General

By Michael Schiff, Executive Vice President, NAI Capital

The decision regarding how long of a lease to sign is very different for an office tenant than it is for a retailer.  An office tenant needs to consider, among other things, how long it will take before they outgrow their space, and if they predict rents will be higher or lower at the end of their lease term.  As an office tenant’s business grows, typically the number of employees they have also grows and they therefore need larger space.  It’s a bit different for a retailer because as a retailer’s business grows, the retailer usually expands by opening up more units, not expanding the square footage of each unit.  In addition, retailers don’t like to relocate profitable stores at the end of the lease since, as the saying goes, “If it ain’t broke, don’t fix it”. 

When a retailer already has one or more successful stores and they come to me wanting to open another, they almost never want anything less than a 5-year lease.  But what about the entrepreneur who is about to open their first store?  They of course believe this new business venture will be successful (they wouldn’t be investing their money into it if they thought otherwise), but until this is proven, they worry about committing to a 5-year lease.  I can’t tell you how often I hear first-time retailers say, “Will the landlord consider doing a 3-year lease instead of a 5-year lease?”  Some landlords will not do anything less than a 5-year lease while others will do it but give very little in the way of leasing concessions (Free Rent, Tenant Improvement Allowance, etc.).

If a landlord is willing to do a shorter term lease to appease the nervous tenant who is opening their first store, is this something the tenant should push for?  Before I offer an opinion on the answer to that, it is important to understand the tenant’s liability if they do default.  Some people think that if they sign a 5-year lease and default after year 1, they are required to write a check for the remaining 4 years of rent left on the lease.  Fortunately for tenants who go out of business, this is not at all the way it works.  Without going into a long dissertation on a landlord’s legal recourse, the simple fact is landlords are only entitled to recoup whatever damages they incur.  This includes things like current and future loss of rent as well as whatever expenses they incurred evicting the tenant and re-leasing the space.  Having to pay these kinds of damages is what I would refer to as the worst case scenario.  Since almost all leases provide the tenant the right to assign or sublease, this is without a doubt the better way to go if you are able to.  Think of it as selling your house before the bank forecloses on it – Even if you are only breaking even or taking a slight loss, it is the much better option because you will avoid paying late charges, interest fees, legal expenses and court fees the landlord incurred processing the eviction, etc. (all of which I consider throwing money out the window).  Many tenants who sublease their space come out relatively unscathed – only having to pay a subleasing commission for the period remaining on their lease.  Heck, some tenants are even lucky enough to sublease their space at a profit because rents had risen from the time they originally signed their lease.  (Side Note:  Try to make sure your lease does not state that all profits made from subleasing must be given to the landlord).

Now, let’s get back to answering the question about a 3-year lease vs. a 5-year lease.  Here are some of the pros to signing a 5-year lease:

#1 – It is usually easier to sublease a space that has a longer term remaining.

Most businesses that fail do so in the first 12 months.  If your business has lasted 3 years, it’s probably safe to say it’s successful.  However, if your business is still struggling at the end of the first year and you are starting to run out of money, you will want to begin looking for a sub-tenant to sublease it to.  Subleasing a space that only has one or two years remaining on the term is difficult.  Any potential sublessee will be fearful that, if at the end of their lease term they don’t want to move because their business is successful, the landlord will take advantage of this situation by significantly raising the rent.  This is a legitimate concern since landlords know that tenants rarely relocate successful businesses.  In addition, if the sublessee’s type of business is one that requires an extensive build-out, they certainly will not be willing to invest the tenant improvement dollars into a space that only has two or less years remaining on the lease.  Even if you have an Option to extend the term for an additional 3 years (assuming the lease allows such Option to be transferred to the new sublessee), 5 years with no options remaining is not considered a long time in the business world.  However, if you sign a 5-year lease with a 5-year Option and decide after the first year that it is not working, you will most likely have an easier time subleasing since most subtenants will feel that 9 years (4 years plus the 5-year Option) is an adequate amount of term remaining.  Ask yourself the likelihood of your business failing at the end of its 3^rd year vs. the 1^st or 2^nd year (which is statistically unlikely).

#2 – The longer the term, the more concessions you will typically be able to get from the Landlord.

When you are negotiating the terms of your lease, you will almost always be able to get more free rent on a 5-year lease than you would on a 3-year lease.  The same holds true for Tenant Improvement Allowances – If the deal includes a T.I. allowance, the landlord will not be willing to give as much on a shorter term deal because they have to amortize the free rent and T.I. allowance over the initial lease term.  Obviously it pencils better to amortize these costs over a longer period of time.

#3 –  If your business is successful, you will regret not having a longer lease.

3 years (or 6 years if you get a 3-year lease with one 3-year option to extend) goes by way faster than you realize.  If your business is as successful as you predict it’s going to be, you’ll be kicking yourself 6 years from now when you have no option terms remaining and the landlord is raising your rent to whatever rent they think they can get away with charging you.  If rents have risen significantly by the time your lease expires and the landlord raises your rent to market value, this could be a huge blow to your bottom line profit.  Will your business be able to afford a 20% or higher rent increase?  It is for this reason that many tenants (especially those who require expensive build-outs) prefer to sign 10-year leases with two 5-year Options.  This gives them a 20-year term which puts them in the driver’s seat with the landlord for a long time.

#4 – You will have a very difficult time selling your business if you don’t have a long term lease.

What if your business is so successful that you decide to sell it and retire?  When buyers look at purchasing a business, one of the first things they look at is how much term is remaining on the business’s lease.  Selling a retail business with almost no term remaining is next to impossible since without a lease, the business is most often worthless.

So when would it make sense to do a 3-year lease instead of a 5-year? I can only think of two reasons:

#1 – You know you will want to upgrade your space in 3 years.

If the shopping center you are leasing space in is less than desirable or not a great location but it is all that you can afford right now, it might be a good idea to sign a shorter term lease.  Then after the business has proven itself and you can afford higher rent in a better location, you can do so at the end of your short term lease. This most likely will only make sense if the cost to build out your store is relatively inexpensive since it won’t make sense to invest a ton of money into a short-term deal.  You would not invest into putting a pool in the backyard of a house that you were only renting for 3 years, would you?

#2 – You predict rents will be lower in 3 years.

If you think rents are going to be lower 3 years from now, you might be able to negotiate a better lease rate with your landlord in three years when your lease expires.  There are of course several problems with this:  First, nobody has a crystal ball so it’s impossible to predict if rents will be going up or down, and most experts (myself included) predict that rents will be higher 3 years from now.  Secondly, if you really think rents are going down, you are making the prediction that our economy is headed in the wrong direction.  It’s doubtful that this is really your prediction because if it was, you most likely would not be opening a new business right now.  Lastly, let’s say your rent is a little over market 3 years from now – The landlord is still in the driver’s seat because they know that the cost of moving is expensive (not only the actual out-of-pocket costs but also the potential loss of business).   Would you relocate your business just because rents on comparable properties were 5% cheaper?  Of course not.

I always tell my clients to do whatever they are comfortable with and nothing more.  There are pros and cons to a 5-year lease vs. a 3-year lease and each deal is unique with its own set of circumstances, however there are many advantages to a longer term lease and for most people the pros seem to heavily outweigh the cons.