When it comes to running a successful business, corporate real estate agreements don't always fall at the top of the startup executive team's list of priorities. However, they would be wise to not overlook several key issues that could potentially result in devastating consequences to future business transactions, or at the very least give cause for serious headaches to all involved. This article, written by Gabe Chao, Esq., Managing Director at Newmark Cornish & Carey, outlines the top issues that startup executive teams should be wary of when entering into any real estate agreement.
Arguably the most important issue for a startup to address is the exit strategy (most often through a sale of the company). During my legal career, of the thousands of term sheets that came across my desk, never did a broker adequately address this issue. Typically, the issue gets glossed over or left out of the term sheet entirely. This (i) results in many leases not including adequate protections for the company, (ii) ends up costing the tenant more in legal fees (even if the attorney happens to understand how to negotiate for these protections, and many don’t), and (iii) could result in a landlord holding up a multi-million (or billion) dollar deal). This is the proverbial tail wagging the dog. I would estimate that 99% of brokers don’t consider this issue, and if they do, they don’t understand how to request the adequate protection in the term sheet. In my personal experience, sophisticated owners (especially institutional owners) have never refused this request once they understand the business and legal reasoning.
One way that landlords like to “handcuff” tenants to limit tenant leverage during lease renewal negotiations is to include onerous provisions in their leases requiring the tenant to restore their space to a specified condition. Landlords know that if their lease agreements make it extremely cost prohibitive for a tenant to move, even if lower rent alternatives exist, then the tenant’s threat of leaving (the tenant’s only real leverage) is diminished. By understanding how to navigate this issue, I was recently able to help a client save over $1.5 Million immediately by having the landlord agree to remove the tenant’s restoration obligations out of an existing lease during lease renewal negotiations. This was not a potential savings, but quantifiable immediate savings.
Operating Expense Passthroughs
Tenants typically focus on the base rent figures because those figures are easy to compare against other options. However, tenants have additional payment obligations other than simply the base rent, and landlords know how to manipulate those obligations in their form leases. The parties typically wait for lease negotiations to address these issues because (i) brokers typically don’t understand how to deconstruct the standard lease provisions to address these protections for the tenant, and (ii) it takes more time to push for these during the term sheet phase (when brokers simply want to close and move on after identifying the space). However, by waiting until the lease document phase rather than negotiating during the term sheet phase, the tenant loses leverage and it also will cost the tenant much more for the attorneys to negotiate rather than addressing these issues in the term sheet phase. For any sizable transaction, I negotiate these tenant protections directly into the term sheet to maximize leverage and save the client thousands in legal fees; but most importantly, achieving the OpEx protections ultimately can save a company hundreds of thousands of dollars over the term of the lease.
Real Estate Taxes
In a typical “full service” office lease with a base tax year, landlords can achieve a windfall and “double dip” from the tenant if the landlord successfully appeals real estate taxes during the base tax year. Landlord enjoys the tax reimbursement, but with a lower tax base year (and tenant paying the increase in taxes above the base tax year amount), it would be the tenant who ends up paying significantly more over the term of the lease. Most brokers don’t know how to address this issue in the term sheet. I have seen brokers attempt to address this issue, but when pressed for an explanation from the landlord during negotiations, cannot articulate the rationale and end up looking silly attempting to ask for this (and end up not getting it for the tenant). I understand how to attack this issue, and have even had a client’s real estate attorney (a partner at one of the largest law firms in the world) ask me to help draft the protective language during lease negotiations because she felt I had a better understanding of the issue.
A main concern for a startup is business uncertainty. The company does not know where it will be in 6 years, let alone 6 months, but landlords are trying to lock in tenants for a longer term while the market experiences historically high rental rates. Brokers rarely try to push for a shorter term or consider other alternatives because brokers get compensated more for longer terms and more square footage. Sadly, this is a pervasive practice in the industry. I help clients exhaust efforts for more flexible lease terms, even if it means lower compensation in the short term. For example, in one recent transaction, my client’s previous broker advised that anything shorter than a 5-year term would be nearly impossible in the current real estate climate. However, I was able to help my tenant client negotiate a short term lease, and also a “rent phase-in” so that the tenant paid rent calculated based on a lower rentable area during the first 18 months of the lease term, which would only later increase and be calculated based on the actual larger square footage to allow the tenant to grow into the space. This allowed the company to free up valuable capital during its growth phase, rather than having it tied up in rent.
A version of this article can also be found in Mr. Chao's published articles on LinkedIn. For more information please contact Mr. Chao directly by emailing firstname.lastname@example.org.