An office lease is a pivotal tool for small law firms to attract better clients and expand their practices. But it is also frequently the largest fixed capital expense and longest commitment of a small firm. Negotiating favorable lease terms is critical to ensure a lease contributes to, and does not hamper, a firm’s success. Read on, here, for practical advice on how to negotiate for the best deal, even in San Francisco’s tough real estate market.
Today’s San Francisco office leasing market is a landlord’s game. In the first quarter of 2015, average asking rental rates for Class A office space in Downtown San Francisco has broken north of $70.00 psf/year mark for the first time since Qtr 1 2000 . Looking ahead, rates are not expected to fall anytime soon, as technology growth companies have helped fuel the lowest vacancy rates since 2000, and have pre-leased 89% of the 2.2 million square feet of new buildings under or approved for construction in the City .
Small firms cannot compete financially with their market competitors, who will pay higher rents and prepaid rent upon demand. Failure to maintain adequate financials brings creditworthiness into question and kills tenant’s leverage in lease negotiations.
While base rent and escalations seem like an obvious starting point, demand remains sky-high and competition flush, prospective tenants better serve their interests by focusing on other points, including those set forth below.
- Space Improvements. Even in a tight market, tenants can negotiate for landlords to perform or contribute funds toward a build-out, since some improvements will increase the long-term value of the landlord’s asset. In negotiating for improvements:
- Understand landlords seek to recoup its contributions through other lease terms, such as increases in expenses passed through to the tenant or in determining rental rates.
- Clarify all landlord requirements and costs, such as vendor qualifications, materials requirements, and insurance requirements.
- Strike a landlord’s right to require removal and restoration of improvements to their original condition upon lease expiration – this is costly and difficult to assess. Alternatively, require landlord to confirm any restoration requirements at the time its grants approval.
- Commencement Date. Where a space is being built-out, lease commencement should be tied to issuance of a Certificate of Occupancy, rather than “substantial completion of construction.” Determining substantial completion can be problematic if construction milestones are technically met but the Certificate of Occupancy is delayed, in which case tenant cannot open for business but is obligated to perform all monetary and other lease obligations. Also, provide for tenant’s right to terminate the lease if the certificate is not issued within 60 days of submission for approval.
- Term Length and Option Periods. Term length and extension options should be strategically negotiated.
- Term length should match a firm’s business plan. Heidi Hoch, Founder and Broker of Hoch Consulting, specializing exclusively in tenant representation and Co-Author of the book “Business Success with Ease” says, tenants should “think with the end in mind” when leasing commercial space. Costs and legal implications can often be avoided if a Tenant anticipates outgrowing a space or efficiency of space layout meets the tenant’s short and long term goals for their business prior to signing a lease agreement.
- If needs shrink or if the market tanks, tenants can find themselves locked in to paying for more space than it needs, at above market rates. On the flip side, if the market continues to rise, they are locked in at the current rate.
- For longer terms or options, cap operating expense escalations and cap or exclude tax increases, since over a longer term more building repairs or reassessment are more likely to occur.
- Pass-Through Costs and Tempering Spikes. For office leases on a modified “gross” leases, where landlord pays property taxes and common area operating expenses, and tenant pays their share of increases of such costs over the amount in a base year. A tenant cannot completely predict or control these charges, but make sure the tenant understands the property’s bottom line and mitigate risk of increases.
- Request the past two year building operating expenses to compare to defined lease terms negotiated and forecast potential operating expense pass-through to the tenant.
- Gauge the risk of tax spikes attributable to Proposition 13. Find out the appraisal value and determination date, and whether landlord intends to sell, refinance or perform financed improvements. Then push for exclusions or caps on related tax increases.
- Limit operating expenses to appropriate costs expended for the benefit of the building. Exclude costs related to a single tenant’s space, and any reimbursable or insured costs.
- Limit pass-through costs, such as management fees, to competitive market rates.
- Request the right to inspect landlord’s books at Tenants cost – with reasonable time period and review.
- Security Deposits and Letters of Credit. Most small law firms cannot afford to deposit high security deposits some landlords are demanding. Tenants should try and offer alternate security options.
- Include a burn-down clause whereby landlord refunds all or a portion of the deposit upon set reduction triggers, provided tenant is not in default.
- Post a letter of credit instead, to maximize liquidity (ideally with a burn-down clause as well).
- As a concession for reduced deposit requirements or weak financials, a landlord may require a personal guaranty. If so, mitigate risk by negotiating (i) a hard cap on the guaranty amount, (ii) an early release date based on good performance, or (iii) a “good guy” clause that releases the guarantor upon tenant’s vacating the space and surrendering the keys.
- Subleasing & Assignment. Commercial leases stringently restrict a tenant’s ability to transfer its leasehold interest, so that landlords can control who is occupying its asset. That said, it is important for a tenant to have flexibility regarding transfers, especially when paying top-dollar rent for a space it may outgrow. Accordingly, tenants should do the following:
- Landlord’s approval criteria should be “reasonable.” Criteria based on transferee net worth or financial performance are appropriate, but not, for instance, simply because a transferee may have once toured a space in the same building.
- If a landlord has rights to share in profits resulting from a sublet or assignment, make sure “profits” are calculated net of tenant’s costs related to the transfer, including broker’s commissions and attorneys’ fees.
- Push for a “permitted transfer” provision that foregoes consent requirements for transfers to affiliates or successors by merger or acquisition – to stay in good standing under the lease, without landlord’s involvement.
- Be strategic in negotiating landlord’s rights to take back the space, or “recapture,” and terminate upon tenant’s request to assign or sublet. Strike it entirely, or restrict recapture rights to total, but not partial, transfers (with right to rescind the transfer request).
- Negotiate the right to “license” part of the space on a short-term, desk-by-desk basis without landlord consent.
- Maintenance Costs and HVAC. Tenants should ensure appropriate allocation of maintenance costs for the premises and building.
- Limit tenant’s obligations to items related to its use of the premises only, not common areas, structural components or major building systems. Also, exclude any items separately charged as operating expenses.
- Inquire about compliance under the Americans with Disabilities Act and limit tenant’s responsibility to the premises itself – hold landlord responsible for compliance in common areas and paths of travel.
- Limit tenant’s obligations regarding heating, ventilating and air conditioning (HVAC) units to general maintenance and minor repairs, and hold landlord responsible for major repairs and replacements.
- Relocation Rights. Leases often grant landlords the option to relocate the tenant to another space in the building. These rights are typically exercised when the opportunity to rent to a full-floor tenant arises. Odds aside, relocation is highly disruptive to tenants.
- Landlord should pay moving costs, unamortized costs of tenant improvements, and abate rent for the relocation period.
- The replacement premises must be equal or superior to the original in terms of usable square footage, general condition, layout, light, views, improvements, and usability.
- Rental rates and increases should be based on the original lease terms, and limited to the maximum square footage of the original space.
- Landlord should waive restoration requirements for any tenant improvements or alterations to date.
- Restrict landlord from exercising the right within the first or second years of the term, and grant tenant a right to terminate the lease if relocation is exercised within 24 months of expiration.
While certain lease points are still negotiable, in today’s tight market, small firms must approach the leasing process eyes wide open, be willing to pick their battles and understand their risks in order to secure an office space to help their practices thrive.
About the author:
Laura Drossman practices commercial real estate and business law, with an emphasis on representing tenants in commercial lease negotiations. She is a member of the Executive Committee of the San Francisco Bar Association’s Solo and Small Practice Group.
 CBRE Marketview Report, San Francisco Office, Q1 2015.