As economies and strategies change, businesses may find themselves ready to downsize their space or expand into larger space. Unfortunately, these scenarios don’t always align perfectly with a lease expiration date. Tenants have options when it comes time to leave a lease agreement prematurely, including a lease buyout and subleasing.
To best position yourself and your business, understand the benefits of both options before deciding which aligns best with your business goals.
Benefits of a Lease Buyout
While there are many scenarios in which a lease buyout may occur, it typically happens when a tenant pays their landlord a significant amount of money to terminate the lease before its official expiration date. Usually, this includes unamortized lease-up costs, such as:
- Tenant improvements.
- Free rent.
- Brokerage commissions.
- An additional penalty equal to the present value of the remaining rent obligation.
In these cases, a lease buyout will relieve the tenant of further liability for their unoccupied space. Additionally, a lease buyout may end up not being overly expensive for the tenant if the landlord needs the tenant’s space to incorporate into a larger transaction, may have plans to redevelop or re-image the site, or market rental rates are higher than the tenant’s lease rates. In these instances, the buyout amount that the landlord is most likely to consider may be less than the total balance of the outstanding lease payments.
However, if none of these conditions exist, the lease buyout cost will be onerous.
6 Steps of the Lease Buyout Process
Preparing for the lease buyout process and negotiations can be difficult without support. It’s always best to consult an experienced real estate broker to help you through the process. They’ll answer any questions you have, help you prepare, and expound on these six steps and how to execute them.
Step 1: Evaluate the current real estate market supply and demand. Be sure to perform a market study to ensure you have adequately assessed the market’s conditions.
Step 2: Conduct a comparative financial analysis. This will help you better understand prior period statements relative to future/expected financials. Also, compare the potential sublease financial savings to the lease buyout amounts under negotiation.
Step 3: Uncover the landlord’s motivations. Your real estate broker will help you understand what your landlord’s goals are based on any documents or notes you provide; they have the experience to help decipher any jargon or navigate the terms with which most tenants are not familiar. They can also expound upon the landlord’s other options in the current market environment and possibly implications associated with the property’s debt.
Step 4: Calculate the lease buyout penalty. Be sure to consider the following in your calculation. Your real estate broker will be able to further assist.
- The present value (based on a negotiated discount rate) of the balance of base rent through expiration.
- The unamortized lease-up costs (leasing commissions, tenant improvements, free rent, and other concessions from the original lease negotiations) based on a negotiated discount rate.
- The value of the lease compared to current market conditions.
- The remaining term of the lease and the projected downtime lease-up costs for the landlord to secure a new tenant.
Step 5: Negotiate the lease buyout with the landlord and an experienced real estate advisor. Just as in Step 3, it’s always best to bring in your real estate advisor to help navigate the conversation. They can negotiate on your behalf, ensuring that your landlord’s intentions do not place you in a difficult position from which to negotiate.
Step 6: Lean on an early termination right if available. Ideally, the tenant has negotiated an early termination right that provides a formula instead of negotiating a lease buyout.
Benefits of Subleasing
Oftentimes, negotiating a lease buyout is capital intensive and not always realistic. Instead, tenants can save money through subleasing. Subleasing is the act of transferring a portion of your rental rights to another party for a temporary time. You may sublet part of the premises while you continue to occupy the space, or sublease the full premises until your lease term expires.
Subleasing allows tenants to quickly transfer partial rights of a commercial leasehold to save money on rent expenses and prevents them from breaking the lease terms or paying the landlord the outstanding lease payments. Many leases require the tenant to seek the landlord’s approval for a sublease which often cannot be unreasonably withheld.
Tenants in shared spaces may benefit from shared resources or customers, networking, and workplace diversity.
Is Subleasing the Best Option?
Subleasing may be most advantageous if:
- Market rental rates have increased relative to the tenant’s lease rates, particularly if the tenant is permitted to keep all or part of the increased rates under the sublease.
- Your company has outgrown the current space and needs to move on, but the lease agreement isn’t over yet.
- Your company has downsized and no longer needs the same amount of square footage.
- You run a seasonal business for part of the year and would like to lease the space to another company during your offseason.
- You run a start-up company that could use some extra help covering the cost of rent and building expenses.
- Your organization is a big box store that can partner with a smaller retail entity and rent a portion of the building, like a bank branch or coffee shop.
Each option comes with pros and cons and, ultimately, your real estate advisor can help you decide which best serves your needs. While both may afford benefits, there are seemingly countless specifics that should go into your evaluation, and your broker can ensure you explore each to make a confident decision.
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