Demanding flexibility in uncertain times, prospective office tenants are pushing landlords for shorter lease terms and cancellation clauses.
And while it may put a crimp in cash flow projections for five and 10 years out, many landlords are obliging.
Think of it as the adjustable-rate mortgage of the commercial leasing world landlords lock in tenants at a time when the market is soft, while tenants hedge against long-term commitments.
It can be a bit of a gamble for both.
“There are two reasons this is happening: The question of whether rents are going to continue to go down and the economy overall,” said Gary Weiss, managing director of Credit Suisse First Boston Realty Corp.
Signs of the economic decline were starting to show earlier this year. Bill Boyd, senior vice president with Grubb & Ellis Co., said that while the trend toward shorter lease terms began last summer, it really began to gain favor since Sept. 11.
The move to shorter lease terms was a factor in the recessionary market of the early ’90s, but there are signs that it’s more prevalent today.
Some tenants just want as much flexibility as they can get.
One such company is Riverside-based law firm Graves & King LLP, which has an office in Glendale. “With the uncertainty of the business climate we thought a three-year lease would be more suitable,” said Victor Johnson, the firm’s director of administration. “We thought we’d look at three years in terms of evaluating our growth regardless of the (state of the) Glendale market.”
Unable to land a three-year deal, he said the firm expects sign a five-year sublease for 3,600 square feet at 500 N. Brand Blvd.
Johnson also tried to get a cancellation provision that would have required Graves & King to give six months notice and repay 50 percent of any tenant improvements put into the space. Again, the landlord balked, and the firm ended up with a straight five-year deal.
Advantage to landlords
For landlords, the short-term lease can act as a safety net. “The space will be there three years from now,” Boyd said. “It gives them the right to take advantage of an increased rental market, assuming there is one.”
Hunt Barnett, senior managing director at Insignia/ESG Inc., said both sides win. For the tenant, it’s a matter of focus. They bear the risk is of betting incorrectly that the market will continue downward.
“If you’re in a historically healthy market like Beverly Hills or Century City, the difference isn’t going to be that great,” Weiss said. “You’re willing to roll the dice more in markets that are softer because you never know when the market’s going to turn.”
One soft market as yet untouched by the trend is downtown, according to Tony Morales, a partner at MaguirePartners. He said downtown tenants have been coming to landlords with as many as five years left on leases to re-up for the long-term.
It shouldn’t come as a surprise, however, since with a vacancy rate of 17.5 percent and asking rents of $2.41 per foot per month, the sub-market is a relative buy. And Morales, whose buildings downtown are largely asking below those market rates, believes tenants want to lock in rates before rents spike up.
If Morales hasn’t reaped the benefits of the new short-term trend, he has seen its effects firsthand. One potential tenant for 1733 Ocean Ave., a 91,000-square-foot Santa Monica project due to open in February, decided to sign a two-year extension with its current landlord rather than commit long-term to the beach.
Similarly, tenants negotiating for space at the developer’s Water’s Edge project at Playa Vista said they’d prefer the shorter deals, Morales said.
Dave Toomey, senior vice president at CRESA Partners LLC, said he’s been through the “commitment phobia” with several clients of late. A Swiss technology company in the South Bay was looking to expand its 20,000-square foot space to 35,000 square feet somewhere in that submarket. The company initially wanted a minimum five-year lease.
“Now they’re looking to extend their lease nine months to let them see more clearly what the future has in store for them,” Toomey said.
For those tenants ready to pull the trigger but nevertheless wary of the future, real estate agents have been able to work cancellation clauses into contracts.
Jeff Cowan, corporate managing director for Julien J. Studley Inc., said cancellation penalties usually make exercising the out clause prohibitive, but it’s something that gives a tenant a feeling of control. “It’s security in the case of Armageddon,” Cowan said.
For the time being, only the strongest landlords with the tightest vacancies have the luxury of naming the terms in lease negotiations. Tough economic times have hurt everyone, but they give cautious tenants something of an advantage. “It’s a special tenants that feels up to do a long, 10-year lease with 4-percent annual escalators,” Cowan said.
