Is This the New Normal for Leases?

It can be hard to get an accurate picture of what’s going on in the commercial real estate market: anyone’s view always depends on the deals he or she is seeing.

Out here in Southern California, I’ve been hearing a lot from various landlords seeking to fill their buildings that, despite all the happy talk about the economic recovery (the U.S. economy reportedly grew at a 2.8 percent annual rate in the fourth quarter of 2010), the market is still extremely favorable to tenants. They report that even paying tenants are renegotiating their leases at steep discounts compared to their prior lease rates.

This seems to be borne out by yesterday’s report from Moody’s, which said that U.S. commercial property prices (as measured by the Moody’s/REAL Commercial Property Price Index) slipped for the second straight month in January, slumping 1.2 percent from the previous month and 4.3 percent from the previous year. Moody’s interpretation was that distressed real estate sales have been holding values down.

Some of the landlords I’ve talked to think that this is only part of the problem, and that office and retail tenants are losing business and are forcing rents down radically. Worse, many complain that to fill their buildings, they need take a lot more financial risk by providing better tenant improvements ("TIs") to get worse lease deals.

What we’ve seen recently in a number of neighborhood grocery anchored centers, for example, is that almost all of the non-anchor tenants have either closed, or renegotiated their rent to be approximately half of their prior rent – which also means they are typically triggering loan covenant defaults by the property owners. (Some of the anchor tenants are doing so also.) Some of the lenders are ignoring these defaults, apparently hoping that the situation will right itself so that enforcement action will not be required – even if their borrowers, the property owners, approach them affirmatively to try to work out their loan issues.

In the lease renegotiations we’re seeing, I’m also seeing tenants negotiating hard to shift risks to their landlords. Obviously, the success of such tactics depends on the parties’ leverage – institutional creditworthy tenants will do better than mom-and-pops. In addition to seeking reductions of rent, here are some of the most common tenant-friendly provisions currently being negotiated by credit tenants:

1. Termination Rights. If a landlord can’t deliver the premises in "ready for tenant’s work" condition to the tenant within a certain time period (e.g., 30 or 60 days) after lease execution, most significant tenants are now requiring the right to terminate the new lease.
2. Use. Tenants are demanding, and getting, broad use clauses – which can create havoc with other tenants’ exclusive rights if not carefully monitored.
3. Loan Requirements. Many currently proposed leases don’t meet all of the minimum leasing requirements of the loan encumbering the center. Even if a landlord wants to give up these requirements in order to pin down a tenant, it may not have the right to do so without the prior written approval of its lender.
4. Taxes. Tenants are requiring that the landlord/property owner, and not the tenant, be responsible for any increase in taxes due to sale or transfer during the initial term.
5. Audits. Many tenants are seeking the right to have their audits conducted by contingency auditors.
6. Service Interruptions. If services such as electricity or water are interrupted, even if the landlord did not cause the interruption and has no control over it, many tenants are asking for rent abatement if services are not restored within 2 – 3 days, and for the right to terminate the lease if the services are not restored within a longer period of time (such as 30 or 60 days).
7. Condition at Delivery. Landlords are being required to deliver the premises in compliance with all applicable laws, including with the Americans with Disabilities Act, and are being made responsible for paying the costs (without pass-throughs) and doing the work needed to bring the premises and any building in which they are located into compliance as of the commencement date of the lease (as opposed to being responsible only for complying with any changes in law).
8. Improvements. Tenants are demanding that they not be required to remove their initial improvements at the end of a lease (which can be expensive for a landlord stuck with out of date TIs in its property). Further, they are seeking to do alterations that don’t materially and adversely affect the building – even structural alterations – without first obtaining their landlords’ consent.
9. TI Allowance Disbursements. Tenants are seeking to have to provide conditional lien waivers prior to disbursement only from the general contractors, not from all of the subcontractors and suppliers.
10. Options to Renew/Purchase. Tenants are seeking longer options to renew at a then below-market price. Some are even seeking options to purchase the properties in which their premises are located.

Other requests I’ve seen negotiated are requests for better signage, for caps on administrative expenses, for limitation on expenses that can be passed through to the tenants, for free and/or reserved parking, and for more tenant-favorable risk-allocation language concerning hazardous materials and indemnities.

Obviously, this shift in leverage is great for tenants and not so great for landlords.

So, is this "the new normal"? How long will it last? I’d love to hear your opinions about whether these renegotiations are happening on the ground in your market, and if so, your opinion about how long it will be until things change, and what will trigger a change in your market.