Help! My Landlord Wants to Double My Rent!

If you’re an office tenant in San Francisco (or any other market where vacancy is plummeting), there’s no doubt you’ll probably face a substantial rent hike upon your upcoming lease expiration. Since 2010, rents in the City have risen 39% and in 2012 alone, 24%; representing the biggest gain of any market in the world.

Relocating your office can be expensive and disruptive to your business, so if your first choice is to stay and renew, here are a few strategies that can help mitigate the rental increase.  The days of passive negotiation are gone; you need to be proactive.

1. Renew your lease as early as you can.  The sooner you renew, the lower your rate will be.  Unfortunately, your landlord is also aware of this and typically will not renew your lease if too much term is remaining.  They’d much rather have you come back to negotiate at a later date, when rents are higher.  Every ownership is motivated by different things, however, so it doesn’t hurt to begin the dialogue early. 
2. Explore options outside of your building.  Even if you fully intend to stay, you need to get out in the market and see what else is available.  You cannot expect to have any negotiating leverage with your landlord if their property is your ONLY option.
3. Explore options within your current landlord’s portfolio.  If you’re getting priced out of your current office space, perhaps there’s a less expensive option elsewhere in the building on a lower floor, or even within another building your landlord owns.
4. Reduce your square footage.  One of the most effective ways to reduce your monthly operating expenses is to simply lease less space.  Identify inefficiencies within your current space and consider consolidation or reconfiguration.  Are there employees in private offices that could be just as effective in a workstation?  Could employees who are out of the office regularly share a common workspace? There also might be an opportunity to “give back” some space upon your renewal whereby the landlord carves out a section of your office and builds a demising wall, thus reducing your rentable square footage.
5. Hire a commercial real estate advisor.  Your broker is the best source of market information, and when you’re well-represented, your landlord knows you have access to valuable market information and may potentially relocate if they don’t offer you a fair deal.  But your broker also knows something your landlord does: renewing existing tenants is cheaper for the landlord than signing leases with new ones. Should you leave the building, the landlord will temporarily lose rent while the space is unoccupied. Also, brokerage commissions and tenant improvement allowances are typically higher on new leases.  Your broker will quantify these costs, translate them into real numbers your landlord can understand and then make a business case as to why your renewal rate should be lower than their current asking rate.

Rental increases are a natural part of the cycle and being prepared and proactive is the best way to mitigate an inevitable rental hike.  Ultimately, you’ll need to weigh out the two options of either staying in your space and softening the blow, or relocating to a less expensive building or submarket.

See also: When is the Best Time to Renew an Office Lease?

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Is “Free Rent” Really Free?

Depending on what stage of the “cycle” the real estate market is currently in, landlords will sometimes offer tenants “Free Rent”; but what exactly is it and why do landlords use it?

Free Rent is a number of months that a tenant is allowed to occupy their space without having to make rental payments and is typically applied to the beginning of the lease term.

However, to really understand the concept of “Free Rent”, it’s important to look at it from the landlord’s perspective.  Offering a tenant free rent creates perceived value and is a compelling incentive when signing a new lease or renewal, therefore it serves as an effective strategy for luring tenants.  But it the tenant truly getting “free rent”?  Not exactly.

A landlord is focused on the “Net Present Value” of the lease when evaluating a transaction, or rather, the total dollar amount a tenant will pay in rent over time, after taking into consideration the time value of money and applying a “discount rate”.

What we’re really evaluating here is the “effective” or, average rent – which in both of the following cases is $24.00 per square foot, annually.  If a landlord offers a tenant 2 out of 12 months free with a $2.40 start rate, it’s essentially the same as offering another tenant 0 out of 12 months free with a $2.00 start rate.

This can be extremely beneficial to a tenant, since foregoing rental payments for a few months can help offset their relocation costs, or any of their own money they may have used to build out the premises.  Free rent at a new location can also help a tenant relocate from their current location in advance of their lease expiration date.

But for a landlord, it helps maintain a higher contract rent, which over time results in a more profitable building.  Take the previous two lease offers, for example.  The landlord would much prefer brokers trade a recent lease comparable with the higher $2.40 start rate, because they want rental expectations to be set as high as possible for their property.  And from the perspective of the lender or investor, this keeps them happy and in some cases there might even be a price per square foot threshold lease rates need to stay above in order to get their approval.  Factoring “free rent” into the overall economics of the transaction helps achieve this.

There are a few pitfalls a tenant needs to watch out for, however.  Before signing your new lease agreement or lease renewal, look out for a clause called “Inducement Recapture” and make sure your broker redlines it.  If you don’t and find yourself in default, you could be held liable to repay in arrears for any free rent you received at the beginning of your term – this could get expensive.

Also, make sure you’re not leaving any money on the table that could be applied to your transaction as free rent.  For example, if the landlord is offering a $10 per square foot tenant improvement allowance and you’re fine with taking occupancy “as is”, don’t just spend the money just to spend it, or walk away from it altogether.  Rather, negotiate to have that allowance converted into free rent.

The number of months in free rent a tenant receives depends on many factors such as a tenant’s current leverage in the market, the financial health of the landlord and the building’s vacancy rate.  Hiring an active tenant broker to represent you in your lease transaction will ensure that you receive the maximum benefit of incentives the market currently has to offer.

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How much office space should I REALLY lease?

Leasing too much (or too little) office space can be a costly mistake, however determining exactly how much space you require is one component of the leasing process that is often rushed or inaccurate.

Unfortunately, our industry is partially to blame for this.  Tenants often think they need more space than they actually do, and since a broker earns more when you lease more, they may be the last person to tell you that you could scale back.

Taking the time to identify the size, configuration and quantity of each element of your new office will not only save you time and money down the road, but chances are you’ll find that you require less space than you originally thought you did.

Old rules of thumb such as, “tech tenants require 150 square feet per employee, and law firms require 350” is an unreliable measure and nothing more than an insightful metric for spotting a gross irregularity; there are far too many variables involved in determining your space requirement to simplify it in this way.

A better and more accurate solution is to take an analytical approach by using a tried and true Excel spreadsheet.

First, calculate the quantity and size of all your desired offices, cubes, conference rooms and supporting spaces such as kitchens, server rooms, storage closets, reception area so as to arrive at your Net Square Footage.

Then factor the following into your spreadsheet as they’ll substantially affect your true space requirement.

• Circulation Factor – this is simply “the space between” and takes into account all the interior space that hasn’t yet been accounted for such as hallways and walkways between cubes.
• Load Factor – Buildings add a percentage on top of the actual square footage of your office to account for common areas such as lobbies, restrooms and hallways.  This is the difference between the Useable Square Footage (USF) and Rentable Square Footage (RSF). Properties can vary greatly in how efficient they are, and a good broker will not overlook this important factor.

Finally, this exercise will yield an accurate square footage of what you require today, but what about in the future?  Take time to consider factors that will affect your space requirement throughout the term of your lease such as hiring or consolidation, planned mergers and acquisitions and changing in funding schedules.

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