Lease buy-out options:win-win for tenants and landlords

Much of the recent discussion in cor­porate real estate (CRE) has been focused around structuring flexibil­ity into a portfolio. A strategy of negotiating shorter lease terms across the portfolio has resulted. In reality, in more stable indus­try sectors, tenants tend to remain in their premises for periods longer than the initial lease term. Portfolio usage, if analysed, shows that many leases have their options exercised.

Short term lease premiums

Shorter term leases with options provide flexibility, not having to be locked into sites for long lease terms. But this comes at a cost. Since rentals are inversely correlated to the term of the lease, this usually means rental levels for shorter leases are at a premium to long term leases – certainly in terms of in­centives.

Thus companies regularly exercising lease options across a portfolio are paying a premium for this short term lease profile. And then, by regularly exercising lease op­tions, they are not making use of the inher­ent flexibility. Despite this knowledge and probably because of the challenge of the un­certainty of the future, this practice persists. Tenants still want the ability to relocate to smaller or larger premises if their business operations so dictate.

So, can a rental advantage be achieved by early re-negotiations across a portfolio having a short term lease expiry profile? To start, it is important to objectively assess the term that the user is likely to remain in oc­cupancy – unrelated to the unexpired term of the lease. With a realistic assessment of the real need for flexibility, the challenge is to determine the points in time when the flex­ibility options need to be structured and the price that should be paid for these rights.

Lease buy-out options

What are lease buy-out options? These are arrangements by which tenants can buy-out of their future lease obligations at set in­tervals and prices. Generally landlords are reluctant to include these options in new leases. But when linked to re-negotiating ex­isting leases and extending the term, these can be structured to provide a platform to terminate the leases and achieve rental ad­vantages. These terminations are usually at predetermined intervals and penalty pay­ments by the tenant. This concept is a com­monly used and widely accepted practice in the finance industry.

But to be attractive to tenants, these buy-out options should also provide significant savings by virtue of lower rental traded-off in return for the longer lease terms. And po­tentially also include a significant up-grade to the property to support the extended life of the tenancy. In a financial analysis, these provisions should be cost neutral for the ten­ant, even taking into account the buy-out costs. Structured correctly, these options can have a significant advantage to the tenant in providing flexibility at a price payable when exercised, and also provide significant on-going rental savings.

What about the landlord?

Why would a landlord be willing to agree to lease buy-out options? Start by considering the driving forces behind landlord profiles. Obviously all landlords wish to retain their premier tenants – sourcing tenants and final­ising new lease agreements are major costs and risks. It makes sense to retain good ten­ants, if this can be achieved by balancing the risks and financial returns. In negotiating with existing landlords, ensure that the buy-out dates do not create worse lease tenure profiles than the current situation. The lease buy-out intervals are then structured to provide flexibility but pay­ments are made only if exercised. This is bal­anced against the longer tenure offered and this needs to be attractive to the landlord.

Landlords operating in a transparent in­vestment environment – and being subject to on-going market commentary by finan­cial analysts – are well aware of the scrutiny attached to major lease expiry dates. Listed property trusts or even large syndicates, place a lot of emphasis on their weighted average lease expiry profiles. With a significant lease in a portfolio due for renewal, analysts will be reviewing and commenting on the impact on performance if not renewed. This is strong motivation for the portfolio manager to agree to a lease extension, even if attached to buy-out op­tions and lower rental levels. The potential positive impact of the lease renewal on the weighted average lease profile, and conse­quently the portfolio rating, can provide a big boost in fund value. Syndicate landlords approaching the fund wind-up dates, with valuations pending, also need certainty of tenure, even if at reduced rental rates. This is similar in other portfo­lios when asset re-valuations are pending. In determining capitalisation rates, valuers will be seeking certainty of future tenure for all major tenants with impending lease expiries. ­Although the impact of buy-out options on revaluations are often a challenge for valuers, provided the penalty structure has been priced correctly, this should not result in lower asset values.

Obviously for ‘mum-and-pop’ landlords with single or few properties in their port­folio, there is good reason to be amenable to negotiations to extend leases. A large va­cancy in these portfolios will impact cash flows, and potentially be treated negatively by bank managers. By way of example consider the applica­tion of a lease buy-out option on an exist­ing 10,000 sq m lease, a year from expiry and with an existing 10-year renewal option written into the lease. Based on the term and rental conditions, the option is unlikely to be exercised. The tenant wants lower rental and flexibility to terminate if business changes so dictate. The landlord does not want to go to market seeking a new tenant. The creates the ideal situation for renegotiation buy-out lease options.

Win-win outcome

With financial modelling, the buy-out price for each potential buy-out event over the new 10-year term can be determined. The tenant now has flexibility and pre-determined buy-out costs, with no re-location and transac­tion costs, achieves a lower rental cost and possibly an up-grade to the building.

In addition, with generally improved rela­tionships, there should be improved commit­ment to service levels. The landlord has the im­mediate benefit of a new 10-year lease, albeit at a lower rental level, with no lease down-time, marketing costs, and potentially no incentives. Even though buy-out options now exist, from an occupancy perspective, the landlord is in a stronger position than previously.

For tenant and landlord, this is a ‘win-win’ outcome. This strategy can provide exceptional outcomes for tenants who are not compelled to relocate, meeting their two primary drivers across the portfolio – lower lease rentals and flexibility with buy-out options. For landlords, improved security of tenure from major tenants provides im­proved weighted average lease expiry pro­files, leading to portfolio re-ratings and im­proved fund valuations.