While we often comment on broader trends in real estate and the NYC economy, it is also important to go back to basics from time to time. As everyone is aware, the effects of inflation are being felt in both our business and consumer lives. Commercial real estate is no exception due to increased costs of such essential items as oil, electricity, and labor. As a corollary, the cost of construction is increasing dramatically due to the supply chain delays and higher cost of materials including aluminum, lumber, and steel.
The purpose of this article is to make 5 concrete suggestions to help our tenant clients avoid the full brunt of these costs when negotiating a new lease. Below is some initial context in which we provide those ideas.
Landlords will suffer the overwhelming impact of increased costs in operating their buildings and performing necessary renovations which include both normal upkeep and the need to construct new environmental features and amenities that clients are demanding. Tenants should therefore be aware that landlords have the right to pass on certain costs in their leases under escalation clauses which are generally considered “standard”. It is important to pause a moment to note that landlords are doing important and necessary work to upgrade their properties, which is the right thing. However, we primarily represent tenants who are small and mid–sized businesses whose power to block landlords from passing on substantial percentages of those costs (and each building is different) has historically been very limited. That is no longer the case in a secular bear market for NYC office space, with the exception of trophy Class A properties that are flying off the shelves, so to speak.
At a time when buildings are a little more than 1/3 occupied in New York City, tenants have more bargaining power than they may think. As a result, the savvy tenant may be able to negotiate leases that result in significant savings. Except for the very highest class of buildings, the leverage has shifted and it is very much a tenant’s market in the office sector. Accordingly, our clients should take advantage of their newly found bargaining power and consider raising the following specific issues in lease negotiations. Our five specific ideas for tenants to protect against the landlord passing along their increased costs are the following:
1) In every lease the landlord has the right to pass on a proportion of share of operating costs to the tenant. However, the manner of calculating this escalation varies from building to building. Some buildings have a fixed annual escalation dollar amount. Others have a variable percentage based upon the specific operating expenses of running the building as they turn out in a given year.
In times of high inflation like these, tenants may want to have a fixed increase rather than a variable one so that the landlord is bearing the risk of high inflation rather than the tenant. The agent for the tenant should run the numbers for their client so they can make an informed decision as to how to proceed. While a large landlord may be able to hedge against some inflation risk (as airlines do against higher fuel costs), it is impractical for a tenant to do so.
2) If a tenant must do significant construction work rather than receive a fixed dollar work allowance, they should finalize a floor plan before the lease is signed and have the landlord commit to building that plan. This is a much less risky approach than getting a fixed dollar work allowance. For example, while $80.00 per square foot may cover the work now with the economic situation in flux it may not be a large enough amount to cover all of the contemplated work in three months when the construction project starts.
3) If possible avoid construction completely and opt for a pre-built space as construction costs are higher than ever. Note that sometimes construction is a good idea for the tenant because the deal is so favorable that it is worth the additional cost. However, if they can tenant should avoid raw space which is the most expensive construction job, as compared to the modification of existing space which is a cheaper alternative. And if you have to take raw space, make sure that the landlord is doing the buildout as they are experienced builders – tenants are not.
4) The proportional share increase in taxes allocable to a tenant in the building is generally passed straight through in the lease to the tenant. However, tenants should request a base tax year as far in the future as possible. Accordingly, a tenant negotiating a lease in 2022 should ask for a base year of 2023.
5) Electric costs are also generally passed through to tenants. However, if your electric is on a submeter, you can actually turn the lights out or monitor your usage more closely than before, hopefully with the assistance of technology. This is as old school as it gets, but might help a bit.
Finally, beware the real estate broker who tells you that you can terminate your lease early. You can do so, but it will be very costly. The better approach is to try to sublet excess space with a minimum of fuss. We can assist with that as well.
During these times of March Madness, we (under)score that in real estate as in basketball it is important to stick to fundamentals. Don’t complicate things – take the easy layups. Every little bit of savings helps. Please feel free to contact Wharton Property Advisors to tap our expertise regarding all matters involving your office space. We represent our clients with creativity, integrity, diligence, and independence.