Commercial tenants need more than a healthy incentive

18 Apr 2024 06:46 AM

“Price is what you pay; value is what you get.” - Warren Buffett 

Warren Buffett credited this statement to Benjamin Franklin, whose investment principles guided Buffett’s investment decisions. The fact is that this statement is both true and applicable to anything one purchases, as time has a way of revealing value or the lack thereof. 

Some years back, the carpets in our home needed cleaning. We consulted Dr. Google and hired a carpet cleaner whose reviews were fine and whose price was lower than the alternatives. 
We experienced firsthand that “price is what you pay; value is what you get”—the cleaning cost was $500, and the resulting rectification works were $50,000. We had not been due and diligent in understanding our requirements and validating the service provider who applied a cleaning process that destroyed the fabric of our wool carpets. 

We took the matter to the relevant NSW Tribunal, which found in our favour. However, the provider had no insurance, so we were not able to recover our loss. There certainly is a marked difference between what you pay and the value received! 

Commercial leases can increase business risk 

“Only loss teaches us about the value of things.” - Arthur Schopenhauer

This is most definitely the case with commercial lease negotiations, where a tenant can make the mistake of giving too much attention to the landing point for rent and incentives, with too little attention given to less obvious items which prove to be injurious omissions during the lease term. 

Such omissions often cause great harm and can even be a core reason for business closure. 

This is indeed the case with many a hospitality business in 2024, where omitting to consider the potential for impaired utilisation of the leased premises during the lease term, and failure to negotiate rent reduction provisions should impaired utilisation eventuate, resulted in the closure of restaurants and cafes across the country. 

Many of those who have suffered loss in this way would be quick to concur with Schopenhauer that “Only loss teaches us about the value of things”. 

At LPC we have a slightly different perspective to Schopenhauer which is that loss does not have to be incurred to recognise value, but that loss can be avoided by better understanding what represents value for a tenant in a commercial leasing arrangement, and thereafter focusing the lease negotiation process to extract that value. 

The starting point is to understand what terms or omissions in a lease agreement accentuate business risk for a tenant, noting that the same commercial lease arrangement will impact business risk differently for different tenants. 

For example, for a suburban general practitioner whose business goodwill is inextricably linked to a particular location, a short-term lease with no options to renew will pose a very significant risk to the tenant. 

On the other hand, a short- term lease with a tenant-friendly option to renew will suit a not-for profit operator that needs the space to deliver social services funded by a time-framed government program, and where the specific location is not vital for the business. 

Another example is to consider the impact that the omission of landlord guarantees pertaining to building services, grade, status, and amenities would have on a top tier legal firm that commits to a long-term lease in an iconic CBD building to gain a competitive advantage in attracting talented employees and clients. In such a situation, landlord upgrade works, or infrastructure works adjacent to the building can significantly impair the tenant’s utility value and can harm the business. 

Indeed, the devil is in the detail when it comes to defining what lease terms really matter for a specific tenant, and when it comes to the actual lease negotiations. 

Focusing on utility value will reduce the risk in lease arrangements 

"There can be no value in the whole unless there is value in the parts.” - Bertrand Russell 

It is no easy feat for a tenant to get to an optimal tenancy arrangement that overcomes the tenant’s disadvantage, and that has regard for the tenant’s business requirements and risks into the future. 

At LPC we work with clients to pre-define what an optimal lease arrangement looks like when it comes to location, premises, and commercial terms. As the devil is in the detail we get to the detail by facilitating an informed long-term accommodation strategy review aimed at drawing our what really matters to the client, and we use our LPC barometer to analyse and document the essential commercial terms pertaining to occupancy cost, risk, flexibility, obligations and guarantees. 

With reference to the Bertrand Russell quotation, we ensure value in the whole leasing arrangement by paying considerable attention to the parts. By way of illustration, let’s return to the examples cited earlier in this opinion piece. 

Almost every tenant in Australia was disadvantaged during the pandemic as utilisation was interrupted while rental obligations continued (despite the ‘after-the-fact’ intervention by government). Considering the potential risk of interrupted or impaired utilisation for a great number of possible causes would have brought this risk to the negotiating table, with the tenant’s aim being to link occupancy cost to the tenant’s utility value. 

In relation to the example of the suburban general practitioner whose business goodwill is inextricably linked to a particular location, consider how a deeper consideration of how to mitigate the risks of lease expiry and premises deterioration would have minimised the business risk. 

Specific commercial terms such as multiple renew options with a capped annual escalation, and an effective market rent review (treated as a new tenant and not a sitting tenant) for each new option term, are just two commercial terms that would mitigate business risk and add considerable value to the business.

Concluding comments 

“Value is more than just a lower price” - Phil Hardwick 

I end where I started. 

Focusing on obvious cost items (rent and escalation and outgoing) is important, but an additional focus on the less obvious cost items, and on the commercial terms that impact tenant risk, tenant flexibility, and the obligations and guarantees of each of the lessor and lessee, will mitigate the potential for tenant loss during the lease term, and will ensure the leasing arrangement is more supportive of tenant enterprise throughout the lease term. This requires the tenant to pay more attention to utility value that the tenant requires from their leased asset.

Author: John Reed, LPC Director

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