3 Lease Clauses That Can Cost You the Sale and How to Mitigate Them
In investment sales, it is common to take the client’s word that the lease is standard and truly NNN. The challenge we…
In investment sales, it is common to take the client’s word that the lease is standard and truly NNN. The challenge we as investment sales brokers face, is that these words are far more subjective than most investors realize. As a result, we must carefully pour through each lease to evaluate each potential deal killer before taking a property to market. We can then properly craft the marketing plan and cater it to the correct buyer pool without wasting valuable time.
It is not just the buyers who must be considered in these situations. There are buyers that are more accepting than others of these clauses, however, lenders, appraisers and other parties have bearing as well and can often kill the deal. The most common clauses that we look for in investment sales are listed below, along with a few ways to mitigate those during a lease negotiation.
1. The Cancellation / Reduced Rent Option
Knibbe: The cancellation option is one where the tenant has the option to terminate the lease or pay a reduced rent in the event of a certain situation or simply at will. The most common of these terms allow it after a definite set in time. For example, a tenant may have the option to cancel at any time after 36 months with 90 days notice. While this may seem harmless to an investor who assumes the location is good for the tenant and the likelihood of them vacating is low, lenders will see this differently, and for good reason.
Lenders will evaluate the lease as a short term lease with continuous ninety day renewal options. This will not only impact the amount of leverage offered but could potentially deny leverage all together for a single tenant building. Even if the tenant pays a penalty for such right, the fact that the tenant can exercise the right at any time effectively makes this a 90 day lease until the end of the lease term. This can make it near impossible to refinance or sell after the tenant has crossed into the option to terminate timing.
Some tenants will push instead to pay a reduced rent should certain adverse events occur in order to minimize the impact and prevent a closure all together. The challenge with those clauses is that it places the burden of a broken tenant strategy on the owner, indefinitely. A good case study would be Radio Shack. Radio Shack had clauses which stated that should sales drop below $300,000 for example, that they would pay just 10% of rent to sales for the remainder of the lease and option periods. At the time of those leases it seemed unlikely to most developers that that should ever occur to such a strong name. When the concept as a whole began to fail as a result of shifting consumer behavior, Landlords were then in a position to subsidize a failed business model. In our opinion, it was due to these lease clauses that enabled Radio Shack to stay in business as long as it did. Landlord’s had no options available to re tenant the space irrespective of market conditions.
A Possible Alternative
Babcock: If striking the cancellation option all together is not an option during lease negotiations, attempt instead to compromise with the prospective tenant. Defining a specific date that the option should be exercised or waived is one way to do that. In addition, the tenant should be required to pay back any unamortized leasing commissions and tenant improvement allowances and possibly even re tenanting costs. This allows landlords to postpone refinancing or sale plans until said date has passed instead of locking them into a decade long limbo.
2. Short Term Continuous Renewal Options
Knibbe: It is surprising the number of times we hear renewal options advertised as an owner benefit. There is never a benefit to the owner, only the tenant. It is essentially an option similar to that in the stock market that enables the tenant to control the location for a specified period of time and usually a predetermined rate. At worse it puts a cap on the owners potential income and reduces his or her potential to respond to market changes and maintain or increase the value of the property. At a minimum it puts the owner in a position to keep a tenant that may no longer be best suited for the property. Nonetheless, most tenants require them and most leases have some form of renewal options. Renewal options that continue far in excess of the original lease term and for short increments can impact the property in the same way as the cancellation clauses discussed above.
A Possible Alternative
Babcock: As Chad mentioned, virtually all leases have them, making the ones that do not more valuable to buyers. When presented with unreasonable renewal options in a lease negotiations (think Walgreens and fifty, one year options) an important rule of thumb is to never allow the tenant to obtain more control in option periods than they would in the base lease term. Also, most tenants will agree to some form or variation of “market rate” allowing the property to better respond to market conditions.
3. CAPS on NNN Reimbursements
Knibbe: Not everyone’s definition of NNN is the same. This is even true amongst different single tenant assets with the same tenant in each. While some leases are straightforward, placing 100% of the responsibility and cost of maintaining the property (single tenant) or their lease space and common area (multi tenant) others have what we would consider “slippage”. You can learn more about the specific variations of NNN leases here. (link). Slippage is the difference in what is collected (or paid directly) by the tenant and the actual expenses. It is vital to the pricing of assets as it directly impacts the net operating income and in turn the value of the property. The most common challenges we face when underwriting an asset is seeing caps placed on those expenses. How close those caps are to the actuals tells us how much risk there is in seeing slippage now or in the near future. In multi-tenant properties caps are pretty common and as long as they are within reason and only on controllable expenses than most investors and lenders can get comfortable with them. The deal killers are when the caps involve property taxes or insurance or are unreasonably restrictive and do not allow a landlord to keep up with inflation.
A Possible Alternative
Babcock: It is most common for inexperienced tenants or agents to request caps or flat rates with NNN leases. I usually find it beneficial to describe the NNN charges similar to an escrow account on a home that covers property taxes etc. It is not a profit center for the landlord but enables the landlord to safely lease the property under the long term lease the tenant needs without exposing them to the risk of skyrocketing property taxes which for a large center could cause the landlord to default on their loan if the leases were not fully NNN. I usually advise landlords that any cap on non-controllables (taxes and insurance) is a deal killer and should never be considered, when in doubt, point to your bank who would certainly take issue with increased risk. An alternative is to work with the tenant in proposing a reasonable cap of 5% annually on the controllable expenses only.
These clauses can impact multi tenant and single tenant properties differently and the proportionate share of the tenant’s space should be taken into consideration when in negotiations. In the eagerness to sign the lease, take prudence and care to ensure the value of the center is preserved and improved through appropriate negotiations.
It is surprising the number of times we hear renewal options advertised as an owner benefit. There is never a benefit to the owner, only the tenant”Chad Knibbe, CCIM
For more information on how your lease negotiations could be impacting the value of the property, visit with an investment sales broker who is not a party to the lease negotiations. The market and its acceptance of lease terms varies significantly over time. Investment sales brokers can offer a unique perspective to the lease due to their activity in the sales market.