In recent years, three to five year terms were the norm for the Las Vegas office market. In the face of uncertainty, many tenants are asking for terms of one to three years. How do you determine the “right” lease term?
Your real estate decisions should support your business plan. We’ll explore how two business scenarios affect leasing strategy. Firstly, a “Survival” strategy focuses on defensive measures. The “Flexibility” strategy takes a longer term approach and is designed to take advantage of the opportunities offered by the current market.
If your business forecast includes falling income and reduced head count in the near term, the focus will be on short term survival. Priorities will include minimizing rental expenses and lease commitments.
The objective in this scenario is to negotiate the short lease term (one to three years) without incurring a substantial rate premium. Fortunately, current market conditions are conducive to this strategy as most landlords are focused on shoring up cash flow for the short term.
The sweet spot between rate and term will vary based on your landlord’s (and possibly their lender’s) perspective. Proposing more than one term can yield the answer.
If you’re concerned about survival, a short lease term will have the additional benefit of reducing your liabilities. This is particularly relevant if your lease contains a personal guaranty (a common requirement for small businesses). In the event that you’re forced to close the location, minimal liabilities (including loans, lines of credit and leases) will help reduce the effect on your business or personal credit.
In the second scenario, the viability of the business is secure, however there’s uncertainty regarding future needs (ie contraction versus expansion). The objective is to balance cost control with flexibility. The key difference between this situation and the “Survival” scenario is that the real estate decisions are based on a longer timeline.
For example, what happens when a short term lease expires in two years? If the economy is in recovery mode, rental rates will spike as demand outstrips supply. Rental rate increases will be more dramatic than in past cycles because the lending environment has frozen almost all speculative development. The result is a two year period (“Development Lag”) during which developers and lenders will scramble to catch up.
During the Development Lag period, landlords with existing product will enjoy unprecedented pricing power. In the absence of alternatives (new development), tenants will be competing for a shrinking supply of office space. Ideally, you would avoid entering a new lease during this period.
A good leasing strategy will address the short and long term factors affecting the business. For example, a 3 – 5 year lease term could include the following features:
• Reduced lease rate
• Rental abatement (free rent) in the near term
• Option to Terminate
• Option to Expand
• Option to Renew
The strategic approach will allow the business to balance real estate expenses with flexibility. Just as importantly, your business will enter the next economic phase with lower real estate expenses than the competitors who failed to take a long term approach.
Your tenant broker can provide guidance on leasing strategies that support your business model, allowing you to focus on your business.