As discussed in my article, What’s a Cap Rate?, a capitalization rate is the unleveraged return generated by an income producing property; meaning if an investor bought a property all-cash (no financing) the cap rate would reflect the ratio of the property’s net operating income (NOI) to the purchase price. For example, if a property’s NOI is $100,000 and is purchased for $1,000,000 the cap rate would be 10%. Cap rates are used to calculate an asset’s value using the direct capitalization method in which the property’s net operating income is divided by the cap rate.
Cap rates are constantly changing because they are determined by the interaction of the capital market and space market, which are also in constant flux. Cap rates vary by market, asset type, asset class, etc. and reflect the demand for and risk associated with an asset. Market cap rates can be calculated through an analysis of recent sales comps but are still relatively subjective as they indicate how much an investor is willing to pay for a dollar of NOI.
Discount rates are similar to cap rates because they too are used to calculate value using a property’s net operating income; however, discount rates are applied to future income streams while cap rates are applied to a property’s current NOI. This is an important distinction because additional risk must be factored into the rate of return to account for potential changes to the property’s income. Therefore, a discount rate can be defined as the current market cap rate plus a risk premium. Like the direct capitalization method, a discounted cash flow analysis calculates an asset’s value by dividing future net income streams by the discount rate. Using the previous example, an investor may apply an additional 2% risk premium to the 10% market cap rate for a discount rate of 12% thus lowering the price they are willing to pay for the same asset to $833,333.33 ($100,000 ÷ 12%).
While market cap rates do reflect elements of risk, discount rates provide a more comprehensive approach to property valuation and are particularly useful when calculating the value of multi-tenant properties and multiple income streams. Every tenant’s risk profile is different and leases expire at different times. The discounted cash flow model allows investors to apply individual discount rates to specific income streams to account for the opportunity cost associated with each. The discounted income streams are then added together to calculate the price an investor is willing to pay for an asset which reflects their confidence in each income stream and risk tolerance.
When you’re at the top, the only way to go is down. The East End, CBD, and West End are considered the DC metro area’s premier office submarkets; however, millions of square feet of new supply added to nearly 13,000,000 SF of vacant space along with competition from emerging submarkets like NoMa and Southwest have caused fundamentals to suffer, a trend that may continue for the foreseeable future.
RBA: 53,024,189 SF
Vacancy Rate: 14.4%
12 Month Net Absorption: (117,000 SF)
Average Asking Rent: $57.22
12 Month Rent Growth: 0.1%
The East End is the largest and most expensive submarket in the DC metro area with over 53,000,000 SF of inventory and an average rental rate of $57.22/SF; however, competition from emerging submarkets with lower rents and increases in supply have resulted in negative absorption, rising vacancy rates, and anemic rent growth. Developers have been demolishing older office properties and building trophy assets in their place; delivering over 1,600,000 SF in the past 12 months. This led to a 2.9% increase in the vacancy rate in the past year. In addition to the new supply, more than 10,000,000 SF of older supply remains vacant. Interestingly, a large portion of this inventory consists of 4-Star properties built before 2000. The 14.4% vacancy rate is 1.5% higher than the metro average. This disparity is dwarfed by the difference between the East End’s availability rate compared to the metro average: 21.3% to 17.1%. The forecast for East End fundamentals is grim as traditional tenants (corporate law firms) continue to downsize while others look at other submarkets like NoMa and Southwest that provide the same quality product at more affordable rents.
Central Business District (CBD)
RBA: 45,135,622 SF
Vacancy Rate: 10.9%
12 Month Net Absorption: (433,000 SF)
Average Asking Rent: $54.07
12 Month Rent Growth: -0.3%
The CBD submarket is 2nd only to the East End in terms of total inventory, asset value, and average rents at over 45,000,000 SF, $22.2 billion, and $54.07/SF respectively. Unfortunately, the submarket is also experiencing similar trends and the associated pains. Like the East End, developers are repositioning older assets and flooding the submarket with new supply. Over 360,000 SF has delivered in the past 12 months with an additional 600,000 SF delivering by year’s end. This new glut of supply has resulted in over 433,000 SF of net absorption over the past 4 quarters; leading to a 0.9% increase in the submarkets vacancy rate and a 0.3% drop in rents. Fundamentals should continue to suffer as another 557,000 SF is scheduled to deliver in 2020.
RBA: 4,822,739 SF
Vacancy Rate: 8.1%
12 Month Net Absorption: (49,800 SF)
Average Asking Rent: $51.18
12 Month Rent Growth: -0.8%
The West End submarket may be included in the Downtown DC submarket cluster along with the East End and CBD and is similar in that it has some of the highest rents in the metro area, but at only 4,822,739 SF of total inventory it only 9% and 10.7% the size respectively. The office inventory in the West End is old with average age of 59 years (median 41 years); however, due to limited developable sites and the associated construction costs there are no new projects under construction or proposed. While the lack of new supply has kept vacancy rates below the metro average, the submarket’s aging inventory and high rents have led to a flight-to-quality and more affordable submarkets; resulting in a 1% increase in the submarket’s vacancy rate in the past year and an associated 0.8% decrease in rents. The West End is also a “big footprint” submarket with approximately 40% of tenants occupying more than 10,000 SF; making it especially vulnerable to move-outs. The outlook for the West End is grim as traditional tenants (government, law firms, and consulting companies) continue to downsize and others relocate to emerging submarkets.
Commercial leases are full of “dos” and “don’ts” along with penalties for doing any of the “don’ts”” and/or not doing any of the “dos.” The good news is that there are also typically grace periods before the associated fees, interest, etc. apply. These penalties can range from nominal fees to the landlord terminating the tenant’s right to possession of the premises and accelerating the remaining rental payments. Grace periods can also range from a couple days to a relatively indefinite amount of time under the condition that the tenant is diligently pursuing a cure to the default in question.
While most numbers are relatively arbitrary there are generally accepted/reasonable standards that limit grace periods and penalties. For example, some landlords may provide a tenant up to 5 business days after written notice for nonpayment of rent before it is considered an event of default while others may only provide 3 days with no written notice. Both could be considered “reasonable” but most would agree that 30 days is not. Another example, and the focus of this article, is the interest and/or late fees incurred for the nonpayment of base rent or additional rent. While the interest is generally capped at the highest non-usurious rate allowed by law, the additional rate above the Prime Rate and fee amounts can vary based on the tenant’s negotiating leverage, market conditions, etc.
When it comes to penalties, tenants can try and extend the grace period and/or limit the fee/interest charged, but this could raise some red flags in the landlord’s eyes. Grace periods are already a concession on the part of the landlord and the penalties are in place to compel the tenant to abide by the terms of the lease. If a tenant is pushing back on what could already be considered “reasonable” terms and/or “nibbling” at relatively arbitrary numbers it can give the impression that they intend to pay late or are concerned with their ability to pay rent on time and are trying to mitigate their damages.
The solution I recommend is to accept the existing fee/interest amount but request an exception once per calendar year. This shows that the tenant understands the burden their violation will/can have on the landlord and acknowledges their fault by means of compensating the landlord based on the landlord’s own calculation of their damages. It also allows for honest mistakes/oversights that could arise because the tenant is on vacation, overlooks a notice/invoice from the landlord, etc. without having to incur costly penalties. Default provisions for nonpayment of rent would still apply, but the “once per calendar year” exception can be an effective, efficient, and mutually acceptable solution for both parties.
According to the Bureau of Labor Statistics, 20% of small businesses fail in their first year, 30% fail in their second year, 50% fail after five years, and 70% of small business owners fail in their 10th year in business. Yikes! Despite these grim statistics, commercial leases are generally a minimum of 5 years and contain severe, default penalties. In some cases, landlords will require the tenant to personally guarantee the lease, effectively using the tenant’s personal assets, i.e. home, as collateral to secure the lease.
Most tenants understand the implications of defaulting on their lease and enter into the agreement, eyes-open, and with every intention of abiding by the terms and conditions. The road to hell (and default) are paved with good intentions. Economic downturns, lost contracts/clients, sequestration, etc. can disrupt even the best laid plans; leaving tenants struggling or unable to meet their monetary obligations under their lease. In such cases, tenants’ most powerful tool/strategy to avoid default is to sublease or assign their lease.
Most, if not all, commercial leases contain Assignment and Sublease provisions and while the specific language and conditions can vary there are general, shared principles. Subletting and assigning are similar in that they both involve a transfer of the tenant’s right or interest in the lease that allow another (3rd) party to occupy the leased premises. Under the terms of most lease agreements the original tenant will remain responsible for the terms of the lease in the case of either a sublease or an assignment. This means that the landlord can proceed against the tenant in the case of a default by the subtenant or assignee; including but not limited to, rental payments, damage to the leased premises, etc. As a result, it is in both the tenant and landlord’s interest to carefully vet the proposed subtenant or assignee.
If subleases and assignments are similar in that they essentially allow the tenant to “rent out” their space to a 3rd party, what’s the difference?
Under a sublease, the tenant is either (sub)leasing a portion of the leased premises for the remainder of the lease term, all of the leased premises for a portion of the lease term, or a portion of the leased premises for a portion of the lease term. Subleases do not necessarily indicate financial hardship on behalf of the tenant or a likelihood of default. In fact, in some cases, companies may choose to lease more space than needed upon the lease commencement date in order to reserve the space for future growth. This is more common with large companies, i.e. Google, that can afford the lease payments but may seek to reduce expenses by subleasing the unused space. Another situation in which a tenant may request to sublease their space is in the case of a downsizing, consolidation, etc. where the they no longer need their entire space but do not want to move and can offset their rental obligations by renting the unused portion to another party.
Under a lease assignment, the tenant transfers all of its rights and responsibilities under the lease to the assignee along with its right to occupy the entire leased premises for the remainder of the lease term. A lease assignment is a much more serious request on behalf of the tenant than a request to sublease the space. While not always the case, a request to assign the lease may indicate that the tenant is unable or unwilling to continue to make lease payments and is likely to default on its lease then or at some point in the future. As stated earlier, most leases require the original tenant to remain liable for the lease (payments, responsibilities, etc.); however, with lease assignments the landlord may release the tenant and enter into a direct relationship with the assignee. The landlord’s decision will be based on a number of factors, most notably the financial strength of the assignee and the difference between the contract rent and market rents. Assignments are not necessarily indicative of financial trouble and can simply be the result of tenants relocating or consolidating; resulting in them no longer needing the leased premises.
Most commercial leases contain Assignment and Subletting provisions which allow the tenant to (sub)lease a portion of or the entire leased premises to another party, known as an assignee or subtenant/sublessee. In most (if not all) cases, landlords must consent to the sublease or assignment. Language governing that consent can range from “in landlord’s sole discretion” to “not to be unreasonably withheld, conditioned, or delayed.” In addition to required consent, two of the most important rights available to landlords under the Assignment and Subletting section of the lease are Recapture provisions and Profit-Sharing provisions. They allow landlords to maintain control of the space/property and mitigate the impact of below market lease rates thereby allowing them to maximize the resale value of their asset.
Recapture provisions allow the landlord to terminate the lease and retake possession of the leased premises. There are a number of “triggers” that allow the landlord to exercise their right, including but not limited to, events of default, failure to maintain a certain gross sales revenue (in cases of percentage rent), etc. but in this case we’re focused on the instance in which the tenant requests the right to sublet or assign the lease.
Profit-Sharing provisions require the tenant to share any net profits from subleasing or assigning the leased premises. Generally, it’s 50/50 and the key term is “net” profits, which means that the tenant’s expenses in procuring a(n) subtenant/assignee, i.e. brokerage commissions, free rent, improvement allowances, and other considerations are subtracted from the gross rental value.
There are multiple issues for the landlord to consider when determining which right to exercise. Certainly the recapture right provides greater control over the space, but profit-sharing may be preferable in certain cases. The goal is maximizing value and/by minimizing risk.
Who secures the lease? Who’s the tenant? Who’s the proposed subtenant/assignee? Does the tenant have a personal guaranty? How much time is left on the lease? Is this an assignment or a sublet? What’s the difference? Why is the tenant seeking to sublease or assign the lease? What is the opportunity cost of releasing the premises? These considerations are intermarried but form models for decision-making.
The landlord’s primary goal is to collect (at least) the contract rent from the lease. The stronger party financially is the one with the greatest likelihood of doing so. If Google leased more space than it needed initially and requests the right to sublet a portion of their space, the landlord will prefer to share in the net profits from a sublease rather than recapture the space, regardless of the difference between the market rent and contract rent. In many cases though, landlords will need to consider the financials of two relatively similar parties. Generally, the minimum requirement for consent to a sublet/assignment is that the proposed subtenant/assignee have a financial net worth/strength equal to the tenant at the time of lease commencement. In cases where two parties are comparable financially the difference between market rents and the contract rent will govern the landlord’s decision.
Related to the landlord’s primary goal of collecting rent is the risk of default. The reason behind the tenant’s request to sublease or assign the leased premises is another key factor that landlords must consider. In the previous case, there is little to no risk involved. Large companies like Google will sometimes lease more space than they need at the time in order to extract maximum concessions from the landlord, take advantage of economies of scale, and ensure room for future growth. In such cases, companies may choose to sublet their space until they need it. Conversely, many (if not most) requests to sublease or assign the lease are the result of lost contracts, decreased revenue, declining profits, etc. and can foreshadow default. If market rents are higher than the contract rent in such cases the landlord should choose to recapture the space.
The opportunity cost associated with recapturing/releasing the space takes into account the previous two considerations and the difference between the contract rent and market rents, as well as market concessions. Depending on the condition of the space, the tenant’s proposed improvements and the associated costs, and current market tenant improvement allowances, the landlord may choose to simply take 50% of the net profits from the sublease/assignment.
Another closely related and crucial element is the time remaining on the lease term and whether the tenant is seeking to sublease or assign the lease. If there is not much time left on the lease, i.e. less than one year, the landlord may choose to recapture the space to secure a long(er)-term tenant when market rents exceed the contract rent. In the case of a sublease for a portion of the space for a portion of the lease term, the landlord may choose to simply share in the profits under the presumption that the original tenant will reoccupy the subleased space within the lease term. If a tenant is requesting to assign the lease the landlord will carefully consider the reason behind the request when making its decision.
The guiding principle for landlords/owners is to maintain control over their property by providing themselves with the most options/rights to manage changes in the market or their tenant’s financial condition. A property’s net operating income (NOI) sets the benchmark upon which it will be valued, but the risk associated with that income determines the capitalization rate to be applied, which ultimately establishes the property’s market value. The higher the NOI and the lower the risk/cap rate the greater the value.
Pre-leasing and new construction are the main themes of the Bethesda/Chevy Chase submarket. JGB Smith delivered 4747 Bethesda Ave in August 2019. This 5-Star office building was 80% leased prior to this and, in addition to serving as JBG’s new headquarters, will host Booz Allen Hamilton (65,000 SF), Host Hotels & Resorts (55,000 SF), and Orano (22,000 SF). Carr Properties will deliver another 361,000 SF, 5-Star Building at 7272 Wilson Ave in August 2020, which was already 60% leased in Q1 2019 with tenants such as ProShares (55,000 SF), Fox 5 (60,000 SF), and Enviva Partners (80,000 SF). Another 1,300,000 SF is under construction of which nearly 1,000,000 SF will be occupied by Marriott International, Inc. that is moving its corporate headquarters to 7750 Wisconsin Ave, set to deliver in January 2022.
Interestingly rent growth was negative this quarter, but this mostly the result of negative net absorption in the submarket’s 3-Star and 1 & 2-Star properties. Rent growth was actually positive for 4 & 5-Star properties (1.3%) and should continue to rise as new, trophy office space comes on the market. The strong demand evidenced by strong pre-leasing and new construction should continue but it will likely be marked by a flight to quality and an increasing disparity between average rents for 4 & 5-Star properties and 1, 2, and 3-Star properties.
RBA: 11,240,588 SF
Vacancy Rate: 15.1%
12 Month Net Absorption: 74,000 SF
Average Asking Rent: $30.33
12 Month Rent Growth: 1.3%
The woes of the North Bethesda/Potomac submarket can be attributed to large scale, government agency relocations and consolidations. The submarket has struggled to fill blocks of space vacated by the FDA, National Institute of Allergy and Infectious Diseases, and the National Cancer Institute. Vacancy levels hit 20.5 in Q2 2015 but have been gradually declining since and are at their lowest in over 5 years. Just as things were starting to look up, Marriott, the submarket’s largest tenant, will be vacating approximately 800,000 SF when it moves into its new headquarters at 7750 Wisconsin Ave (Bethesda/Chevy Chase submarket) in January 2022. This move will have a devastating impact to the submarket’s fundamentals; causing the vacancy rate to skyrocket and pushing rents down. The one bright spot and a bit of sweet revenge was ABT Associates relocation from the Bethesda/Chevy Chase submarket to 6130 Executive Blvd in Q1 of this year. The 130,000 SF lease deal had a notable impact on the submarket’s vacancy rate, but with new construction in neighboring, Bethesda/Chevy Chase, the North Bethesda/Potomac will be hard pressed to compete with demand with its aging inventory and lack of access to public transportation.
RBA: 10,835,109 SF
Vacancy Rate: 10.8%
12 Month Net Absorption: 62,000 SF
Average Asking Rent: $30.18/SF
12 Month Rent Growth: 2.8%
At first glance, Rockville’s fundamentals look strong. The vacancy rate is below the metro average, and the past 12 months saw approximately 62,000 SF of net absorption with a corresponding 2.8% growth in rents. Despite these positive metrics the submarket has still not recovered from the Great Recession and is particularly vulnerable to large-scale, move-outs from government tenants. The submarket’s demand is driven by government agencies and the federal contractors that want to be close to them. Combined they account for over 40% of the office space in Rockville. Relocations by government tenants, such as the National Institutes of Health vacating 115,000 SF last year, have an oversized impact on a submarket such as Rockville because government-related businesses that support such agencies will seek to relocate as well to be in close proximity. Still Rockville is a Biotech hub with the U.S. Department of Health and Human Services occupying nearly 1,200,000 SF. If it can maintain this reputation is should be able to continue to attract companies in this rapidly growing field.
HUBzones are “Historically Under-utilized Business” zones located within qualified census tracts; qualified non-metropolitan counties; lands within the external boundaries of an Indian reservation; qualified base closure area; or redesignated areas. The HUBZone program was created in 1998 by the HUBZone Empowerment Act. Its primary goal was/is to incentize businesses to operate and create jobs in historically, economically downtrodden communities/areas by requiring federal agencies to set aside more than 3% of their budget in the form of prime contracts for HUBZone certified small businesses. HUBZone certified companies benefit from preferential treatment in the form of set-aside contracts and 10% price evaluation preference in full and open contract competitions.
The Small Business Administration (SBA) administers the program and establishes the requirements for businesses to qualify as HUBZone certified. First, a company must qualify as a small business under SBA guidelines as based on size requirements established by the North American Industry Classification System (NAICS). Second, the business must be at least 51% owned and controlled by a U.S. citizen(s), a Community Development Corporation, agricultural cooperative, Indian tribe, or Alaska Native Corporation. Third, the company’s principal office must be located in a HUBZone. “Principal office” is defined by as location in which the greatest number of employees work. Because this excludes contract sites maintaining HUBZone certification can be especially challenging in the DC metro area. Finally, 35% of the company’s employees/total workforce must reside in a HUBZone. Under the current rules, businesses must re-certify their HUBZone status every three years; however, there is no limit to the number of times a company can re-certify as long as they continue to qualify under program’s existing requirements.
The SBA has a HUBZone map on its websites that allows one to search a specific address to see if it is located within a certified HUBZone:
Despite the billions in federal contracts available to HUBZone certified companies, the program, like the areas it attempts to aid, has been historically underutilized. This is because the rules and requirements have made compliance difficult to achieve and maintain, and sudden changes can cause a company to no longer be in compliance; rendering it ineligible for the program. The two biggest compliance challenges are the requirements for the company’s principal office to be located within a HUBZone and for 35% of its employees to reside in a HUBZone. An issue that is further compounded by the continuous and unpredictable movement of HUBZone areas and boundaries.
The SBA has proposed three changes to the HUBZone program requirements to address these issues:
Freezing HUBZone maps until the 2020 census after which maps will be updated every 5 years.The new regulation would also provide companies with up to 3 years to move to a new HUBZone if their principal office and/or employee’s residence loses its designation as a result of changes to the HUBZone map. That’s a total of 8 years to relocate to a new HUBZone, which is more than enough time considering most commercial lease terms are 5-10 years.
Changes to rule requiring 35% of employees to reside in a HUBZone.Current regulations require an employee to live in a qualified HUBZone for at least 180 days or be a currently registered voter in that area and be hired by the company before that employee will count towards the HUBZone/Non-HUBZone employee mix. Under the proposed change, after such period, the employee will always count as a HUBZone employee as long as they remain employed by the HUBZone certified company, even if that employees moves to a non-HUBZone area or their residence loses its HUBZone designation.
Changes to the eligibility requirements for contract awards.Currently companies must be HUBZone certified at both the time they bid on a contract and at the time the contract is awarded. The proposed rule change would only require companies to certify or recertify their HUBZone status once a year (by its annual recertification date) thus eliminating the need to prove compliance at either the date of bid and/or time of award.
So, what does this mean in the context of real estate investment? For one, because the purpose of the HUBZone program is to revitalize economically depressed areas, they increase the likelihood for increased rents and property appreciation. Secondly, landlords with properties within a HUBZone can use this status as a marketing tool to attract prospective tenants. The allure of billions in federal funds could be the deciding factor in a competitive market and the financial stability/prosperity from multi-year government contracts reduces the landlord’s risk of tenant defaults. With changes to the rules that have caused the HUBZone program to be historically under-utilized, itself, property owners and residents of HUBZone areas should begin to see the fruits of the program’s intended purpose.
With only 4,688,075 SF of total inventory, the Route 7 Corridor is a relatively small submarket; however, fundamentals are strong. The submarket’s “age” differentiates it from other, similar size submarkets. The average age in Ashburn is 35, a statistic only surpassed by the average age of its office buildings: 15 years (median age is 13 years). In fact, the submarket does not have an office building that was built before 1990 and over 40% of its inventory is comprised of 4 & 5-Star properties. The average rent for the submarket is $28.17/SF but this is a little deceptive as 3-Star properties account for 56.6% of the inventory with average rents of $25.08/SF ($7.44/SF lower than the average rent for 4 & 5-Star properties). The submarket’s vacancy rate is well below the metro average at 7.2% with 4 & 5-Star properties lower still at 6.1%. Based on this it’s not surprising that over 103,000 SF of 4 & 5-Star space is currently under construction with another 195,000 SF proposed. Fundamentals should remain strong despite this new supply as the submarket is likely to see increased demand with the delivery of the 2nd phase of the Silver Line metro and continued expansion of notable projects like One Loudoun.
Leesburg/West Loudoun Submarket
RBA: 3,829,925 SF
Vacancy Rate: 7.6%
12 Month Net Absorption: 7,700 SF
Average Asking Rent: $26.49
12 Month Rent Growth: 0.6%
The Leesburg/West Loudoun submarket encompasses South Riding, Leesburg, Purcelville, Aldie, Middleburg, and Hamilton. Despite spanning such a large area the submarket only has 3,829,925 of total inventory. What’s interesting is that this is comprised of 346 individual properties while its neighbor, the Route 7 Corridor, has over 850,000 SF more inventory which is spread over only 81 properties. The median age and size of the submarket’s inventory is 41 years and 4,900 SF with over 65% of the office product located in Leesburg. Despite its distance from public transportation, the submarket has experienced continuous positive net absorption since 2011; resulting in a vacancy rate that is well below the metro average at 7.6%. The average market rent for the submarket is $26.49/SF; however, nearly 83% of the submarket is comprised of 1 & 2-Star and 3-Star properties which have average rents of $25.75/SF and $25.22/SF respectively. Of the many “cities” that make up the Leesburg/West Loudoun submarket, South Riding may be the most promising and primed for commercial development. The recent expansion of Route 50 has improved east-west transit and Route 28 and Loudoun County Pkwy provide convenient north-south access.
As mentioned in previous articles, every commercial lease is unique. Landlords have their standard lease agreements, which vary based on asset type, i.e. office, retail, etc. and by individual property within the same asset type, i.e. freestanding retail vs. strip center. Even leases for the same property will differ based on the tenant and the specific deal terms. On top of that, leases are subject to further customization based on the tenant’s/broker’s/attorney’s review and negotiation of individual lease provisions. Despite this, most commercial leases have a similar structure and governing practices that are common. Because of this there are certain standards that should be verified in each lease or inserted if absent in the initial draft. The standard of “reasonableness” is perhaps the most important.
A relatively minor case in which a reasonable standard should always be applied is for attorneys’ fees. Many leases require the tenant to pay for the landlord’s “attorneys’ fees” if the landlord must enforce any of the lease provisions against the tenant or review any tenant requests such as subletting the premises. Particularly in contentious situations where there is a dispute between the tenant and landlord, legal fees can be significant. Landlord’s do not necessarily have an interest in incurring unnecessary or excessive attorney’s fees, but in the absence of a reasonable standard there is nothing limiting their ability to do so and pass the expense along to the tenant. In this case, “reasonable” does not have a strict or set definition, but such a standard imposes a requirement on the landlord to justify such costs if contested.
Reasonableness is most important in cases where landlord’s approval/consent is required. In commercial leases such cases include but are not limited to signage, assignment/subletting, and alterations to the premises. Regardless, in each and every case, consent/approval should not be “unreasonably withheld, conditioned, or delayed.”
The initial draft lease may already include this standard but, because most leases are landlord-sided, it’s likely that the standard is that “consent shall be granted or withheld in landlord’s sole discretion.” Another possibility is that “consent shall not be unreasonably withheld.” This is certainly better than the previous standard, but the addition of “conditioned” and “delayed” are important distinctions that should be included.
Having consent not unreasonably “conditioned” imposes a reasonable standard on the factors guiding the landlord’s approval. Some leases will explicitly list the conditions governing the landlord’s approval. In such a case tenants/brokers must review and assess the reasonableness of said conditions. Common examples include minimum requirements of financial strength (often the same as tenant at the time of lease signing), impact on building systems, other tenants, and/or building (aesthetic and/or reputation); etc. Reasonableness should be based on an objective standard but must also be viewed through the lens of the tenant’s business/use, plans, i.e. selling the business during the lease term, etc.
It is important to not have consent unreasonably “delayed” because of the old adage, “Time Kills All Deals.” As is the case with the conditions guiding consent, many leases will provide specific timeframes in which the landlord must respond to tenant requests. These must also be evaluated both objectively and with an understanding of the time required for the landlord to consider and process the tenant’s request. A key example in which unnecessary/unreasonable delays could negatively impact the tenant is in the case of a requested sublet or assignment. The tenant’s proposed subtenant may have a required sublease commencement date due a lease expiration date, contract, etc. and if landlords are not required to respond in a timely manner/within a reasonable timeframe, the tenant may lose the deal.
After the initial adversarial nature of the LOI/lease negotiations process, relationships between tenant and landlord are generally good and reasonableness governs the relationship. Communication and ample notice are good practices that can prevent many of the issues that reasonable standards protect against. Still, tenants should require a reasonable standard in every leases and landlords should be amenable to this standard. It’s unreasonable to be unreasonable.
CAD stands for Computer Aided Design. In the context of commercial real estate, CAD files are essentially digital blueprints/drawings/schematics that allow architects to more easily manipulate and design buildings/spaces. Because CAD files come in both 2D and 3D formats they can be used to create simple floor plans to in-depth, walkthroughs of imaginary spaces. Previously, architects/engineers were forced to use paper drawings which were not easily modified, shared, or understood. Basically, CAD files make life easier for everyone involved in the space planning, design, and construction process.
The importance of CAD files cannot be understated, but it can be measured based on asset type. The owner of a single office condo may not “need” CAD files depending on how they choose to manage their asset; meaning whether or not they choose to obtain permits for any alterations (whether they’re required or not). If owners/landlords opt to perform any work without the required permits they are at risk of potential ADA (Americans with Disabilities Act), fire/life safety, etc. violations and in addition to fines may be required to remove the alterations without compensation.
On the other end of the spectrum, for landlords with multi-story, multi-tenant office buildings, CAD files are an absolute must. In order to appeal to the greatest number of potential tenants, landlords must offer the greatest number of square footage options. There are a number of code requirements that govern how spaces can be demised, but one of the most important is ingress/egress requirements. This is specifically related to fire safety and refers to the maximum allowable distance to an exit. By using CAD files, architects can easily measure distances from anywhere on the floor to the nearest available exit and thus create a “blocking” plan which shows how the floor can be divided into individual, smaller suites.
Even if a floor is not multi-tenanted, CAD files allow architects to easily and quickly create “test-fit” plans, which represent their interpretation of the tenant’s desired floor plan/layout. If the initial plan is rejected by the tenant the architect can simply modify the existing plan until they create one that works. Because CAD files have dimensions they can also be used by the tenant’s furniture provider to digitally furnish the office with accuracy. Tenant’s can see exactly what their space will look like furnished before the space is even built and furniture ordered. They can even add digital employees.
Despite their importance, some buildings/spaces do not have CAD files or, for whatever reason, they’re unavailable to a new owner. In this case, one of the first orders of business should be to have CAD files created for the entire building. Time kills all deals and if a prospective tenant is considering multiple spaces the time required to have CAD files created, after the fact, and a test-fit performed could be the factor that causes the landlord to lose the deal. Furthermore, when marketing a property it is in the landlord’s interest to be able to present the most (code compliant) options possible. CAD files are absolutely necessary if landlords want to effectively market and lease their space. They provide owners with the information they need to estimate the cost of tenant improvements, which in many cases is the driving economic force behind the deal.