Ten Tips for Negotiating a Good Deal
By Louis E. Teitel
[1] Work with a Great Broker and Make That Broker Work!
Clients sometimes seek to save money by looking for office space without a broker. However, in markets like New York City, this is usually unwise. Asking rents in the city are pegged by owners who understand that a brokerage commission is a standard expense and part of the cost of doing business. Though owners’ and tenants’ brokers wear different hats, they are the negotiating messengers and information purveyors for principals in almost all real estate transactions and therefore are valuable and experienced sources of market information. A good broker is a repository of street knowledge, capable of providing insight into individual buildings, neighborhoods, and owner anomalies. Because the broker usually earns a commission only on closed deals, a good broker will work hard to find a space to fit your needs and to ensure that any problems that crop up before closing are fixed in a timely and favorable fashion.
[2] The Devil Is In The Details—Fixed Rent Is Only Part of Your Costs.
New York commercial leases are lengthy and complex documents, often drafted in terms highly favorable to landlords. In reviewing a lease, it is a mistake to overlook what appear to be “boilerplate” paragraphs that may have serious financial consequences in the future. In addition to understanding the monthly base rent budget, every potential tenant should keep in mind the amount of additional rent and pass-through expenses it will be responsible for. Landlords have several methods of recapturing their expenses from tenants, and tenants as part of their due diligence should review trending increases in these pass-through rents. Invariably tenants will be required to pay as additional rent their pro rata share of the increases in a building’s operating expenses and real estate taxes, and even utility costs if they are included in monthly rent.
An important factor in calculating these additional rent items is the base year used in making the calculations. The tenant’s proportionate share of space in the building and the agreed-upon base year ordinarily form the basis for calculation of a tenant’s additional rent. However, strict square footage calculations based solely upon the total square footage of the building may not be an appropriate in many circumstances. For example, a normal pro rata allocation of square footage may not be appropriate in calculating additional rent when the building has a retail and office mix.
Frequently, specific items included by landlords in pass-through operating expenses should not be passed through to the tenant. For example, capitalized expenses should be eliminated wherever possible. When owners are required to make investments to comply with existing and future laws or legal requirements, a lease will often try to pass capital expenditures on to tenants. If the term of the tenant’s lease is short, the tenant should try to completely avoid such additional capitalized rent pass-throughs. If the landlord doesn’t budge, the lease should require proper amortization of such capitalized items. To protect the tenant in the case of a building that is not fully occupied, the tenant should ensure that the lease contains a provision calculating base year real estate taxes and operating expenses as if the building were fully occupied. In this way, the base year used in calculating escalations will not be artificially low, and the pass-through rent will represent a tenant’s fair share.
[3] How Much Is Negotiable When It Comes to Leasehold Improvements? Know Early On.
Owners will often agree, particularly in longer-term leases, to contribute to a tenant’s particular leasehold improvements. These monetary contributions factor into square footage market rents and are commonly calculated on a square footage basis. If instead of performing specific work owners agree to contribute funds to a tenant who undertakes improvements, owners will ordinarily do so much like a bank, in installments, after work is completed and paid for and upon receipt of lien waivers and an architect’s certification that the work has been completed pursuant to filed plans that were approved in advance by the landlord. Carefully negotiating workable terms in the lease can save tenants significant time and money.
[4] Beware The Expanding Building.
Miraculously, the square footage of existing New York office buildings defies the laws of physics and grows each year. “Phantom growth” may be buried in a lease as a mathematical formulation unmoored from physical reality. The term “loss factor” was dreamed up years ago by real estate executives to get higher rents without raising the price per square foot. Landlord measurements for the space rented by commercial office space tenants routinely include a pro rata allocation of the building’s elevator shafts, halls, stairwells, lobbies, walls and other unrented common areas. For example, an office tenant who needs 1,500 square feet of net usable office space and expects to pay $50/square foot or $75,000/year for the space should not be surprised when the landlord calculates that the 1,500 square feet will cost not $75,000/year but $100,000/year. The space you measured didn’t grow; rather, the landlord calculated its square footage measurement using a “loss factor” of 25%. When comparing the true cost of office space, tenants should know in advance the loss factor each landlord uses, as loss factors can vary significantly from building to building.
[5] Keep Your Options Open.
Business owners generally opt to rent rather than own their offices because renting is less capital-intensive in the short term and may not require substantial capital investment with extended financial obligations. While many business owners entering a lease focus on shorter horizons, a savvy tenant can and should plan whenever possible for renewals, expansion, and even contraction. Such changes may occur during or at the end of the initial lease term.
Tenant options, such as rights of first refusal or rights of first offer and options to extend or reduce the term or size of the space rented, come in all shapes and sizes and should always be explored. The costs of electing options have to be ferreted out and negotiated if possible. Landlords generally avoid offering such options, so negotiating options is best done prior to a tenant signing a lease when the landlord is most motivated to clinch the deal.
Exercise of an option to surrender portions of leased space prior to the expiration of a lease term may require a separate payment by the tenant. Timing and notice provisions governing early surrender options are key terms. Expansion and renewal options can sometimes be negotiated with landlord work, monetary contributions or rent credits from the landlord tied to requisite leasehold improvements. Renewal options based on market rents are often pegged to market rates at the time of the exercise of the option. A failure to spell out all details in the lease may lead to an uncertainty that does not serve a tenant’s interest.
[6] Watch Out For Hidden Costs of Leasehold Improvements.
Landlords will usually agree not to unreasonably withhold consent to a tenant’s request to make non-structural leasehold improvements. Such improvements must not adversely affect building systems or capacities or the building’s Certificates of Occupancy. However, landlords will generally require that the tenant comport with building standards and all legal restrictions. As a practical matter, with the exception of purely cosmetic work, the tenant will have to hire an architect to file plans with the Buildings Department and will have to obtain sign-offs of the work, including all electrical, mechanical and plumbing work. In addition, landlords will usually charge for their own architect’s and/or engineer’s review of any proposed alteration plans and almost always require that the tenant’s architect maintain and supply “as built” CADD drawings to the landlord in regard to a tenant’s work. Landlords will typically charge the tenant from 5% to 20% of the cost of a project for supervising and coordinating construction work. If the landlord or its contractors perform the work, charges for their overhead and profit will usually be factored in to the cost/price of the work. The best time to eliminate or reduce these additional fees is when the lease is being negotiated, not when the tenant decides to do the work.
The landlord will also will insist on reviewing the tenant’s contractors and subcontractors and their insurance policies; sometimes a landlord will also require that the contractors employ union labor. Unless a landlord agrees to waive such charges in the lease, a tenant will have to reserve and pay for all after-hours freight elevator service and staffing needed for tenant’s construction and after-hours HVAC supplied by the landlord. Many leases also contain such charges relating to a tenant’s initial move-in to the premises.
Finally, if the lease does not specifically address the question, the tenant ultimately may have to restore premises altered by the tenant to its original condition by removing tenant improvements or paying the landlord for doing so. A tenant therefore should not only obtain approval for expected work prior to signing the lease, but should also obtain approval for the improvements to remain at the end of the lease term. A good lease provides some degree of certainty that a security deposit will not be held hostage to these issues.
[7] Negotiate The Right To Make A Graceful Exit. Being A “Good Guy” Has Its Rewards.
Security deposit requirements in commercial office leases are significant considerations for every tenant and landlord. Because a lease is a contract, a tenant’s breach may give rise to a damage claim by a landlord for unpaid rent through the end of the lease term and for consequential damages. One might assume that language in leases requiring the landlord to make reasonable efforts to mitigate damages would then become an important topic for negotiation. However, as a practical matter, this is not true. If a tenant breaks a lease, the tenant entity in default will likely be judgment-proof, with no remaining assets to cover damages. Knowing this, landlords will seek protection by requiring either a substantial security deposit from a tenant or a personal guaranty of the lease by the tenant’s principals or parent. Tenants, on the other hand, will seek to avoid exorbitant security deposits or having to give full personal guaranties of the tenant’s lease obligations, which include liability for unpaid rent due over the remaining term of the lease and consequential damages. To solve this dilemma, leasing attorneys invented the “Good Guy” guaranty.
The Good Guy guaranty protects landlords from unscrupulous “judgment proof” tenants who stop paying rent and continue in business and possession of leased premises until forcibly evicted. A Good Guy guaranty is a limited personal guaranty. It is often given to the landlord by the tenant’s principals to reduce the size of a security deposit. A Good Guy guaranty terminates any personal liability of the guarantor for future rent if the tenant surrenders and vacates the leased premises in accordance with the terms of the lease without being in default up until the surrender date with specified advance notice and with all rent paid through the date of surrender. Where a tenant vacates leased premises pursuant to a Good Guy guarantee, the security deposit is not applied to the rent prior to the tenant’s surrender of possession and is forfeited by the tenant to the landlord. However, by surrendering in this fashion the tenant’s principal escapes further personal liability for remaining unpaid rent through the end of the term.
[8] Understanding Privity Is The Secret To Subletting.
Absent a landlord’s approval to relieve a tenant of lease obligations, a tenant may not avoid lease obligations by assigning or subletting space. When a tenant sublets space, the tenant’s contractual obligations to the prime landlord are not transferred or diminished. These rights and obligations arise from privity of contract between the prime tenant and the prime landlord. While subtenants are subject to and must comply with the covenants and restrictions set forth in the prime lease, a subtenant does not have contractual rights or claims against the prime landlord. Subtenants must ordinarily seek redress for any problems through sub-landlords.
In almost all circumstances, landlords require tenants to obtain approval before a tenant can assign or sublet all or a portion of the leased premises. Leases generally impose many qualifications to obtain this approval. Some leases strictly forbid sublets. Other leases restrict subtenancies with respect to the amount or the configuration or the terms for proposed sublet space. Still others may impose formidable qualifications for a proposed subtenant.
In addition to requiring approval of any sublease, landlords seek to recoup all or a portion of a tenant’s sublease profit. Tenants should always seek language requiring the landlord not to unreasonably withhold, delay or condition consent to a proposed sublet. Additionally, a tenant should seek to remove particularly onerous restrictions limiting subletting rights, especially assignment rights in connection with a sale, merger or reorganization by the tenant.
Just as a prime lease is subordinate to the landlord’s mortgage and can be foreclosed if a landlord defaults under his mortgage, a sublease is subordinate to a prime lease and can be foreclosed by a prime landlord if the tenant defaults. Under the prime lease, in both cases a tenant (with a mortgagee) or subtenant (with the prime landlord) can seek protection through a Subordination and Non-Disturbance Agreement. A landlord’s formal consent to any sublease customarily contains an attornment provision option given to the landlord from the subtenant recognizing the contract rights of the landlord against the subtenant pursuant to the prime lease. This can and should be adapted to provide a similar non-disturbance terms for the benefit of the subtenant.
[9] Don’t Sign Anything Until You Have Consulted with a Qualified Attorney with Leasing Experience in the NYC Office Market.
Commercial office leases in New York City generally run forty or more pages (in single-spaced, 10-point font) and contain fifty to sixty separate article headings and section sub-headings and sub-sub headings, and sub-paragraphs and sub-sub paragraphs—invariably addressing, in each instance, the responsibility and accountability of the tenant to the landlord for almost every conceivable eventuality. The panoply of these ‘standard’ lease clauses have one goal—to capture as much revenue and recover as many expenses as the landlord can from tenants occupying office space. Focus on the fine print is essential. Landlords are used to negotiating lease points, but they will not voluntarily relinquish rights or revenue streams unless the tenant or the tenant’s lawyer negotiates for them. The tenant must navigate the fine print to know what and where particular liabilities and revenue streams are incorporated. As such, the tenant’s attorney is an indispensable aid in avoiding the hidden snares and pitfalls found in office leases.
[10] Forbearance Agreements During the Current Covid-19 Pandemic.
When catastrophe hits many tenants will want to negotiate Forbearance Agreements to facilitate a stable platform during the crisis to lighten the load of a tenant unable to pay the total monthly rent due. Landlords will often agree to enter into such agreements to insure a fixed minimum cash flow to landlords, avoiding what could otherwise lead to a precipitous termination or abandonment of an existing lease. Tenants in entering such agreements seek to delay and/or reduce payment of the contracted monthly rent due over a fixed time period. These agreements commonly call for a scheduled repayment down the road of the reduced and deferred amount of rent in a lump sum or installments.
Such Forbearance Agreements are treated basically as lease amendments where the parties work out the business details in regard to basic minimum payments to be made and the time period for repayment of the deferred balance at or over a specific period of dates. Additional details are often included: if possible tenants will want to request a complete abatement of the deferred rent; of course, landlords will in most cases oppose a permanent abatement of the deferred rent. Outcomes with respect to the above will depend on negotiations between the landlord and the tenant, and the circumstances and results in regard to each lease will vary from landlord to landlord, and tenant to tenant. In each case, landlords and tenants will most likely want to include in the Forbearance Agreement a confidentially and non-disclosure agreement binding on the parties.
*Required Disclaimer: This alert is provided for informational purposes and does not constitute, and should not be considered legal advice. Specific facts and circumstances will differ. Neither the transmission nor the receipt of this information shall create an attorney-client relationship between the transmitter and the recipient. You should not take, or refrain from taking, any action based upon information contained in this alert without consulting legal counsel of your own choosing. Under applicable professional rules of conduct, this informational publication may be considered attorney advertising.
Louis E. Teitel is a partner in Dunnington’s real estate practice area. He has more than three decades of experience in the New York City real estate market, having counseled landlords, commercial tenants, real estate developers, portfolio investors, joint venture partners, office property managers, cooperative boards, and individuals in all manner of real estate transactions. Mr. Teitel has spoken on real estate law both in the U.S. and abroad, including a lecture series conducted throughout China.
