NPV) the approximate (then) present value of the five-per-cent discount off market rates per the renewal clause language.

That would equate to a renewal year total of approximately $45.00/ft2 of built-in ‘value’ to the tenant and, conversely, $45.00/ ft2 of built-in cost to the landlord – approximately $4.5m on a 100,000ft2 lease.

Now, let’s say that our law firm recognises that within a year’s time it will need to rebuild, reburbish and technologically upgrade certain areas within its original space at a cost that could approach $2m for design and hard-cost construction;

As per its original lease, it will be taking over a sizable area of expansion space that could require another $500,000 to redesign and renovate. Additionally, as it will take 18 to 24 months to fill that space with fee-earners, some partial rental abatement over the following year would greatly help cash flow during the ramp-up period;

There is a strong desire among junior partners in the firm to stabilize out year rental costs at some meaningful discount to market. That way they won’t feel that the next generation will be stuck with the bill for the fat profits enjoyed by the current generation (partly resulting from currently favourable rental costs).

So, if our law-firm tenant really thinks that this building could work for at least the next eight to ten years, why not engage the landlord at this time to restructure the lease and reallocate that $4.5 of future value to meet some immediate and longer term needs? By so doing, the firm would realise direct financial, as well as intangible benefits to its operation, generational relations, etc.

An example of the results of an early lease renegotiation

In our example above, a very possible result from such a negotiation between a motivated tenant and landlord could be the following:

A lease extension for seven years beyond original termination date;
A $2m construction allowance for the law firm’s renovation costs over the next 18 months;
Approximately $500,000 in partial monthly rental abatement following the firm’s takeover of the expansion space;
Out year rentals of $41.00/ft2 (in a $45.00/ft2 market).

What’s most interesting about this new structure is that – on a discounted cash-flow basis – it is economically neutral as compared to the projected built-in value/cost at the expiration of the original lease. Yet, there are clear financial as well as intangible benefits to the law firm. And, for its part, the landlord has achieved a near-term increase in the value of its building: a win-win!

Now, even though the rational landlord (as maybe even more highly motivated by a desire to sell within the next couple of years) should be willing to play ball on this basis, achieving the desired goal will take more than just a phone call. There would be obstacles to overcome. First, there would have to be some meeting of minds as to what the anticipated market rentals and ‘then market concessions’ are likely to be three to four years out. Additionally, the building owner would have to get past the traditional landlord reluctance to reduce its near-term cash flow from already budgeted levels predicated on existing leases. In other words, the deal would have to be negotiated.

Negotiating the early lease renewal deal

Conventional wisdom, once again, has it that the most effective way to negotiate a lease renewal deal is to engage the outside market at the same time the tenant is negotiating with the existing landlord. Aggressive bids from outside owners could be leveraged to force the existing landlord to sharpen its pencil – so the argument goes. Moreover, a more efficient outside building test-fit with a fresh and updated space plan could result in a reduced space requirement at that other building as compared to the existing space. And, a reduction in space need by, say, five per cent, would be the same, economically, as a $2.25/ ft2 reduction in the rental rate (assuming $45/ft2 rentals) – further leverage against the current landlord.

Most importantly, even just the possibility that the tenant may move out of its space – as lent greater credence by the tenant’s actively (and blatantly) engaging the market – provides the best leverage of all. For, the landlord is all too aware of the enormous costs it faces if a major tenant were to move out. Not only would the landlord have to pay market concessions to attract a new tenant, but the landlord would suffer the added cost of ‘down-time’ with no rental revenue on the space for a year, or even longer. To avoid this added down-time cost, the rational landlord should be willing to sign a below-market deal just to keep the tenant from moving out.

However, the existing landlord is not without its own leverage in these competitive renegotiation scenarios. For, he/she knows that the law-firm tenant would most likely have to incur construction costs to fit out its new space that could be substantially above construction allowances typically available in the market. For a law firm, that cost could be anywhere from $25/ft2 to $50/ft2 above the allowance, equating to $4 to $8/ft2 in annual amortization costs. This factor, together with the law firm’s natural aversion to the disruption of a move, could induce the rational law firm to be willing to renew its lease at a rental that could even be above the prevailing market.

So, the offsetting dynamics of the renegotiation scenario can create what could be referred to as the ‘zone of negotiations’. This is illustrated below as the area between ‘The Landlord’s Rational Lower Limit’ and ‘The Tenant’s Rational Upper Limit’. Just where the parties come out in that ‘zone’ could be a function of a myriad of factors, including: the credibility of the tenant’s likelihood of actually vacating the building; the skill of the negotiators; and the landlord’s time horizon for holding versus selling the asset (based on this time horizon, the landlord may be more or less willing to risk losing the tenant vis-à-vis achieving the highest possible rental rate from that tenant or a replacement tenant).

All of this goes to demonstrate that – not necessarily contrary to conventional wisdom, but certainly as an important qualifier – even the most skillfully orchestrated competitive negotiation is fraught with uncertainty and may not produce the optimal result. As an alternative, in theory, the exercise of the tenant’s renewal rights could produce at least as favourable a result. This would apply even in an attempted early renegotiation scenario.

Conceptually, the exercise of the renewal right should put the final result within the bottom half of the above referenced ‘zone of negotiations’. That’s because any reference in the renewal provision that the new rental reflect ‘a market rate’ (or, better yet, 95 per cent of market) should, by definition, mean just that. And, in no event should the new rate be above market (as we have seen it could very well be in a typical renegotiation outside the renewal clause).

Nonetheless, as we all know, much can slip between the cup and the lip. For starters, particularly three or more years prior to expiration, determining what the ‘market’ will be at that time will be more art than science. So, as noted earlier, the parties will be back to a negotiation with the tenant having the built-in constraints of its renewal clause as protection (possibly as potent as the threat of relocating).

In this connection, it should be noted that most renewal language limits the time frame in which the renewal right could be exercised. It could be, for instance, ‘no earlier than 18 to 24 months prior to expiration’ even for major leases. This shouldn’t, however, limit the leverage it provides in an attempted early renegotiation; the tenant can always make it clear that it will not settle for any lesser economic benefit (on a discounted basis) under an early renegotiation than it would be entitled to once its renewal right ripens.

Another qualifier to using the leverage of the renewal clause vis-à-vis negotiating a lease extension outside of the clause is that the renewal rights might be too circumscribed – for example, limiting the amount of space subject to the renewal; not providing for adequate future expansion; not providing a construction allowance for any needed new term renovations. So, the law-firm tenant might feel it has no choice but to negotiate an extension outside of the renewal rights. However, even in such instances, it’s usually possible to conduct a dual track negotiation – as per the renewal clause for all matters covered and on a separate track for additional items: extra space, allowances, etc.

One more reason to re-visit your renewal rights

We’ve referred to the ‘plain vanilla’ renewal clause – and its built-in future value – as providing added leverage in an early renegotiation setting. Every now and then we have come across a renewal provision that really packs some extra punch. Accordingly, upon initiating any analysis of its leasehold situation, it behoves every law-firm tenant to review its renewal rights, with a particular eye for any language that might confer this type of unique advantage.

An example of this would be a provision that prescribes additional factors that are to be considered in determining the applicable rent upon renewal. As noted earlier, the typical language would call out something like “then prevailing market concessions – for example, construction allowances, abatements, etc.” that are to be taken into account. An example of a highly atypical clause might be one that additionally confers upon the tenant the calculated benefit of any savings realised by the landlord by renewing the lease and not having to find a replacement tenant. These savings could be quite substantial. As pointed out before the biggest single cost a landlord could incur is the ‘downtime’ between the vacancy by the former tenant and the commencement of rental payment by the new tenant (or tenants). For a major space, this ‘downtime’ could extend for a year or more, and taking that into account – per the renewal clause – would hugely impact the formulation of the renewal deal economics.

Another savings the landlord might realise is in the brokerage commissions and marketing expenses. Here, the difference between the costs to the landlord for a lease renewal as compared to replacing the tenant could be many hundreds of thousands of dollars for a major space.

In the above context, another factor to consider is just how would the standard market concessions as well as any extraordinary factors (for example,‘downtime’ and other savings) be reflected in the new lease deal. Once again, standard renewal language would seem to support taking those concessions (and any extraordinary factors) in kind – that is, as front-loaded benefits in the form of actual allowances or abatements. However, there is another view – oftentimes supported by explicit language or even sloppy draftsmanship in the original lease – that these then prevailing concessions and other benefits should be amortized over the renewal term at some appropriate discount rate. In the most extreme cases the impact of this latter construction could be a potential reduction in the renewal term rental of 25 per cent or more below the full service rental cost for the last year of the lease.

Needless to say, the existence of any extraordinary considerations in the renewal clause’s prescribed calculation could add a whole new dimension of leverage in an early lease renegotiation.

Unlocking future value

Upon expiration of a major leasehold, most law firms end up extending their leases even after a serious foray into the office space marketplace. In light of this, most firms should recognise and actively consider – even years before their lease expiration dates – that they very likely have substantial future value locked into their existing lease renewal rights. That being the case, these firms should further consider that they might want to unlock that future value early and derive substantial economic and intangible benefit in the process. This could all be accomplished under a properly orchestrated early lease renegotiation.

That future value could be tapped for a variety of worthwhile purposes. A portion could be reallocated for near-term reconstruction or partial rental relief. Or, much of the value could be spread into the out years of an extended term to provide meaningful discount against future market rents.

The magnitude of the future value could be particularly great if the lease contained any provision to include extraordinary factors – on the tenant’s behalf – in the calculation of a renewal term rental. Moreover, with a strong renewal provision in place, unless the firm wanted to seriously consider the relocation alternative, foregoing a market search wouldn’t necessarily compromise the firm’s negotiating posture in an early renegotiation.

For all these reasons, when, inevitably, the topic of the pending lease expiration first crops up at a management or partners’ meeting some years before the end date, it might behoove the wise managing partner to recommend the following: “Look, we all seem to agree that we like the building, and we can probably stay here for another ten years, or so. We do have some major upcoming renovation costs. And, I’ve heard some grumbling among our up-and-coming partners about the need for all the generations to ‘share the pain’ when our currently favourable rent bumps up at the end of our lease. Lastly, I’d really like to avoid spending the time and getting everyone all stirred up to look at outside office space. So, let’s save ourselves a lot of brain damage and seriously consider an early renegotiation with our landlord.”

David Gilson is a tenant-rep broker at Guild Partners LLC. He can be contacted at davidg@guildpartnersllc.com