May 4, 2011

Although the commercial real estate industry continues to struggle, the news is not all bad in 2011. Office leasing in most major U.S. markets appears to be on the rise. Landlords and tenants continue to amend existing leases at lower base rental rates. At the same time, landlords are offering larger concession packages to entice new tenants and to keep existing tenants in their buildings. Conditions may vary from market to market, but Chicago offers a glimpse at what is happening elsewhere in the country. For example, net rents in the city's central business district are between $17 and $32 per square foot—equivalent to net rental rates in 2007. Conversely, allowances and abatements are higher than in the past. In the Chicago area, for example, build-out allowances are between $50 and $150 per square foot, while rent abatements range from three to six months.

Opportunities for Tenants and Landlords

Given the current state of commercial real estate, it will be a long time before new office buildings are developed in most major U.S. markets. As a result, existing owners have an opportunity over the next few years to capture new leases and lock up lease extensions without competition from new buildings.

In this context, tenants whose leases are up for renewal have the opportunity to give back excess square footage and to rightsize their office space. Rent is often a company's largest fixed operating expense. Therefore, an expiring lease offers a tenant the rare opportunity to reduce fixed costs. In order to take full advantage of this scenario, it is critical that tenants be proactive, review their leases carefully and consult with a real estate broker and attorney. Conversely, a landlord who is facing reduced economic terms in a renewal lease can use it as an opportunity to require additional collateral—whether in the form of a security deposit or personal guaranty. The landlord may also demand that the tenant forfeit certain rights contained in the existing lease, including renewal and termination options, as well as exclusivity provisions. Furthermore, the landlord can require that the new economic terms be subject to a confidentiality agreement between the parties.

In many instances, tenants whose leases are not up for renewal are instead seeking to sublease space. Presently in Chicago's downtown area, there is approximately 2.5 million square feet of office space for sublease in direct competition with approximately 20 million square feet of landlord-controlled vacant space. A tenant seeking to sublet space should review its lease for related restrictions. In some cases, the landlord may have the right to recapture the proposed sublease space, approve the subtenant and withhold consent in its sole discretion. The lease may also prohibit a sublease to another tenant in the building or to certain types of tenants.

SNDAs: Taking Additional Precautions

When engaged in any lease transaction, it is prudent for the tenant to require a subordination, nondisturbance and attornment agreement (SNDA) involving the tenant, the landlord and the landlord's mortgagee. One overriding reason is because many landlords today are in default on their mortgages, but the tenant is not privy to this financial distress. An SNDA will prevent the lease from being foreclosed by the mortgagee so long as the tenant is not in default under its lease. The tenant should also request that the mortgagee acknowledge in the SNDA that it will be bound by any allowances or rent concessions that the landlord agreed to provide to the tenant in the lease. This is especially important for tenants relocating to new space or expanding their existing space. With respect to a build-out, a tenant should require that the landlord escrow the tenant allowance and have the mortgagee agree that the monies will be available for the build-out, even if the landlord goes into default under the mortgage. Remember that the mortgagee, as the successor owner through a foreclosure, may not be obligated to honor any agreements made between the landlord and the tenant in a lease or lease amendment unless the mortgagee specifically agreed to be bound by those terms in writing.

Looking Ahead

In light of Chicago's 10% unemployment rate, it is no surprise that space needs in the city have diminished. As is the case in many other U.S. markets, 2011 leases will continue to be affected by these challenging economic conditions. However, lease transactions can still be completed successfully if each party does its due diligence, is willing to be creative and communicates with the other side (and the mortgagee) in a frank and honest manner.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.