Landlords Impact Deals
Dealing with landlords in transactions has been so pertinent as of late, especially in the frothy California Real Estate market, that I could not pass on the topic. When negotiating the terms of a lease, most people think of the length and price as the main variables. While those may be sufficient during the term an owner is operating a business, there are other clauses that become extremely relevant upon a sale.
One large issue at hand is that leases expiring in 2016 were likely drafted during or immediately after the Great Recession. When buyers are evaluating acquisition targets, they are not concerned about the historical cost of the lease, but rather the cost once they take over. Consider a distribution company who sees its 25,000 warehouse rental rate go from $6/square foot/year to $12/square foot/year. This equates to a $150,000 increase in cost. At a 3x-4x multiple, it could decrease the value of the business by $500,000.
While some variables may remain out of a business owners control, there are things to think about during your upcoming lease negotiations that can mitigate the downside risk or stress when it’s time to go to market.
1) Assignability of Lease: A well written lease will have a provision that references a lessee’s ability to assign or sublet a lease. The most common language would indicate that a lessee cannot assign or sublet the lease without the lessor’s prior written consent, but that consent cannot be unreasonably withheld. However, I have seen many leases with far more strict language that explicitly seek to exclude the right to assign or sublet. The more stringent the language in the lease, the higher probability a landlord can negatively impact your deal.
2) Release of Liability: Even leases that do allow the lessee to assign or sublet to a buyer will often state that the assignment or sublet does not release the lessee of any obligations or liability. This means that if the buyer ultimately defaults on a lease payment several years down the line, the seller can still be on the hook.
3) Language and Detail of Lease Options: Options that give the lessee the right to extend a lease are great, but the language and detail of the option is extremely important. For example, is the rate of the future option period laid out in the lease? Does the option reset to market rate? If so, how is market rate calculated? Options can have a tremendous amount of value if they are structured to provide a home for an extended period of time at favorable rates, but they must be written and interpreted correctly.
4) Sale of real estate: When real estate is sold, the lease typically remains in effect. However, tenants typically do not get prop 13 relief, such that the sale of the building can have a large impact on the property tax that is being passed through to a tenant. Should the building have a low cost basis, thus a low property tax number, and it sell thereby resetting the assessed value to market rate, the monthly payment can increase dramatically.
5) 10 years is the magic number: Buyers typically want to know they have a home for at least 10 years. This includes the lease term plus the option periods. Banks who finance deals feel the same. As you enter a lease negotiation when a sale of your business is nearing, keep this in mind. Depending on your assignability provision and the current market conditions, it could impact whether you enter into an extremely short or extremely long lease.
This is not an all-inclusive list of issues that could potentially arise. Nonetheless, it hopefully articulates the need to have your real estate agent or attorney review your leases prior to signing. When you have been in your building for 10-20 years, it’s easy to get lazy and sign whatever your landlord puts in front of you upon renewal. Don’t. Some review and planning can save you a lot of money and mental anguish.