Desperately Seeking Certainty: Considerations for Office Landlords and Tenants
By Linda Koffman, Michael Manzi, and James Porter – Smith Gambrell Russell
(Editor’s Note: While the topic of the office market is a bit out of our “wheelhouse” here at our apartment association and may not fully align with our typical content on multifamily residential properties, many of our members currently own or are interested in investing in various types of commercial properties, including office buildings. Whether you own or are interested in investing in an office building, or not, you will surely find this article of interest. Where the demand for office space goes, so goes the demand for residential rental properties to live in.)
When it comes to business, much time and money is devoted to limiting uncertainty, and this may be especially true in the real estate business. Justice Oliver Wendell Holmes said, “The longing for certainty … is in every human mind. But certainty is generally illusion.” And so, it was for office owners and tenants as the impact of COVID-19 began to take effect in March 2020.
Although the severity of the pandemic seems to be subsiding, it is too early to predict with any degree of accuracy the scope of changes that will emerge in commercial real estate. The changes depend on variables of human behavior that do not always reflect reasoned thinking. The decisions to be made in the near future by executives, administrators and employees will arise from a variety of causes, such as a desire to return to the community of the workplace that cannot be duplicated by videoconferencing, the desire to remain distant from urban centers, hesitancy to use crowded trains, planes, buses and elevators, and a reluctance to resume lengthy commutes. Employer mandates are also varied: some want a total return to the office, some agree to continuing working from home for now, and others are trying hybrid arrangements.
This article will discuss options office owners and tenants may need to consider in light of increased vacancies as a result of the pandemic and the uncertainty it has created and will delve into lease provisions that may take on heightened importance going forward.
As more workers become vaccinated and return to work, many companies are rethinking their office design and space needs. For those companies that have kept a more traditional office layout with segregated private offices, conference rooms for meetings and “break-out” rooms for eating and socializing, their existing space plan may not need significant changes. For those companies that have opted for “open concept” offices where people sit side by side in an effort to maximize space usage and encourage collaboration, they may consider whether they want to revise their space plan to provide room for social distancing and other safety measures arising from the pandemic.
For many industries, the experiment about whether work from home could be productive and not negatively impact the bottom line has been proven successful. Nonetheless, business leaders across the country are readying their workforce to return to the office on a regular basis. Despite the optimism among many office owners, brokers and company leaders, many others – including a large percentage of employees – do not necessarily want to return to the office full time. The forced lockdowns and other impacts of the pandemic have created significant changes to our behavior, lifestyles, and ideas of work, with many believing they are more productive and happy working from home.
In larger cities like New York, many companies recognize that employees with less space at home, roommates, or families with young children, will likely embrace coming back to the office as a quiet place where they can be more productive. For others, reclaiming hours previously spent on a long commute and the flexibility that comes from working from home may be too difficult for them to give up. With concern about losing good employees who prefer to work from home, many companies are rethinking office design to allow for a hybrid style of working with flexible space at the office to allow those who wish to be in the office an ability to do so, and to convene in-person meetings and collaboration sessions.
The commercial office sector is experiencing a sea change in the way people think about their work. This does not mean that high-rise office buildings are doomed, or that downtowns will be deserted, but it does mean that significant change is happening in the office building sector and landlords and tenants will be adjusting to those changes for years to come.
From an owner’s perspective, there is concern about rising vacancies now and in the future as tenants shed space to allow a more flexible work environment. Owners of office buildings may need to embrace repurposing some office space to other uses. In most urban centers in the United States and beyond, commercial buildings (particularly warehouses and factories) have been converting to residential and mixed use for some time. An owner facing an empty or soon-to-be-empty office building can explore the possibilities of converting the building to a condominium or rental building if such reconfiguration is architecturally feasible and zoning compliant (putting aside issues of affordable housing mandates). As many cities were and remain adherent to a single-use zoning plan, conversions may be difficult. Although mixed-use buildings and developments are not new and are popular in cities such as Toronto, this popularity may increase considerably going forward, particularly if local governments take a more flexible approach to zoning, which they should do in an effort to expand and diversify the tax base. The day may soon be near when the urban dwellers can take care of all their basic needs – work, home, medical, retail, grocery, dining, entertainment, religion – under one large roof. The dependence of building owners on an office-only building in downtown areas may become unsustainable.
For those tenants with office space that does not allow for social distancing, the tenant will need to evaluate the practicality and cost of reorganizing the space. Many tenants nearing the end of their lease term will want to consider whether their current building, location and amenities are compatible with the company’s preferred working style. Buildings that are not as dependent upon elevator use and those that provide more open space, natural light, windows that open, easy food and beverage options, green spaces, and COVID-19 protections (touchless features in the restrooms, flexi-glass dividers, hand sanitizers, air filtering systems, etc.) will likely be in higher demand after the pandemic. There is also an increased focus on making the workplace a comfortable and exciting place to go.
Some employees may still be working from home most of the time. A tenant needs to consider what changes it should make to conference room(s) to improve audio and video capabilities to make it a productive experience both for those attending in person and those participating virtually. Another trend among tenants is “office hoteling,” where employees no longer have a dedicated private office and instead reserve a desk or office for the day. Companies exploring hoteling will need a reservation system to manage bookings and to avoid overcrowding. Some employers are adding lockers into their office design so that employees have a place to store personal belongings only used at the office.
Financial / Lease Considerations
Before COVID, most office leases were for a term of five years or longer. Because of the uncertainty caused by the pandemic, office tenants are now seeking leases with shorter terms, and many tenants who decide to renew are negotiating renewals at steep discounts. For tenants who did not fare well financially during the pandemic or have determined that their current space doesn’t meet current needs, or who wish to reduce lease expenses going forward, there are a number of strategies they may want to consider. A good first step is to undertake a strategic analysis of its space needs after reviewing its financial performance during the pandemic, its business plan post-pandemic, how well the space meets its current needs and to what extent its employees will either be working from home or on a hybrid schedule. Once these determinations are made, the tenant can develop a plan going forward. Essential to any such plan is negotiating preferred lease terms or amendments.
Many tenants who are staying in their existing leased premises are looking for ways to reduce charges for underutilized, or unused, office space. Following are a few areas of focus in this regard:
- Reduce Pass-Through Operating Expenses. One area of potential savings is operating expenses, with a particular focus on variable costs such as janitorial. Some leases allow landlords to mark-up pass-through expenses with an administrative fee. Tenants should look closely at these provisions and seek changes where savings can be attained. As with any negotiation, success often comes down to relative leverage.
- Caps on Operating Expense (“OPEX”) Increases. Requests for caps on OPEX increases are becoming more common. Obviously, no landlord wants to agree to an OPEX cap, but if a landlord is forced into a position to consider this concession, it would be wise to focus on whether the cap is cumulative or not cumulative. For example, if OPEX costs increase in the year following the lease amendment but not up to the cap, can the landlord carry over the difference between the OPEX cap and the actual increase in OPEX charges to the next year? A non-cumulative cap is best for tenants.
- Contraction/Drop Space Clauses. Tenants may want to seek a contraction option (sometimes called a “Drop Space” clause). In negotiating a “drop space” clause, the following are concepts the parties should consider:
- identify the portion or portions of space that can be “dropped” from the lease premises. The space should be identified with reference to an exhibit;
- identify the time period(s) by which the tenant must exercise its right to contract its space. If the tenant is on a multi-tenant floor, the landlord will want to coordinate this “drop space period” with the expiration or expansion periods of other tenants on that floor or adjacent floors;
- the parties need to agree whether annual base rent will be reduced based upon (i) a reduction in the rentable area of the premises using the rental rate per square foot set forth in the lease, (ii) the then current rental rate for other space in the building or, if there aren’t a sufficient number of comparable transactions, the then current rental rate for other comparable space in comparable buildings in the vicinity of the building or (iii) another formula;
- tenant’s proportionate share of operating expenses should be decreased by the reduction in the rentable area of the leased premises;
- subject to any approvals required from the landlord’s lenders, the parties should enter into an amendment to the lease to accurately reflect the changes in the leased premises, base rent, tenant’s proportionate share of operating expenses, a reduction in parking spaces, the construction of demising walls, systems, etc. to divide the dropped space from the leased premises the tenant will continue to rent and other agreed-upon terms; and
- the parties should discuss the consideration for the reduction in space. This could be a lump sum, such as a “termination fee,” an extension of the lease term, credit enhancement such as a lease guaranty or other consideration determined by the landlord and tenant.
Assignment / Subleasing
With more tenants looking to sublease office space, a landlord’s own tenants may become its biggest competitor for office space. When a tenant is looking to reduce its financial obligations under its lease, the tenant will usually be able to offer a subtenant a lower price per square foot than the landlord is asking of new tenants coming into the building. Allowing existing tenants to enter into subleases at a significantly lower rental rate may impact fair rental value. To guard against this, landlords would be wise to negotiate recapture rights that permit a landlord, at its option, to terminate the lease with respect to space that an existing tenant wishes to sublet. Such a provision allows landlords to maintain a higher level of control in the building.
It is important for a tenant to understand challenges involved in a sublease transaction. Besides the responsibility for managing the subtenancy, it will take time to identify a prospective subtenant and may involve construction if the space is to be divided. A sublease transaction also involves a number of transaction costs, including: (i) payment of brokerage commissions, (ii) providing “free rent” or cash as an incentive, (iii) construction costs, (iv)likelihood that the subtenant will want a “discount” from the sublandlord’s then current per square foot rental amount, (v) downtime (that is, how much time the space will be on the market), (vi) possible profit-sharing with the landlord; (vii) attorney fees to negotiate the sublease, and (viii) paying the landlord’s attorney fees (and possibly an administrative fee) to review and consent to the sublease.
What options are available to landlords facing higher vacancy rates? What does a landlord do with excess office space where the supply of available space exceeds the demand? This article touched on these questions in the earlier discussion of potential repurposing of excess space. The following are a few additional considerations.
It is important for landlords to communicate with tenants about new and enhanced operating protocols so that tenants will feel more confident that the building is a safe working environment. While many employees are still working from home and occupancy percentages are still low, landlords may want to undertake construction projects at the building to further enhance safety precautions or to construct or enhance amenities to make the building more appealing to tenants.
This may be a good time for owners/operators to consider the right tenant mix for its building. In the past, many office landlords considered it a good idea to lease most, if not all, of a building to a single tenant. The pandemic has shown that this previously attractive strategy may have a serious downside as some large tenants are using their considerable leverage to negotiate significant concessions or failing to renew entirely. Spreading risk among multiple tenants and types of uses may be the preferred strategy in the future.
If a landlord finds itself with empty space in its building, it may want to consider building that space out into a conference room or rooms with attractive amenities and offer that space to lease to existing tenants on a reservation basis. In such event, it will be important for a landlord to have its attorney carefully review its loan documents and determine if it needs to work with its lender to implement such changes.
Some landlords, pre-pandemic, were launching their own shared office brands. Besides being a way to increase revenue for available space in the building, these shared spaces can be incubators for start-up companies that may later wish to lease larger exclusive space in the same building.
In closing, it is clear that the COVID-19 pandemic and the response of federal, state and local governments across the country have created an elevated level of uncertainty about the future of office space and how it will be used in the future. Tenants and landlords will need to carefully consider the issues raised in this article, and many others, to successfully navigate their way through. Experienced legal counsel, with an ability to think outside the box, can help determine the best path forward.
The authors, Linda Koffman, Michael Manzi, and James Porter are partners with the law firm of Smith, Gambrell & Russell, LLP. This article was first published in “Trust the Leaders 2.0” magazine and has been reprinted with permission from Smith, Gambrell & Russell, LLP. For more information, contact Linda Koffman, Partner, at (213) 358-7218 or visit the firm’s website at www.sgrlaw.com.