How to evaluate your landlord’s financial health during your next lease negotiation

By: Jim Jetland, Principal

With so much news about struggling office properties, many businesses looking for office space mistakenly think they should have more options, better lease rates, and more flexible terms. Instead, we’re seeing a tale of the “haves and have nots” in commercial office properties.

Many factors drive a business’s search for office space beyond cost, access, and location, including the number of employees who need a workspace, and the types of building and area amenities important to the company and its employees. In today’s market, businesses need a modern checklist for evaluating new office space to ensure it makes long-term financial sense.

Assessing a landlord’s financial health

A new consideration in the search should be the financial health of the building’s owner/landlord.  Although high occupancy generally indicates that a building is financially healthy, increased costs from significantly higher interest rates when a loan matures are pushing many otherwise healthy landlords to the brink of foreclosure. Couple that with the fact that most lenders/banks don’t want to operate commercial real estate by taking assets back, the environment for office properties is being challenged from all sides.

Understanding the impacts of loan maturities

A recent example is a high-profile Class A property with high occupancy and high rental rates in Normandale Lake Office Park. It faced crippling cash flow shortages due to previous vacancy and had a maturing loan.  Rather than coming up with large amounts of equity to fill the gap, the owners decided it may be best for it to go back to the lender. Recently, some buildings were  valued and sold for up to half of their 2019 value. In many of these sales the loans had matured or were close to maturing with few financial options available that worked for the property owner.

Trepp, a commercial real estate research firm, tracks loan maturities across the country, and recently reported that loans on commercial properties are being modified at alarming frequency due to lower property values and higher interest rates. These modifications allow the property owner to extend the current loan rather than refinancing to avoid putting additional equity into the property.

“In 2023, the volume of CMBS loan modifications rose dramatically, largely due to lower property values and a higher interest rate environment that has seeped through the commercial real estate (CRE) market ever since the Fed’s rate hikes started in 2022. Instead of refinancing old loans into new ones as loans came up on their maturity dates, often loans would undergo modifications, which mainly include extensions and any other amendments to loan terms,” Trepp reported.

Now the question tenants should ask is “When is the debt maturing?” That drives whether the landlord would need to add equity if the building’s value has declined. Or whether the landlord will need to refinance at much higher interest rates, limiting their ability to reinvest in the property.

Checklist for office space lease negotiations

When you factor in the financial health of your potential landlord, you need to add these four requirements to your lease negotiations:

• Tenant Improvement budget: Generally, landlords provide money to fund tenant improvements in exchange for a lease with certain terms. That budget is typically based upon the square footage and the number of years a tenant leases the space and is often paid as the tenant completes the improvements. However, a good practice when the financial health of the landlord is in question is to require these funds be placed into escrow so that the landlord is sure to provide the agreed-upon funds.
• Right to Offset: When possible, the Tenant should have the right to offset by deducting from its monthly rental obligations the tenant’s costs which are incurred if the Landlord defaults in its performance of certain lease obligations and the tenant undertakes to compete those unpaid financial obligations of the landlord, such as repairs and maintenance and initial buildout provisions.
• Amenity protection: Struggling landlords may skimp on property improvements and amenity upkeep. For many businesses, the amenities and common areas are important reasons why the property was selected, especially when businesses are working to attract more employees back to the office.  By adding lease language that requires certain amenities to remain open and functioning as promised, the company protects its investment in the space on behalf of its employees. Think of the importance of on-site fitness centers, tenant lounges, or cafeterias in the selection of the property, and it’s easy to see how requiring those amenities to stay open is important to a tenant.
• Self-help rights: Tenants should have self-help rights documented in their leases, which allows them to repair or update items in their space that would typically fall under the landlord’s responsibilities and get reimbursed by the landlord should they refuse to respond in a timely manner. Some examples are workspace issues that disrupt the work environment – like lighting, plumbing, or security.

Evaluating office space options

When those additional checklist requirements for office spaces are factored in, it’s easy to see how quickly the office market tightens, limiting the places that would be a good fit for your business. Even if you aren’t able to secure all of the  protections that we recommend, asking the right questions gives you the information to fully evaluate the financial standing of your landlord.

The lack of limited new office development magnifies the problem of “haves and have nots.” As a tenant, if you occupy space in a “have” building, you may have much less control over price, terms, and options than you may perceive. Understanding the difference and partnering with the right real estate advisor will go a long way in leading to the right decision for you and your business.

Need help assessing your office space requirements? Forte’s experienced advisors are ready to help you navigate and evaluate your options in today’s dynamic market. Contact Forte’s expert real estate advisors today!