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Tenants: Don't Wait, Act Now on Lease Negotiations

Rather than maintaining the status quo during the recession, smart tenants will take action with their landlords and use the downturn to negotiate the most bang for the buck.

Feb/Mar 09
In these uncertain times, most companies are sitting on the sidelines and waiting to see what happens as it relates to their real estate plans. Like investing in the stock market, following the trend will probably not produce the desired results. But for savvy investors, bucking the trend and taking advantage of this down period in the market will result in savings for companies that lock in lower cost options in long-term leases.

As in most markets, no one knows where the bottom will be, and by the time they think they've reached the bottom, they've already missed it. To follow hockey legend Wayne Gretzky's advice, "I skate to where the puck is going to be, not to where it has been." Over the last few downturns in the real estate market, many companies locked in long-term leases and, by doing so, kept their costs considerably lower than their competitors, who watched and waited for the market to drop further while in fact they had already missed the opportunity.    

What to Ask For
In today's climate, tenants can use leverage when negotiating rental rates and other important lease terms that will have a serious economic impact on their bottom line. Over the past six months, rental rates in Manhattan overall have fallen 8 percent to around $60.44 per square foot, while vacancy rates have risen to 10.1 percent. Landlords are anxious about the current and future state of the market, and consequently are offering more attractive lease terms. Terms such as options to expand, contract, or renew; favorable escalation clauses; electric rates; and cleaning costs can have major financial impacts on long-term leases.

For example, one of the biggest costs to a tenant is the cost of renovation, whether to current space or a relocation. Landlords are now offering greater tenant improvement allowances and in some cases will build-to-suit to tenants' specifications. In addition, in order to attract tenants to vacant spaces, many owners are now offering full architectural services at owners' cost, which could translate to $4.00-$7.00 per square foot, thereby saving tenants upfront capital outlay. Tenants should keep in mind, however, that their leverage is relative to the size of the transaction and credit worthiness.

What to Expect
The process of negotiating a new lease (relocation or renewal) could take 12 to 36 months, depending on the size of the transaction. Due to the volatility of the economy, the market can change during this period of time; therefore, starting the process in the down cycle is even more crucial.

Many tenants attempt to renegotiate their leases on their own due to their "good relationship" with their landlord. Tenants should realize, however, that they are negotiating a contract that accounts for one of their largest cost obligations. Not having professional representation is similar to going into the courtroom without an attorney - it leaves them vulnerable.  

A Sample Negotiation
In the last market downturn, in 2002, IBM hired a consultant to review the terms that its landlord had proposed for renewing the lease terms on its New York City headquarters. IBM had previously engaged in direct conversations with the landlord. Since the company had been the original tenant in the building at 590 Madison and also an equity participant, it assumed that the terms that had been presented by the new landlord would be at market rates due to the company's history and credit worthiness. However, upon reviewing the terms, it was obvious that the landlord perceived IBM as a "captive" tenant, assuming that they would not leave the "IBM building."

When the consultant surveyed the marketplace in similar quality properties, he realized that IBM was, in fact, paying a premium when it should have been receiving a discount. The landlord, realizing that IBM was in the market and serious about relocating, began to discuss a substantial reduction in rental rates, as well as offering an increase in concessions. During this process, which took approximately 18 to 24 months, IBM realized that by consolidating in other, less expensive locations outside of New York City, its commitment in Manhattan would be reduced, resulting in millions of dollars in savings. Due to the drastically reduced rents, the work letter (which originally had been offered on an "as-is" basis) and consolidation, IBM saved in excess of $50 million.

By committing to a deal while the market was in a down period, IBM was able to lock in a long-term deal at low rates. The rents in this property climbed 30-50 percent over the next few years.

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