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Cutting the ties that bind: Negotiating lease terminations.

Most landlords shudder at the thought of taking back leased space on a speculative basis. The beauty of a sublease situation that eventually involves lease termination is that it isn't really a gambling venture. The tenant is responsible for their lease obligations until a new tenant has signed a lease for the same space.

Terminations Can Pay Off

A lease termination and the subsequent release of the space invoke an artful poker game. This strategy can prove vastly more profitable than standard sublease or recapture solutions. It's particularly beneficial in a rising rental market whereby new leases yield substantially higher rates. The main benefit to the landlord is that an existing tenant pays a lease termination fee, while the landlord leases the space to another tenant. The landlord can then negotiate rents based on direct rates, usually a premium compared to sublease space. It also enables the landlord to lease for a period of time longer than the existing lease term. Thus, the landlord has generated income from two sources for the same space with overlapping time frames.

Tenants who are faced with the problem of excess space can either sublease the space or terminate its lease. (This, of course, assumes they don't want to spend funds paying for space they won't use.) If they opt to sublease, they'll incur loss to lease, broker commissions, tenant improvements, potential marketing costs, legal fees, and likely rent differential between the lease contract rate and the sublease rent. There's also the difficult-to-quantify but very real headache of administering sublease space. Who's going to collect the rent and deal with maintenance calls? Unless tenants have an idle in-house real estate department, they are ill-suited to administer a sublease.

Given economic parity with a sublease, the freedom of lease termination beckons alluringly. If the landlord can find a new tenant, the existing tenant can simply pay a termination fee and leave without looking over his/her shoulder. However, in order to reach a compelling financial agreement to terminate the lease, critical factors such as timing, the market and the tenant's responsiveness need to be considered.

Timing: The Pain Curve

Grizzled real estate veterans recognize that timing plays a crucial role in sublease outcomes. Assuming a five-year standard lease term, the curve looks something like this:

At the beginning of the term, it's easy to sublease because the tenant can offer a near full lease term. Also, the recently-signed lease rent is presumably close to market rent so the tenant isn't faced with significantly discounted sublease rates. Similarly, sublease pain is minimal during the last year of the lease term because the tenant has only a few remaining months before their lease obligation expires. Space is virtually impossible to sublease for less than a year unless a cooperative landlord is willing to extend the term (or the tenant has a non-personal right). Thus, a tenant is most motivated to defray lease expenses in the middle portion of the term when there is a weighty rent obligation remaining.

The Market & Building Profile

The best prospects for available space come from your existing tenant base. Should you be lucky enough to have an adjacent tenant considering expansion, you can kill two birds with one swoop of documentation. Good land-lords reap the rewards of close tenant relationships because they know whose businesses are expanding. The lease termination can work for everyone because the existing tenant is off the hook, and the expanding tenant has more space via a lease amendment. Meanwhile, landlords reap financial benefits while accommodating their tenants' needs.

Competitive space casts its strong influence on successful terminations. Should the suite compete with comparable space, the costs to lease increase and likely rent decreases. The liability of the space also depends on configuration--is it an open, flexible plan or are substantial tenant improvements needed? These factors should be considered in assumptions when calculating the termination fee.

If you've determined that a lease termination is viable, you can list the available space in announcements to the brokerage community. The existing tenant should be amenable to tours in order to consummate a lease termination. Touring through occupied office space can be tricky, however, so it's best to minimize conversations until you've finished the tour.

Responsive Tenants

Most property managers have experienced the demanding tenant, who then becomes unresponsive. Unanswered telephone calls and delayed document signings can scuttle any deal. It takes a tenant with some financial sophistication to understand the spreadsheet you've outlined. Also, you must be sure that the tenant can deliver an executed lease termination. One of the prickly areas to be aware of is the landlord's representation of available space, and then the inability of delivering square footage to interested prospects. Because landlords place their reputation on the line with the brokerage and tenant community, most insist that tenants sign the lease termination fairly quickly in this whole process. This allows the landlord and the existing tenant to fully negotiate the lease termination before (or simultaneously with) negotiations with the new tenant.

Calculating the Lease Buyout Number

The spreadsheet on page 60 illustrates how to calculate termination fees. First, list the tenant's existing obligation per the lease (base rent, parking, operating expense, storage rental, etc.). Assume that operating expenses grow at an assumed annual rate, and calculate the tenant's anticipated share accordingly. Use historical data for operating expenses; if this isn't available or you think it will be inaccurate for the future, remember to plan conservatively.

Second, calculate anticipated sublease expenses. This involves assumptions regarding time to lease, expected sublease rent, tenant improvements and broker commissions. Don't forget any other marketing costs that might be needed per current market conditions such as a broker open house or higher broker commission incentives.

The resulting total is then discounted on a net present value basis, assuming a lump sum payment. The result is the "lease termination fee." Discount rates mimic the return rate of a conservative investment, such as a money market. Financially troubled tenants sometimes arrange installment payments. In that case, the discount decreases, because the fee is paid over time.

As the landlord and tenant negotiate a lease termination, the level of expenses can be cause for debate. For instance, the bold tenant claims he can sublease at high rates. The more realistic landlord argues a lower rent. This is where a landlord's market knowledge can come into play. Show the tenant a list of comparable sublease deals to bolster your assumptions (see chart on page 61).

The Poker Players

Terminations are predicated on the assumption that the landlord can come to lease agreement with another tenant concurrently. Here's where good poker players excel; it's important that the landlord keep the identity of the prospective new tenant confidential as long as possible. Otherwise, the tenant can compete by offering a sublease to the (new) prospective tenant. Also, should the tenant discuss the termination fee with the prospective tenant, the two can collude in negotiations with the landlord. Throughout the process, any written proposal should contain a contingency clause that states the proposal is valid only when the landlord has a signed lease with the new tenant and conversely, has an executed termination agreement with the existing tenant.

Documentation

Ideally, the lease termination and the new lease executions work in tandem. The landlord negotiates each deal individually. When the documents are signed, each (the termination and the new lease) contain clauses that make the deals contingent upon the other; a fully executed lease termination (if it's the new lease) and a fully executed new lease (if it's the termination). The contingency clause is absolutely critical, because the landlord doesn't want to release the tenant from the lease before securing a substitute tenant. Because it's highly unlikely all parties will be in the same room signing at the same time, contingency clauses allow each party to fully negotiate and sign the documents days or weeks before the other side has concluded its signing. Once all documents have been signed, most landlords follow up with a letter confirming that the contingency has been satisfied and that the documents are now in effect.

Despite a real estate market that is filled with a glut of sublease space, today's savvy real estate managers can take full advantage of current conditions by carefully negotiating lease terminations.

Alice Devine, CPM[R], RPA has over 17 years of leasing and property management experience.
Sublease Scenario for Joe Tenant

3800 rentable square feet

Year 2002

 Jan. Feb. Mar. Apr.

Base Rent
Operating Expenses
Sublease Rent
Sublease Operating Expenses
Tenant Improvements ($2/sf)
Brokerage Commission ($2/sf)
Marketing Expenses
Subtotal

 May June July Aug.

Base Rent $5,000 $5,000 $5,000
Operating Expenses $400 $400 $400
Sublease Rent $0 $0 $0
Sublease Operating Expenses $0 $0 $0
Tenant Improvements ($2/sf) $7,600 $0 $0
Brokerage Commission ($2/sf) $7,600 $0 $0
Marketing Expenses $1,000 $0 $0
Subtotal $21,600 $5,400 $5,400

 Sept. Oct. Nov. Dec.

Base Rent $5,000 $5,000 $5,000 $5,000
Operating Expenses $400 $400 $400 $400
Sublease Rent -$3,500 -$3,500 -$3,500 -$3,500
Sublease Operating Expenses $0 $0 $0 $0
Tenant Improvements ($2/sf) $0 $0 $0 $0
Brokerage Commission ($2/sf) $0 $0 $0 $0
Marketing Expenses $0 $0 $0 $0
Subtotal $1,900 $1,900 $1,900 $1,900

 Total

Base Rent $35,000
Operating Expenses $2,800
Sublease Rent -$14,000
Sublease Operating Expenses $0
Tenant Improvements ($2/sf) $7,600
Brokerage Commission ($2/sf) $7,600
Marketing Expenses $1,000
Subtotal $40,000

Year 2003

 Jan. Feb. Mar. Apr.

Base Rent $5,000 $5,000 $5,000 $5,000
Operating
Expenses $420 $420 $420 $420
Sublease Rent $3,500 -$3,500 -$3,500 -$3,500
Sublease
Operating
Expense -$120 -$120 -$120 -$120
Subtotal $1,800 $1,800 $1,800 $1,800
Total Lease Obligation
without Sublease
Total Cost to Sublease
Total Sublease Rent
Remaining Sublease Obligation
NET PRESENT VALUE DISCOUNTED
AT 5 PERCENT (TERMINATION FEE)

 May June July Aug.

Base Rent $5,000 $5,000 $5,000 $5,000
Operating
Expenses $420 $420 $420 $420
Sublease Rent -$3,500 -$3,500 -$3,500 -$3,500
Sublease
Operating
Expense -$120 -$120 -$120 -$120
Subtotal $1,800 $1,800 $1,800 $1,800
Total Lease Obligation
without Sublease
Total Cost to Sublease
Total Sublease Rent
Remaining Sublease Obligation
NET PRESENT VALUE DISCOUNTED
AT 5 PERCENT (TERMINATION FEE)

 Sept. Oct. Nov. Dec.

Base Rent $5,000 $5,000 $5,000 $5,000
Operating
Expenses $420 $420 $420 $420
Sublease Rent -$3,500 -$3,500 -$3,500 -$3,500
Sublease
Operating
Expense -$120 -$120 -$120 -$120
Subtotal $1,800 $1,800 $1,800 $1,800
Total Lease Obligation
without Sublease
Total Cost to Sublease
Total Sublease Rent
Remaining Sublease Obligation
NET PRESENT VALUE DISCOUNTED
AT 5 PERCENT (TERMINATION FEE)

 Total

Base Rent $60,000
Operating
Expenses $5,040
Sublease Rent $42,000
Sublease
Operating
Expense -$1,440
Subtotal $21,600
Total Lease Obligation $102,840
without Sublease
Total Cost to Sublease $16,200
Total Sublease Rent $57,440
Remaining Sublease Obligation $61,600
NET PRESENT VALUE DISCOUNTED $60,300
AT 5 PERCENT (TERMINATION FEE)
Comparable Sublease Survey

Property Suite Sq Ft Term Rental Rate TI

123 Main St 700 3,000 3 yr. $15/yr paint/carpet
1000 Bayhill 220 4,500 1.5 yr $18/yr none
One Plaza Place 575 4,000 4 yr $20/yr $5/sf

Property Broker Comm. Other

123 Main St yes good views
1000 Bayhill yes no parking
One Plaza Place yes overlooks roof
COPYRIGHT 2002 National Association of Realtors
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2002 Gale, Cengage Learning. All rights reserved.

 
Article Details
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Author:Devine, Alice
Publication:Journal of Property Management
Date:Mar 1, 2002
Words:1928
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