Demand for Short-Term Commercial Leases: Challenges for Landlords and Lenders

Real Estate Report

February 13, 2019

Startups and early stage companies want—and demand—short-term space leases. Many mature companies also specify shorter term leases for some of their operations in order to maximize flexibility and prepare for uncertain economic times. This reflects a fairly dramatic paradigm shift in the world of commercial leasing. Startups and early stage companies seek to preserve the ability to grow and contract as their businesses evolve. As such, they are reticent to commit to long-term costs and expenses that only increase over time. Tenants seeking shorter term commitments want to optimize flexibility and long-term lease obligations are inconsistent with maintaining that flexibility. The entire cohort of leasing stakeholders—including landlords, tenants, lenders, brokers, lawyers, and contractors—are or will be adjusting to this new reality.

A primary owner/landlord concern presented by short-term lease deals is that the term sought by the tenant may be inadequate to support longer term financing and/or preferred financing terms sought by the owner/landlord. Additionally, shorter term leases will not typically have the length of term required to justify reasonable tenant improvement allowances. Brokers will have to advise their clients—landlords and tenants—of the new startup and early stage norm, and work to maximize their clients' options. Brokers representing landlords and tenants should expect significantly reduced commissions since the lease terms (and financeable revenue streams) will also be significantly reduced. Lawyers will have to protect their clients over shorter terms and contractors will have fewer opportunities since landlords will presumably reduce or eliminate the “tenant improvement” allowance or other buildout to accommodate a tenancy. Work letters should be more basic and include less work.

Many Questions, Few Answers

With the lease terms shorter, leases in this market segment should turn over with greater velocity, with tenants revisiting their lease needs and landlords potentially backfilling their spaces at accelerated intervals. This should result in an increased volume of lease work for landlords, tenants, brokers, and lawyers, though it does not necessarily follow that more deals means more revenue for brokers and legal counsel. We noted above that shorter revenue streams will mean smaller commissions. By the same token, it stands to reason that landlords and tenants will be less tolerant of the legal time being invested in shorter term transactions. But will short-term leases in fact be more quickly or easily negotiated? They should, as (i) there should be less to negotiate in a short-term lease and (ii) we expect less tolerance by landlords and tenants for wordsmithing a short-term deal, but a few questions will arise. Will the landlords allow for additions and alterations? Would the surrender clause change? Would the subordination, non-disturbance, and attornment provision look different or would a subordination non-disturbance agreement even be feasible? Casualty provisions in short-term leases would probably not require landlords to rebuild. How would security deposits change, if at all? Will landlords ask tenants to prepay a one-year or six-month lease? Over a 10-year or 15-year period, landlords would not have significant recurring fit-out costs. Would that result in a lower base rent to the short-term tenant? As to operating expenses, in the event of a term of one year or less, there would not be a base year, since there are no additional years to the term. Would there be an operating expense section or will the operating expenses be baked into the rent?

There are many questions, but fewer answers at this point, as this paradigm shift is evolving. Lease negotiations should fundamentally change if startups and early stage companies continue to press for shorter term commitments. All parties involved will experience significant transformation; however, there are alternatives to consider.

Growth of Alternatives

In response to the challenges of short-term leases, the market has seen the rather explosive growth of co-working and flexible-space companies that own their buildings or master lease office space from third-party building owners for more conventional, longer terms. They then license or sublease individual spaces, or areas, benches, or desks, to various licensees or subtenants on a short-term basis, providing the user with a variety of amenities (not to mention an abundance of similarly eager entrepreneurs with whom to share information and ideas). This industry segment has seen rapid growth in virtually every major US city. In many cases, the co-working or flexible-space tenant’s arrangements are occupancy or license agreements or “membership” agreements rather than subleases. From the standpoint of the landlord, however, they have the same economic effect as a sublease, albeit for a shorter committed term. However, because the population may be more temporal, the landlord/licensor/host party probably cedes some control over the day-to-day population. On the other hand, evictions should be less time consuming and less costly as the license, occupancy, or membership agreement almost certainly disclaims the applicability of any local landlord/tenant law.

Most of these co-working space companies were founded over the last five years or so, and most have not been through a major economic downturn. The very risk that the short-term tenant seeks to avoid may be one that potentially threatens the co-working establishment; that being, a long-term lease liability financed by short-term revenues. Further, there are few barriers to entry, and competition for the startup and early stage contingent is coming from established, traditional landlords themselves as well as from new intermediaries. In some cases, the sheer size of the leading companies in the field and the degree of financial support they have received from investors and lenders appear to diminish the risk, and some commentators have pointed out that they could become “too big to fail.”

Time to Rethink

The issues presented in this article underscore the importance of carefully considering the changing economic and legal landscape for all leasing stakeholders when lease arrangements reflect radically shorter term commitments. A lawyer asked to identify the “top 10” issues for negotiation in a lease draft should really have different (and probably fewer) bullet points for a much shorter term lease.

Security deposits, guarantees, rights of assignment, casualty provisions, and insurance requirements must be matched to particular circumstances of the deal. Where a space lease is executed to host co-working or flexible-term occupancies, greater emphasis needs to be placed on the master tenant’s subleasing or licensing rights, basically to ensure that the co-working environment can be operated (and market-driven amenities offered) without further permission from the building owner. Both the landlord and its lender need to pay careful attention to the financial condition and business prospects of the parties that actually provide the revenue generated by the space, although the underwriting would seemingly be more abbreviated for a short-term tenancy/commitment. Traditional sublease profit-sharing provisions may no longer reflect the proper allocation of risks and rewards.

The current demand for shorter and more flexible commercial leases presents new and significant challenges for landlords and their lenders. With proper attention to legal structures that reflect changes in the business model, there should be corresponding opportunities.