Business & Commercial Listings Sales Guide

How Tenant’s can Build Future Profits in Today’s Lease Negotiations

By Sam Finnerman

The current business climate is very challenging for most sectors of the economy, but is important not to overlook the opportunities that can be developed. In the commercial real estate market, particularly in the three core area of retail, office and warehouse/industrial sectors one can position one’s business or medical practice now for future net income. As valid and necessary as it is to survive today, if one can look beyond the horizon, there are unique opportunities that the existing business climate and real estate market offers all users of leased space to either restructure existing leases or position one’s operation for long term stable real estate costs.
There is currently the opportunity to structure new favorable lease terms that will last well into the future that will not only contain future real estate costs, but also build in a lower cost structure that will result in higher profit margins. This will increase your net profit revenue as the economy rebounds in the future and your overall revenue increases. This applies to existing leases whose terms go beyond two years as well as new leases with a possession date within the next twelve months.

The obstacles when considering the possibilities and opportunities to improve future net profit margins are fear, inexperience, lack of knowledge and depth, and short term, narrow thinking. On an average most business and professional practices are reporting a drop in revenue from 25% to 35%, and in some instances more. This is true of retail stores as well as medical practices, usually the solid anchor in a challenged economy. This significant decline in revenue from only 6 months to a year ago naturally triggers fear, anxiety and tension in owners and senior management of businesses and organizations. To survive one must focus on bringing current costs in line with current revenue, improving sales and revenues as best one can. While we are focused in a legitimate survival mode which is both responsible and prudent; however, one should not overlook existing and future real estate opportunities. Prudent management and business practices make it an obligation to position one’s operation from a real estate lease perspective for future net profit revenue.

How does one do this? There are several ways and methods. For existing tenants, especially if one’s current rental operation cost is significantly above the standard operational ratio of rent (approximately 7% to 10% of gross revenue) or if there has been a precipitous drop in gross revenue, it is perfectly legitimate to approach one’s landlord to ask for a reduction in rent. Most serious landlords today would rather have a steady income stream than to have a tenant vacate the premises entirely or be forced into bankruptcy. To accomplish this, one will need to be open and forthcoming with one’s landlord and be willing to extend the lease out beyond five years, building in step increases in rent, averaging three percent (3%) per year. One will need to give back some of the immediate reduction out into the future. How much one gives back becomes part of the negotiation process.
For all tenants who have the opportunity to relocate or need to open branch locations, there are several elements to the lease that need particular focus. Traditionally in down markets, recessionary environments such as the one we are in now, several patterns of opportunity emerge. One in particular is the ability for tenants in secondary locations, Class B facilities, to relocate into Class A properties because the landlords of the Class A facilities will likely be willing to accept a rental 20% to 30% below what they would have accepted two years ago. This will allow a tenant to acquire a better location and facility without spending more than they are currently paying. The ability to acquire a retail store in a stronger shopping center at a rental that is based on today’s economics will in the long run result in higher revenue and store traffic for the store.

The second factor that must be addressed is the rent itself. One can build in future net profits by negotiating for the lowest possible rental sustained over the longest period. If one normally would seek a five year lease, now consider a 10 or 15 year lease with clear base rent defined and established throughout the lease period. By negotiating for the lowest possible rental over the longest period possible, net profits will increase as the economy recovers and gross revenue improves. The spread between operational costs for real estate and gross revenue will increase, further adding to the net profit bottom line.

The third component of a commercial lease where future profits can be created is to scrutinize carefully and negotiate for the most favorable escalation clause. Retail and warehouse/industrial facilities are frequently leased on a net basis, with the tenant paying separately for common area maintenance (operating expenses) and real estate taxes. The office sector varies with some buildings leased on a net basis and others on a modified gross basis that includes the operating and real estate expenses. For retail and warehouse, the increases that need attention are the increases in the base rental that most landlords seek. In the past, 3% or more was the norm for per annum increases; today, try to have the adjustment every five (5) years instead of annually and base it on 2% or less and if possible, no increase at all.

With office space always aim for a proportionate share of direct operating and real estate tax expenses, versus a cost of living adjustment or percentage increase. For example, if the operating expenses and real estate taxes comprise $10.00 per sq. ft. of a first class office rental and the costs increase by 2.5%, the rent will be adjusted, i.e. increased by $.25 per sq. ft. per year. If the increase adjustment is based on a 2.5% increase of the rental itself and using a rental of $25.00 per sq. ft. as an example, the rental will be increased by $.63 per sq. ft. It is very obvious that a 25 cent per sq. ft. increase is a lot more favorable.