How Long of a Lease Should I Sign?

by CoyDavidson on June 2, 2010

Lease Term and Real Estate Flexibility

The decision of where to locate your office is critically important to most businesses and various choices in the leasing process can be complex and numerous. Real Estate decisions are long-term in nature and one of those key decisions is deciding what length term of a lease to sign. Most office leases signed by companies are; 3, 5, 7 or 10 years in length and in the case of a very large office tenants or those with highly specialized use requirements, sometimes even 15 years.

Generally speaking, in situations where the tenant can sign for a longer lease provides the ability to achieve significantly more attractive lease terms including rental rate, tenant improvement allowances and other concessions which lowers occupancy costs and improves the bottom line in the long-run.

The obvious advantage in shorter term leases is less financial risk and the flexibility provided to easily adjust space size based on business and economic conditions without having to resort to subleasing. Some organizations, specifically smaller or young companies are just not as comfortable knowing where there company will be financially or size wise 7 or 10 years down the road and should focus on 3-5 year lease terms.

Factors impacting Lease Term Decisions:

  • Economic and Real Estate Market Conditions
  • Size of the Space Requirement and Company Size
  • Stability of the Company, Industry Type and Projected Business Conditions
  • Use of the Space: Specialized vs. Generic Office Use

Economic and Real Estate Market Conditions

Many companies are comfortable signing long term leases in healthy market conditions when business is flourishing, and the outlook is very optimistic, and opt for short term leases in periods when business conditions are deteriorating, confidence is low, and the future less certain

Although this on the surface seems logical, the contrarian approach may be more prudent. In strong markets vacancy levels are low and real estate costs are also typically high, and signing a long term lease will lock into higher lease rates longer term.  In contrast, by signing only short term leases in soft markets, you may miss the window of opportunity to lock into low lease rates for the longer term and pay a higher rate with less concession as your lease matures to renewal.

The ability to understand market cycles and predict with relative accuracy as to when the market has bottomed out and real estate conditions are beginning to improve should drive your decision to act. This is where I believe we are today in most markets, in the early stages of recovery.

Size of the Space Requirement and Company Size

Obviously securing 200,000 square feet of office space for your corporate headquarters is very different exercise than leasing a 2,000 square feet office suite for a small business or branch office in a still un-proven market. A large space requirement is almost always better suited for a longer term commitment unless that space is tied to a shorter term business enterprise or contract.

Stability of the Company, Industry Type and Projected Business Conditions

In today’s volatile economy projecting a business plan out even 3 years is challenging. However, a Fortune 500 corporation, the 75 year old regional law firm or physician with a 20 year medical practice typically has more stability and a better handle on their 5-10 year pro-forma than the internet start up existing on venture capital, or even a young company managed by experienced professionals without historical track record.

Use of the Space (Specialized vs. Generic)

What if the required leasehold improvements for your space are highly specialized or costly for your specific needs?  It is not economically feasible or worth the risk for a lab operation, medical office or law firm with a $75-$100 per square foot build-out to be forced to move after 3-5 years for some reason and duplicate those leasehold improvement costs. The ability to amortize the tenant improvement costs over the longer term is critical for highly specialized and/or costly tenant improvement requirements.

Incorporating Flexibility into Long-Term Lease Agreements

The method in which to incorporate flexibility into longer term lease arrangements is to negotiate lease contraction and/or lease termination options into the lease agreement. There are financial costs involved with these options, in the form of some period of rent payment as penalty and the payback of unamortized landlord transactions cost such as tenant improvement allowances and leasing commissions.

Termination and contraction options are like insurance coverage in that there is a cost associated with these options, but if needed, will save a significant amount of money in the long run by not having to incur occupancy costs on space no longer required. Prior to each of these future contraction or termination dates, you can re-evaluate your space needs internally and make a prudent business decisions as to whether to exercise the option. Landlord are not always willing to grant these termination and contractions options. The ability to win these concessions during negotiations and the costs associated with these options will depend on your negotiating leverage with the Landlord and market conditions.

What Should You Do Today?

For many small businesses or even larger ones who are relatively unsure about business conditions, opting for shorter term leased may be the only prudent option.

Today, market conditions are soft in most markets and you are seeing large corporations take advantage by locking into long-term leases at attractive rates and leasing terms that include termination and contraction options that are much easier to obtain and less costly to come by than in healthy market conditions. Even smaller stable businesses who perceive they can balance the long-term risk are taking advantage of market conditions and signing long-term leases at 20-30% cost savings.

Today, the market is positioned for Tenant’s to seriously consider long-term leases at lower costs with flexibility.

Hire a Tenant Representative

A solid tenant representative will work with your organization to understand your business and real estate needs and help you structure a transaction to minimize your occupancy costs and balance the risk associated with the long-term nature of real estate leases and changing business conditions. The ability to craft the proper real estate strategy and structure a cost saving transaction while mitigating risk will provide your business a significant competitive advantage.

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