“Every problem has a solution; it may sometimes just need another perspective” - Katherine Russell
As people focus on post-pandemic realities, a key challenge is how to stimulate economic activity. In this article, a group of LPC advisors reflect on commercial tenancy arrangements' role in accelerating or impeding economic recovery. They suggest three guiding principles that will refocus lease arrangements to be more supportive of tenant enterprise. They conclude that a new normal for leasing arrangements is needed to accelerate economic recovery.
Guiding principle 1 - Align landlord and tenant interests
“Change is the law of life. And those who look only to the past or present are certain to miss the future.” - John F Kennedy
Covid 19 has brought about dramatic change. We all had first-hand experience of the pandemic's impacts on health, hospital infrastructure, social interaction, business, fiscal policy, money supply, travel, migration, labour, logistics, and numerous other aspects of our world. In many instances, the response by stakeholders to these impacts was quick and effective, characterised by innovation and creative problem-solving. When it comes to commercial leasing, the reaction of landlords was more muted, with little evidence of an innovative shift in the commercial leasing norm to support tenants through the pandemic. It was left to the government to intervene via legislation aiming at interim rent relief for tenants through good faith negotiations, an intervention that did not deliver the expected outcomes.
The major impediment to change to the commercial lease norm is that landlords and tenants have opposite objectives, and landlords exert the most significant influence on lease norms and have a vested interest in keeping the status quo. Landlords seek lease norms that guarantee favourable risk-free income streams and resist changes to the lease norm that increase landlord risk. On the other hand, tenants need more flexible lease arrangements that optimally support their business through thick and thin. The problem for tenants, and the economy, is that the current lease norm retards tenant enterprise and slows economic recovery.
To accelerate recovery, landlords need to reset the lease norm to make both landlord and tenant work harder to ensure the success of the tenant's enterprise. Whilst the current model promotes passive capital, we need tenancy arrangements that drive tenant activity. In other words, the lease norm needs to align the interests of the parties so that landlords share more of the pain and the gain tied to the tenant's use of the leased asset. To better align landlord and tenant interests, leasing arrangements must protect the tenant's utility value and promote tenant enterprise.
Guiding principle 2 - Focus on the tenant’s utility value
“Whenever you want to achieve something, keep your eyes open, concentrate and make sure you know exactly what it is you want. No one can hit their target with their eyes closed.” - Paulo Coelho
At LPC, we follow the maxim of 'business before space' and encourage tenants to draw out the granular detail of the accommodation arrangements that best address the tenant's business requirements and risks in the future. We aim to be as precise as possible about the utility needed by the tenant over the lease term, including considering how this utility will or may change, and then to define the detail of the intended lease arrangements that best suit.
Utility value in accounting is a subjective assessment of the expected return on investment at a given risk (https://financial-dictionary.thefreedictionary.com). Suppose we relate this definition to a leasing arrangement. In that case, the description suggests the tenant's utility value needs to consider the return on investment on the leased premises regarding business and other risks that may impact utility value over the lease term. Paulo Coelho's advice is sound, pointing to the need for tenants to be clear about their requirements, such that they can adequately evaluate a proposed lease arrangement with eyes wide open.
The pandemic evidenced that almost all tenants had not adequately considered the risk of business interruption and impaired use of the leased premises, in that lease terms protected landlord income streams whilst obligating the tenant to meet unchanged lease obligations. Whilst this is an obvious example of a mismatch between the tenant's utility value and their responsibilities, numerous other factors impair utility value and decrease the tenant's return on investment in the leased premises. These include landlord foot traffic representations not being met, landlord or external development works that impair utility, changes in land use, limitations on permitted use, an unfavourable option to renew, and many other lease terms and factors that impact the tenant's utility value.
Our view is that the economic recovery challenge highlights the need for change to the commercial tenancy norm, such that the new model is more supportive of tenant enterprise. We suggest that the starting point for a substantial shift in the lease norm is to focus lease negotiations on tenant utility value tied to the changing business needs of the tenant throughout the lease term.
Guiding principle 3 – Emphasize the long-term impact of lease norms
“Our focus is our future” - David DeNotaris
The long-standing commercial lease norm significantly contributes to the increase in business failures in Australia, with tenants having to meet inflexible lease commitments while simultaneously recovering from the pandemic's impacts on their business. ASIC states, "Survival rates have fallen for smaller and medium-sized businesses. The survival rate for businesses with annual turnover below $50,000 fell from 78% in 2018 to 48% in 2021. Similarly, businesses with turnover between $50,000 to $200,000 recorded a 64% survival rate in 2021, down from 87% in 2018" (Source – ASIC, Australian insolvency statistics). The current challenges have resulted in more and more landlords calling on the bank and personal guarantees to mitigate short-term loss. The regrettable consequence of such actions is that economic activity is being curtailed by increased insolvencies, with long-term damage to our human capital.
At LPC, we think that tenancy arrangements that support sustainable tenant enterprise would better serve the economy, with lease terms that support the long-term success of the tenant business. Whilst such arrangements directly benefit a tenant, and it is clearly in a landlord's long-term interests to have a growing economy with sustainable growth in the number of tenants seeking to grow their respective businesses, as this is a prerequisite for a vibrant commercial leasing market. To focus negotiations on a sustainable lease arrangement, we advocate for a new lease norm with more substantial landlord obligations and guarantees that provide more assurance of tenant utility value over the lease term.
Conclusion
The landlords' and leasing agents' power and influence have embedded lease norms that disadvantage commercial tenants. The need for accelerated economic recovery necessitates a new lease norm.
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LPC provides office, retail, and industrial occupiers with advice and services that make a difference to their accommodation arrangements and respective businesses. With no ties to investor property owners or leasing agents, we only represent occupiers, and our advice is free from any conflict of interest that would disadvantage an occupier. You will find the LPC subscription service most helpful in identifying critical terms for renegotiation and getting to the lease you deserve.
