Tenant unfriendly commercial lease arrangements can be avoided

15 Nov 2021 01:38 PM

This is part 2 of our series on ‘Getting to tenant friendly lease arrangements’.

In part 1 of this series we focused on why it is that ‘tenant friendly lease arrangements are not the norm’, and we highlighted 3 essential perspectives if ‘tenant friendly’ arrangements are to be achieved.   In this article a group of LPC advisors share their insights about 3 mistakes that lessees often make that result in ‘tenant unfriendly’ lease arrangements with increased business risk.  Our message is that these mistakes can be avoided.  In part 3 we turn our attention to the mindset, process, and collaboration required to avoid these mistakes in a way that leads to ‘tenant friendly’ lease arrangements that support the occupier’s business objectives into the future. 

Common mistake 1 - ‘Not starting with the end in mind’

“Start with the end in mind” - Stephen Covey

Starting with the end in mind makes decision making more focused and effort more directed.  This mindset is particularly relevant when negotiating commercial accommodation arrangements, as long-term fixed commitments are made for an organisation that will have to adapt to trends and challenges throughout the tenancy.

In our experience, the most common mistake lessees make is to not give sufficient attention to clarifying the ‘end in mind’.  The impact of this omission is that accommodation arrangements can be somewhat misaligned to the business objectives and strategies, and to the evolution of the workplace needs over time.  This misalignment may not show itself in the early stages of a leasing commitment because lease negotiations tend to focus on near term requirements, but the misalignment becomes more obvious as tenancy requirements are impacted by external circumstances (eg. the pandemic) and / or by internal responses to business challenges.  Accommodation misalignment harms the occupier over time, resulting in undesired outcomes such as having too little or too much space, having to operate from premises that do not work well, having to move from a premises where business goodwill is inextricably linked to the location, or ending up being stuck in the wrong place.  LPC advisors are regularly called upon to help an occupier solve an accommodation misalignment problem that could have been avoided, had more attention been given to clarifying the end in mind from a business perspective, before determining workplace strategy and before entering material accommodation arrangements.    

At LPC, we help clients eliminate this mistake and the related unwanted consequences by emphasising the importance of fully considering ‘business before space’.  In practice, this means we go beyond a superficial accommodation needs analysis by working with occupier clients to fully articulate business objectives, strategies, and risks, before developing an accommodation strategy that supports the business into the future.  In this context, our client’s business objectives are the ‘end in mind’, and we facilitate a needs analysis process that works backwards to determine accommodation arrangements that best align with the business objectives whilst mitigating business risks.  Our team of advisors have the ongoing privilege of working with clients across the sectors (office, retail, industrial, NFP, government) who take the time to align accommodation strategy with long term business objectives and outlook, thereby enabling a sound base for negotiating flexible and productive accommodation commitments.

As is always the case with accommodation commitments, knowing what to look out for greatly improves the negotiated outcome and the occupier’s return on their investment in a single or multi-site accommodation requirement. 

Common mistake 2 - ‘Not recognising the risks and the opportunities’

“Risk comes from not knowing what you’re doing.” - Warren Buffett

It is one thing to ‘start with the end in mind’ but it is quite another thing to know how to get there for ‘the devil is in the detail’.  Little wonder then that Warren Buffet has observed that ‘risk comes from not knowing what you’re doing’. 

In part 1 of this series, we described how the odds are stacked against commerical tenants due to fragmentation, whilst favouring investor property owners due to the consolidation, strength, power, and influence of property owners in conjunction with the leasing agent firms who serve as gatekeepers who protect the owner’s interests.  One of the implications of occupier fragmentation is that tenants have less access to key leasing information than owners and leasing agents do, which means less leverage as information is power in real estate decision making.  This disadvantage is just one factor that results in many occupiers not fully recognising the risks and opportunities associated with negotiating accommodation arrangements.  In our view, the outcome of not fully appreciating these risks is that a great many commercial tenants end up taking on lease risks that are more akin to ownership than tenancy, whilst property owners remain the sole beneficiaries of the growth in the value of the leased asset during a tenancy.  The pandemic evidenced the extent of risk transfer to tenants, as it brought to the fore that most lease arrangements do not provide a tenant with adequate protections relating to diminished utilisation for of the leased asset, whilst protecting the owner’s income stream and the value of the asset. 

As explained in part 1, it is in the interests of investor property owners and leasing agents to preserve this status quo whereby the risks of ownership are transferred to the lessee for the term of the lease, whilst the owner does not assume or share in the risks related to impaired utilisation.  It is in the interests of tenants to negotiate lease terms that provide assurance of utility of the leased asset with no diminishment or interruption of the promised attributes of the leased asset through the lease term.  When a lease is viewed in this way it helps an occupier to better identify the potential for impaired utilisation over the lease term, and to bring these risks into the negotiation process.

At LPC we help to mitigate the risk of diminished utilisation in different ways, including negotiating property owner guarantees pertaining to the attributes that made the premises the preferred choice.  The ‘end in mind’ is that the tenant gets what was promised without interruption, supported by appropriate provisions that protect the tenant should utilisation be impaired for reasons beyond the tenant’s control.  Whilst the pandemic was dramatic in its impact on utilisation, there are many other more subtle factors that negatively impact the tenant’s utility value over the term.  These include downgrade to building status (or shopping centre performance for a retailer), drop off in the building services regime, change to the tenancy mix such that utility value is negatively impacted, reduction in the appeal of the common amenities, landlord and / or redevelopment works that impact utility, drop off in foot traffic (key factor for retail), and a great many other identifiable risks that the tenant does not control and that impact utility value.

We also encourage tenants to consider their business objectives, strategies, and outlook more closely, and to identify key lease terms that either increase or decrease business risk depending on where these terms land.  The key risks and the critical terms change from one client to another, and this reinforces the truism that the ‘devil is in the detail’.  For a multi-site occupier that delivers time-framed government programs that may or may not rollover, business risk will be reduced by multiple break-clauses and related provisions.  On the other hand, a business whose goodwill is tied to a specific location will reduce business risk through negotiating multiple options with favourable market rent review provisions and an option to purchase.    

We have drawn attention to the need to ensure tenancy arrangements de-risk a business.  It is also important that lessees consider lease arrangement opportunities that seldom receive attention.  One such opportunity is to share in the growth in the value of the leased asset that can be linked to the tenancy.  As stated in the previous article, it is our view that it is reasonable that tenants participate in the growth of the value of the asset as their tenancy and covenant contribute to this growth, and that the extent of the lessee participation in the growth in the value of the leased asset should reflect the value of the tenancy.  This is a game changer but is an important opportunity to be grasped by tenants in Australia where commercial real estate continues to increase in value.  The underlying principle is that tenants and property owners should more equitably share in the risks and benefits related to the tenancy.  From a negotiation perspective there is an obvious trade-off between the level of risk assumed by a tenant and the extent to which the tenant shares in the increase in the value of the leased asset. 

Our ‘end in mind’ is to negotiate leases that have robust property owner obligations relating to the attributes marketed to the tenant, with a greater sharing of the risks and value associated with the tenancy.

Common mistake 3 - ‘Not leaving enough time’

“Even a correct decision is wrong when it was taken too late’ - Lee Iacocca

In article 1 we drew attention to the fact that ‘you get what you negotiate’.  This is true, subject to the proviso that one does not make the common mistake of ‘not leaving enough time’, for time is leverage in commercial lease negotiations.

Regrettably tenants regularly lose leverage and end up with tenancy arrangements that increase business risk due to ‘not leaving enough time’.  The worst-case scenario is being ‘out of time’ due to having missed a critical date, thereby foregoing a right of some form such as an option to renew.  An inadequate lease management regime is the typical cause of a missed critical date.  The impacts of such omissions can be business critical and may include a loss of business goodwill due to closure, increased costs associated with forced relocation, a break in business continuity, and acceptance of alternative but inferior tenancy arrangements.  What happens more often than missing a critical date, is untimely attention to lease matters due to an inadequate lease management regime, or due to ambiguous business objectives with insufficient clarity about the business outlook and risk.  These management gaps lead to delay in the review, update, and execution of an occupier’s accommodation strategy, all of which shorten the time available for building leverage. The inevitable outcome of ‘not leaving enough time’ is acceptance of tenancy arrangements that are more tenant unfriendly than they needed to be in relation to occupancy cost over the term, flexibility to expand or contract or to exit early, the level of risk borne by the tenant, and the extent of the obligations and guarantees agreed to by the tenant.

So it is that Lee Iacocca’s observation that ‘even a correct decision is wrong when it was taken too later’ has relevance, for even if correct business decisions are made pertaining to acquiring or disposing sites, or a stay or go evaluation, or any other accommodation decision, the execution of the decision will be greatly constrained by ‘not leaving enough time’, and the outcomes achieved will be far less tenant friendly than could have been the case had the matter been attended to early enough to build leverage.

At LPC we ensure timely attention to tenancy matters by  ensuring disciplined management regimes that provide assurance to a client that their lease portfolio is being overseen and not overlooked.   Our single purpose is to optimise and de-risk the accommodation arrangements to support the business objectives into the future, and our processes and data handling ensure timely alerts and expert handling of all lease activities to maximise occupier leverage.  The same mindset and approach will add value to any multi-site occupier.

Conclusion

If you are a leader of business organisation, or a franchisor, or a head of property for a multi-site occupier, then you are most welcome to reach out to us to work with you to review, reset, and reposition your accommodation commitments to better align with your organisation’s strategic objectives and outlook.  You will find us easy to work with and totally focused on achieving the best possible tenancy arrangements for your organisation.

All the best as you navigate the pandemic and reset your accommodation arrangements for the future.

About LPC & the LPC subscription service

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. Our single purpose is to help commercial occupiers optimise their accommodation and tenancy arrangements. You will find the LPC subscription service most useful when it comes to identifying key terms for renegotiation and getting to the lease you deserve.

Contributors to this article:

Ken Lam | klam@lpc.com.au | +61 411133944
Gillian Heath | gheath@lpc.com.au | +61 404329283
Julian Kurath | jkurath@lpc.com.au | +61 404499419
Michael Raymond | mraymond@lpc.com.au | +61 419477712
Dylan O’Donnell | dodonnell@lpc.com.au | +61 411222836
Adrian Gerber | agerber@lpc.com.au | +61 409001004
John Reed | jreed@lpc.com.au | +61 438648678
 

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