Dimensional-3aOne of the primary considerations of any lease is the length of the Lease Term.  Sometimes flexibility requires a very short lease, and sometimes a lease needs to be longer to amortize a significant tenant improvement investment.  So, how long of a lease term should you sign up for?  There are quite a few factors to consider when making this decision, including, but not limited to, strategy, capital improvements, concessions, and, of course, rent.  Although not always the most critical consideration, rent is extremely important in the overall expense equation. Dimensional-1a-No-Exit-Signs-2Base Rent is established at the outset of a lease negotiation and from that point forward, concessions aside, the Base Rent will increase by roughly 2.5% to 3%.  Annual operating expense and tax increases add to the compounding effect on the total contract rent in a lease.  Once a lease commences these increases send rent higher year by year, but the actual market rent rarely follows that path, as illustrated below. 5-10
This graph that shows market rent (thick red line) and the path that contract rent would follow in any given year during the market cycle.  Five (black dotted line) and Ten year (blue dotted line) leases are represented to show what the rent would be in comparison to market.  The results seem pretty clear that longer term deals can get extremely expensive in comparison to market.  Admittedly, conditions vary wildly from market to market and a custom analysis should be prepared to evaluate your company’s situation.  Regardless, every market cycles, rental rates move up and down, and the same principals are applicable in all markets.  The statistics used in this graph are taken from a selection of Orange County’s Class A buildings as posted in CoStar over the last 17 years. Dimensional-4aThere are some lessons to take from this information.  The first is to be very cautious when signing long term deals in a tight market, as the contract rent can go through the roof.  Also, this graph is quite simplistic and does not take into consideration the different concessions offered at different points in the market.  Typically very heavy concessions are offered when the market is cooling and landlords are trying to preserve higher than market coupon rents.  This phenomenon can significantly reduce the NPV of these longer term “over-market” deals.  Thirdly, be creative and try to negotiate fixed options on shorter term deals, early termination rights on longer term deals, and other customized terms to address your business’s strategic needs.

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