Looking for a great deal on office space?  A sublease may be the answer.  Subleases are often attractive to businesses as they offer a low cost, flexible, turnkey solution.  Start-up companies and established companies can find subleases to be a great opportunity.  They are, however, not without challenges and risks.  In this post, I discuss the advantages and disadvantages of subleasing and how businesses can navigate the sublease process to get a great office space that will help propel their business.

Sublease Advantages As most tenants who are looking to sublease their space are doing so as a matter of cost reduction and not profit, subleases offer the following:

•  Low Cost Rents are typically discounted as the term length tends to be shorter than a direct lease and as a way to entice a subtenant to take the space “as is” without having to contribute any further money to renovate the space (unlike a direct lease where the landlord is offering large cash allowances for improvements).  In keeping with that thinking, where improvements are needed, a tenant/sublandlord will typically offer a period of free rent to allow the subtenant to offset their cost for improvements.
• Flexibility As most subleases are for a shorter-term, they offer flexibility without the long-term commitment of a direct lease.
• Minimal Capital Investment: Turnkey As most subleases come fully furnished and constructed, the space may be “turnkey” ready; thus, subtenant’s investment is minimal, i.e., telecommunications cabling, etc.
• Speed Unlike a direct lease that may require several weeks for construction, the space is likely ready for immediate occupancy.
• Minimal Security Deposit As tenants/sublandlords are looking to “stop the bleeding” and their transaction costs are less (brokerage, attorney and landlord review fees) than a direct lease that typically includes large construction costs, a tenant/sublandlord’s requirements for lease securitization from the subtenant are typically less.

Sublease Disadvantages In a traditional lease, there are two parties: landlord and tenant.  In a sublease, there are three parties: landlord (Master Landlord), tenant (Sublandlord) and Subtenant.  While the master landlord owns the building, the subtenant has no legal relationship with the master landlord. Instead, the master landlord’s relationship is only with the tenant/sublandlord and the subtenant’s relationship is only with the tenant/sublandlord.  It is this disjointed 3-party relationship that is the root of the challenges of subleases. A major misconception is that a sublease is simple to document by incorporating by reference the terms of the master lease; however, there are many issues that need to be addressed in the sublease to avoid any unintended consequences.  In addition to the sublease document to negotiate between sublandlord and subtenant, there is a Consent agreement which is then negotiated among all three parties.

• Uncertainty Being subordinate to the tenant/sublandlord and not having any legal standing with the master landlord, the sublease space is dependent upon the tenant/sublandlord being in good standing under the master lease.  If the lease is terminated (whether through tenant’s default or otherwise), then the sublease is also terminated, and the subtenant is left in a very vulnerable position.
• Enforcing Landlord’s Obligations By not having a legal relationship with the master landlord, the subtenant is handicapped when seeking to have the landlord perform its obligations (i.e., services) and instead must rely upon the sublandlord/tenant to enforce the lease against the master landlord.  Similarly, the subtenant cannot challenge charges it receives from the master landlord, i.e., disputing operating expense charges where they are passed-through as part of the sublease.
• Inheriting Master Lease If the sublandlord/tenant did a poor job negotiating the lease, the subtenant inherits those issues.  Conversely, of course, they can be the beneficiary of a well-negotiated lease.
• Protracted Negotiations As the master landlord continues to collect rent from the sublandlord/tenant, the master landlord does not share the same level of motivation with the sublandlord/tenant and subtenant.  Consequently, the documentation process to negotiate the sublease and consent agreement can take longer than negotiating a new lease.
• Dead-ends If the landlord has a right to terminate the lease (i.e., recapture right) when presented with a sublease for its consent, the subtenant may have just wasted a lot of time going down a dead-end road.

Checklist   To avoid the pitfalls and enjoy the advantages of a sublease, here is a checklist that prospective subtenants and their advisors should consider.  I have organized these into two categories: (1) Pre-Sublease Negotiations – during business negotiations when the prospective subtenant is still considering other properties; and (2) Documentation Negotiations – after receiving the draft sublease and consent documents.  While the prospective subtenant has the leverage, they should try to negotiate many of the points in this second category before the documents are drafted.

Pre-Sublease Negotiations:

• Who is the named Tenant?
• What is the Tenant’s corporate and financial status?
• Independently verify the measurement of the proposed space.
• Does Subtenant’s intended “use” of the premises comply with the “use” provision of the Master Lease?
• Does subtenant’s business conflict with any “no competitors” lease provision
• Who is the landlord and lender?
• Determine the amount of the sublease security deposit or Letter of Credit or better yet, get it waived.  See my prior post on Tenant Lease Security Strategies
• If subtenant is financially strong and instead of a sublease, would the master landlord accept from tenant/sublandlord a termination fee (a/k/a “buyout”) to facilitate a direct lease with the prospective subtenant for terms equivalent to the sublease?
• Sublease commencement should not be a fixed date, instead it should be based upon the date after which all approvals and consents have been obtained so that subtenant can legally occupy the premises.
• Carefully review the master lease and all underlying documentation (i.e., amendments, estoppel certificates, SNDA, etc.) to identify other issues to address with the tenant/sublandlord and the master landlord.
• Are there any restrictions that would preclude the sublease?
• Confirm who owns any furniture and fixtures being included in the sublease and that it is not subject to any liens.
• Related to the sublease language, confirm that the landlord does not have the right to terminate the lease (i.e., “recapture”) for any proposed sublease.
• If the sublease approval process takes too long, can the subtenant elect to terminate and nullify the sublease a certain number of days after submission of the signed sublease?
• Request a “no default” representation by the tenant/sublandlord of both the tenant/sublandlord and the master landlord.
• Under what circumstances can the master landlord terminate the lease?
• Confirm that tenant/sublandlord may not terminate the lease, except for events such as destruction, unless with subtenant’s consent.
• Determine whether lease options and rights (i.e., renewal, building signage, expansion, parking) can be transferred to the subtenant?
• For added flexibility, can subtenant sub-lease or assign this sublease?
• If the sublease is for a portion of the total premises, is the space fully separated in accordance with applicable laws?
• For a sublet of a portion of the premises, address issues of sharing common areas, kitchen, telecommunications, etc.
• How are utilities being allocated?
• Where the subtenant is planning to make renovations to the premises, obtain as part of the consent document, the master landlord’s necessary approvals per the master lease requirements.
• While the subtenant may be required to remove any alterations, the subtenant should not be required to restore alterations made by tenant/sublandlord and/or existing before the sublease term commencement date.

Documentation Negotiations

• If the Master Lease is terminated, does subtenant have a reasonable time to vacate?
• Provide that tenant/sublandlord shall not agree to amend the master lease in a way that would adversely affect subtenant.
• Request a “Recognition Agreement” from the master landlord that, should there be a default in the sublease by tenant/sublandlord, the subtenant would have the right to cure and preserve the sublease.
• Master landlords are reluctant to provide such recognition agreements as it limits their rights to market the space to an outside tenant that may pay a higher rent. As an alternative to the recognition agreement, subtenant should request that master landlord provide subtenant notice of tenant/sublandlord’s defaults and allow subtenant the right to cure.
• Request that the tenant/sublandlord indemnify the subtenant for any liabilities it incurs due to default under the lease and any liabilities caused by tenant/sublandlord.
• To enforce master landlord’s obligations to provide services (i.e., HVAC, electric, etc.) and without a legal relationship with master landlord, subtenant should require that tenant/sublandlord diligently enforce the obligations of the master landlord.
• To motivate the sublandlord to enforce the master landlord obligations, does the subtenant have the right to withhold paying sublease rent if sublandlord is not diligent in enforcing?
• Additionally, should master landlord fail to provide services, subtenant should have the right to sue landlord on behalf of tenant/sublandlord, i.e., subrogation.
• Confirm that sublandlord is paying all master landlord reviews and brokerage fees associated with this transaction.

DISCLAIMER.   Our writings are from a real estate transaction perspective and for informational purposes only. Nothing herein shall be considered legal, accounting, tax or architectural advice. Please consult with the appropriate professional(s).

As commercial real estate values are rooted in a dependable cash flow, landlords (and their lenders) are keenly interested in the creditworthiness of their tenants.  As most businesses are not in the Fortune 500, many will face the issue from prospective landlords of how they will secure their financial obligations under the lease.  Where landlords are increasing their construction allowances to address rising construction costs, lease security has taken on increased importance for tenants today.  It should be addressed early in the business negotiations when multiple properties are under consideration.  A tenant’s business is best served when they can put more of their money to work for their business instead of having their money held hostage by their landlord.  In this post, I outline the three primary approaches to lease security: (1) Cash Security Deposit; (2) Letter of Credit; and (3) Guaranty.

Before I jump into the three approaches, here are a few practical suggestions: (1) New companies (as well as those that want to minimize the amount of money they have tied-up in lease security) should focus on office spaces that require minimal improvements.  The cost of improvements (or construction) is the biggest driver for lease securitization.  For example, an $80/sf construction allowance on a 20K sf space is $1.6M compared to a space requiring $10/sf in cosmetic alterations at a cost of $200K.  (2) To manage expectations, tenants should apprise their senior management and investors of the likelihood and amount of lease securitization.  (3) Explore these issues, along with other key business terms, early in in the process and while you’re negotiating with multiple buildings.  Just as rents will vary among buildings, so will lease securitization.

First, the most common form of lease securitization is the cash security deposit.  The amount of the deposit is a function of the landlord’s out-of-pocket transaction costs (i.e., concessions, construction, architectural & engineering fees, legal fees and brokerage fees) and the tenant’s financial strength. To safeguard the confidentiality of the tenant’s financial information in landlord’s review, most landlords will sign a Nondisclosure Agreement.

Below is a check-list of issues to consider:

• Does tenant earn interest on the deposit?
• Is the landlord required to segregate the funds?
• Did tenant carefully define when the landlord can draw upon the deposit?
• Is landlord required to provide notice to tenant before drawing on the deposit?
• Can the deposit be reduced over the course of the lease term (i.e., burn-off) if the tenant has not been in material default?
• Conversely, does the landlord have the right to request an increase in the deposit? If so, under what circumstances?
• If there is an ownership transfer of the building, what is the landlord’s obligation to transfer the deposit to the new owner?
• If there is a foreclosure, does landlord have an obligation to notify tenant that the deposit is being transferred to the lender?
• When will the deposit be returned? Note, tenants need to carefully negotiate the lease surrender provision. See my post “How Tenants Can Limit Lease Surrender Liability”
• Is the tenant unnecessarily waiving statutory protections of their deposit?

While the norm in a residential lease, a cash deposit is problematic for both landlord and tenant in a commercial lease should either party file for bankruptcy, as the deposit can be frozen and become part of the debtor’s estate.  It also can be complicated if the landlord faces financial trouble and the lender steps-in through foreclosure or otherwise.

Second, to avoid the bankruptcy issues, most landlords today insist upon a Letter of Credit (“LOC”) to be issued to the landlord from the tenant’s bank in the event of tenant default.  The most common LOC is what is referred to as a “Standby Letter of Credit” where tenant’s lender (“Issuer”) will guaranty payment to the landlord (“Beneficiary”) if certain conditions are met in the letter, i.e., tenant default.  The amount of the LOC, like the cash security deposit, is a function of the landlord’s out-of-pocket transaction costs (i.e., concessions, construction, architectural & engineering fees, legal fees and brokerage fees) and the tenant’s financial strength.  Tenants will typically fund the LOC from existing deposits with the lender and/or other accounts.  Tied to the LOC amount, the tenant’s lender will charge the tenant an annual fee.  The major advantage for the tenant is that they can keep their funds with their lender, presumably earning interest.  If the landlord has financial trouble (including bankruptcy), the tenant does not have to worry about their cash deposit being tied-up in litigation or bankruptcy.  Likewise, landlords prefer the LOC since it is not considered an asset of tenant and would not be encumbered by a tenant bankruptcy.

Tenants negotiating the LOC provision should follow the above security deposit check-list (excluding those pertaining to landlord holding the funds), as well as:

• The LOC should be attached to the lease as an exhibit where it will carefully define the triggering events where Landlord can present the LOC to the tenant’s lender for payment.
• Is tenant afforded any additional notice and opportunity to cure before landlord presents the LOC to the lender for payment?
• Is landlord responsible for tenant’s lender fees to transfer the LOC to a new landlord?

Lastly, there is the Guaranty.  While a company owner may offer a personal guaranty, this can be a messy form of recovery in the event of default and many landlords prefer the efficiency of the LOC or cash deposit.  Where a company is a subsidiary or affiliate of a strong credit company, the parent company can guaranty the lease.  If, however, the Guarantor’s creditworthiness weakens, this can open the door for the landlord to request additional security.  This is usually in lieu of a deposit or LOC, but it typically does not have a burn-off provision.  Having negotiated these for domestic and foreign-based parent companies, it can be more complicated when the parent company is based outside the US.

Summary

The irony of lease security is that the tenants who can least afford it are most challenged. Tenants must proactively address this issue.  Absent a parent company guaranty, tenants are well advised to establish a LOC so that the landlord does not hold and control the tenant’s deposit.

A major component (30% or more) of an office tenant’s rent bill is property taxes & operating expenses (“T&O”) which today is on the rise and where tenants have limited control under landlord-favorable leases.  In Chicago, T&O is rising significantly and where most buildings quote rents on a “net” basis (which may be comparable), the amount of T&O can vary significantly among buildings.  While tenants and their advisors will fight hard on the rent and other deal terms, if T&O is not properly vetted and negotiated, those deal terms will be far outweighed by surprisingly large T&O costs. In this post, I discuss the two common rent structures and offer strategies on limiting increases in T&O to provide tenants with cost certainty. 

1. Rent Structures: Net -vs- Gross. While there’s lack of consensus on the terminology (i.e, triple net, modified gross, etc..), office lease rent structures boil down to two structures, “Net” or “Gross”, both of which provide a  basis where landlord and tenant allocate T&O through cost sharing.  The landlord’s objective is to recoup T&O (along with any increases) to preserve its net operating income as well as its ROI.  By contrast, tenants reasonably expect to pay for T&O (and increases) which are operational in nature.
   • Net Rent – tenant pays its “net” rent plus its proportionate share (relative to neighboring tenants) of T&O. To illustrate, on an annual basis, where the net rent is $20/sf and T&O is $10/sf, then tenant’s total rent is $30/sf.
   • Gross Rent – tenant pays its “Gross” rent and is responsible for increases in its proportionate share of T&O that exceed the Base Year or Stop amount. The Base Year is typically the first calendar year of the lease; however, a savvy tenant who wants its Base Year to be as high as possible may request that it be the following calendar year, which is particularly fair where the term starts in the 3^rd or 4^th  For example, if the Base Year is 2017, a tenant wouldn’t face any T&O liability until 2018 assuming an increase in T&O from 2017.   A “Stop” is somewhat of a misnomer for tenants, as one would naturally think that would be the limit of their T&O liability; however, as the lease is drafted to the landlord’s advantage, the Stop is the amount where the landlord’s T&O liability ends and the tenant’s liability begins.  Unless the Stop will exceed the first calendar year, tenants should avoid the “Stop” structure   As an aside, there are some leases (typically subleases) which are referred to as a “pure gross” lease where there is no T&O rent payment by tenants. 

2. Which rent structure is best for tenants? I’m asked this occasionally by clients, as tenants are looking to minimize their costs and have some reasonable predictability.  While they should be cost equivalent to the tenant in a balanced market, if properly negotiated, the Gross rent is more tenant favorable as the landlord bears the risk on T&O for the initial year assuming a “Base Year”; however, in a weakening market where T&O are on the decline, the tenant may be better served with a net rent structure.    Conversely, where T&O are on the rise, tenants may find a Gross rent structure more beneficial.
   • When Gross Rent is Unfavorable. In some markets, a Gross rent structure may not be most favorable to the tenant where the landlord’s T&O are artificially reduced; a common example in Chicago (and other markets) is property tax reduction due to landmark or historical significance.  These landlords quote Gross rents consistent with comparable buildings on a net basis, but they are effectively receiving a higher net rental rate given their reduced taxes.  Savvy tenants with leverage should challenge these landlords and explore structuring their rent on a net basis.

3. How to Limit T&O. Before discussing strategies to limit T&O, there are 3 principles to keep in mind: (i) expenses which are “capital” in nature and inure to ownership long-term should be borne by landlords; (ii) expenses which are “operational” in nature should be borne by tenants; and (iii) as office buildings change hands frequently, tenants should not assume that their future landlord will be benevolent in charging T&O.  In fact, as buildings are trading for record prices based upon the assumption of rent growth, we’re seeing new landlords look to maximize revenue which can include aggressive treatment of T&O.
   • Market Due Diligence. Limiting T&O begins well before negotiating a lease.  It starts with in depth market research and building due diligence.  As mentioned above, while in Chicago we see buildings with comparable asking “net” rents, the T&O will vary considerably.  In evaluating office buildings, the tenant’s broker should examine historical T&O estimates for the current year and status of tax assessments.
   • RFP – historical T&O. After touring buildings, the tenant’s broker should include in the RFP to the short-list candidates a request for an itemized list of key T&O line items for the past 3 years as well as the estimate for the current calendar year.  This is a great tool to identify any “red flags” and dive deeper into why one building may have higher or lower T&O.
   • Base Year. Where a Gross lease is most favorable and a Base Year is being proposed, the Base Year should be the first full calendar year.  It also should be adjusted (“grossed-up”) to assume the building is fully occupied and taxes are fully assessed.  “Grossing-up” is a somewhat perplexing concept which landlords request so that expenses are fairly allocated where the building is not fully occupied.  The expenses to be adjusted should be those which vary based upon occupancy.  To illustrate, if a 100K sf building is fully occupied and utility service is $1/sf, a tenant leasing 25K sf (leasing 25% of the building) should pay $25K (25% of $100K).  If, however, the building is 50% occupied, the building’s utility costs are $50K.  Should the 25K sf tenant pay 25% of $50K (or $15K)?  If so, then the landlord is required to pay the additional $12,500 which the tenant has consumed.  To avoid this inequity, landlords extrapolate these variable costs to assume the building is fully occupied.  Leases commonly gross-up T&O for lease years, but they typically do not gross-up the Base Year.  A grossed-up Base Year safeguards the tenant from having an artificially low Base Year due to low occupancy.  Additionally, any renewal option should provide tenant with a new Base Year.
   • Annual Cap. In the RFP, to maintain maximum leverage, request that tenant’s liability to T&O shall be limited to a fixed % increase., i.e., 3%.  As there are certain items outside the landlord’s control, the fair compromise is to link the cap to “controllable expenses”.  Of course, the landlord will offer an over inclusive definition of “controllable expenses”.  Ideally, the tenant should agree that “controllable expenses” are “all expenses other than insurance, taxes and utilities (to the extent not caused by excessive use by owner or occupants).”
   • Laundry List Exclusions. As leases are drafted by landlords to their advantage and to provide the landlord with flexibility to charge for certain unforeseen costs, they contain a very broad definition of what they can charge tenants as T&O.  While they will commonly provide a short list of exclusions to what constitutes a T&O, the tenant’s broker should have a laundry list of exclusions to close any loopholes. This should be introduced no later than the Letter of Intent stage.
   • Measurement.  Be certain that the Premises is measured in accordance with the agreed-upon measurement standard.  Likewise, to determine pro rata share (based upon a fraction where the numerator is the Premises’ rentable area and the denominator is the Building’s rentable area), be certain the building’s rentable area is measured in accordance with the agreed-upon measurement standard.  For tips on office space measurement, see my post – “How Does Your Office Measure Up?” 
   • Audit Right. What good is this T&O language the tenant fought so hard for if they cannot investigate or contest any unusual T&O charges?  To be introduced with the RFP should be the tenant’s right to audit T&O charges.  In addition to inspecting landlord’s records at its office, practically speaking, it should also include the right to request electronic copies of all records to be sent to tenant and/or its auditor, as many T&O discrepancies can be resolved more cost effectively through a “desk audit”.  Among the issues to consider in negotiating this audit right, is for the tenant to be reimbursed for its audit fees in addition to a prompt refund of any overcharges.  Along these lines, the tenant should have the freedom to have its auditor compensated on a contingent fee basis.  Landlords, to curb audit abuse, will commonly insist that the audit be conducted by a major accounting firm, CPA and/or not allow any form of contingent compensation. Tenant should also be sure they have adequate time to conduct their audit. While landlords will resist, tenants should push to examine prior years’ charges, as an error likely may have been occurring over the term of the lease.

The quest for “transparency” is a major driver in our world today so that people can make the best decisions.  We saw it with banking reforms after the recession as well as with all the new disruptive technologies.  In commercial real estate, we recently saw the push for transparency with the new lease accounting rules.  Commercial real estate brokerage, is a sector in need of increased transparency, particularly given the continued consolidation of commercial real estate brokerage firms where it is increasingly common for opposing parties in a transaction to be represented by agents from the same firm.  Beyond this conflict of interest issue, greater transparency is needed as to compensation and “incentives” offered by property owners to entice agents to show a particular property.

With recent headlines about conflicts of interest in real estate brokerage in the UK, as well as a California Supreme Court decision (Horiike v. Coldwell Banker Residential Brokerage Company, where it ruled a residential brokerage firm owed fiduciary obligations to both buyer and seller even though different agents within the firm represented the parties), this post addresses brokerage law as it pertains to Illinois, which is similar to many other states, and why more transparency is needed in commercial transactions.

In Illinois, like many other states (excluding California), there is a concept called “designated agency” where it is presumed that an individual agent is representing the client (“consumer”) with whom it is working with in the transaction.  This concept arose to replace the common-law concepts of agency and fiduciary obligations which were not compatible with a typical real estate transaction.  In many residential transactions, it is common for the same brokerage firm to have different agents representing both buyer and seller resulting in a “dual agency” situation with conflicting fiduciary obligations.   Under designated agency, the firm’s sponsoring broker can designate different agents within the firm to represent the opposing parties while the firm itself is not technically considered to be an agent for either party.  While each designated agent has “fiduciary-like” obligations, including as to confidentiality, this concept goes further to state that the sponsoring broker is not an agent of either party even though they can receive confidential information from each parties’ designated agents for purposes of “seeking advice or assistance for the benefit of the client”.  While the sponsoring broker is required to “take ordinary and necessary care to protect confidential information” and cannot share confidential information with the opposing designated agent or its client, there should be some safeguards and disclosures to ensure that the sponsoring broker is not favoring one party over the other.  Note, the Horiike decision is the result of California not having such a “designated agency” law and until the state legislature acts, tenants and landlords and their agents should proceed with caution.

“Dual Agency”, by contrast, is a unique arrangement where the opposing parties are represented by the same individual agent.  While some states preclude such arrangements, it is allowed in Illinois and other states, but it requires written consent from each party and the agent’s role is very limited – more of a conduit than an advisor.

As the overwhelming majority of real estate transactions are residential, real estate  brokerage laws are created to address the issues in such transactions. While there are some parallels between residential and commercial transactions, today’s commercial transactions (particularly office) have become increasingly complex involving millions of dollars.  With such high stakes, landlords and tenants have looked to their agents to be more than “order takers” and rely upon them to provide deep financial analysis and negotiations of leases that commonly exceed 100 pages with a multitude of issues. Tenants, particularly small and medium-sized businesses, are less sophisticated in this area than landlords, whose core business is commercial real estate.

Recently in the United Kingdom, the real estate accreditation body, Royal Institutions of Chartered Surveyors (RICS), published a statement containing more stringent conflict-of-interest requirements which will go into effect January 1, 2018.  Namely, informed consent of all parties shall be required for all dual or multiple relationships.  Additionally, it requires clearer guidance on confidentiality.  This RICS statement is based upon a study by the University of Leeds (“Leeds Study Commercial-Property-Agents-and-Conflicts-of-Interest“) which found: (a) potential conflicts of interest and lack of transparency are detrimental to less sophisticated small to medium-sized businesses; and (b) for firms that represent both tenants and owners, there is a lack of separation between their internal tenant and owner agency business units.  The Wall Street Journal in 2014 discussed the issue of conflicts of interest in commercial real estate brokerage firms following a George Washington University study (“Conflicts of Interest in Commercial Real Estate Transactions: Who Represents the Tenant?“) by Peter Smirniotopoulos.

Recently I negotiated a lease for a multi-billion-dollar client with ties to many of the country’s top law firms.  Before commencing lease negotiations, the landlord’s attorney (from one of these top law firms) first obtained a signed conflict waiver from my client who was represented in the lease by their in-house counsel and yours truly.  That’s not the first time this has occurred with this client and others, but I asked myself, why don’t brokers have to obtain similar conflict waivers?  As a lawyer by background, I’ve never heard of the same law firm representing opposing parties in a transaction or litigation.  That’s due to the statutory rules of professional conduct for attorneys, rooted in the principle that one cannot serve two masters.

Beyond conflicts of interest, another industry practice that requires disclosure is compensation and other financial incentives.  As brokers, we’re paid by the commissions embedded into the transaction.  While the tenant doesn’t directly pay the fee, there’s “no free lunch”; but if the broker is doing her job, she’ll save the tenant multiples of her fee.  Commission structures vary from market-to-market, as well as within markets.  Some landlords (particularly, sublandlords) will offer higher commissions to attempt to influence the tenant’s broker.  Any good tenant rep broker is not going to be influenced by such ploys, but they should be disclosed to the client.  Along those lines, landlords will also provide gifts (cash, gift cards, trips, etc.) for touring a building with a client or requesting a proposal, etc…  Again, a good tenant rep broker is not going to be swayed by these gratuities, but they should be disclosed to the client.  Personally, I’d rather see the cash equivalent be reflected in lower costs for my client or donated to my client’s charity of choice.

I’m not going to self-servingly suggest that global commercial brokerages should spin-off their tenant representation practices.  Being realistic and as a co-founder of Blackacre Advisors, where we only represent office tenants, I understand that some companies like the platform of these global brokerage firms while others prefer platforms of tenant-only representation firms.  Instead, and like attorneys who are required to obtain conflict waivers, there needs to be more disclosure to the parties of exactly who is representing whom and how their information will be safeguarded.  There also needs to be more transparency of compensation practices.  As others have suggested and given the differences among 50 states, a model code of commercial real estate brokerage practice  would have merit.

*As stated below, these posts reflect industry practices and do not contain any legal advice and should not be relied upon without advice from your legal counsel.

We’ve all heard of the rich perks leading tech companies offer their employees – from gourmet food to full-service gyms.  Borrowing a page from these companies, office landlords are offering many of those perks to their tenants as added amenities as they look to lease-up their buildings and increase rents.  While their interests diverge, today’s office landlords and tenants (not just the Googles of the world) share a simple mission: create a workplace where people want to be and where they thrive.  That’s particularly the case today where everyone is looking for ways to retain and attract millennials.

We are seeing office landlords offer such perks nationally as reported in yesterday’s Wall Street Journal – Office Landlords Roll Out New Perks

Years ago, building amenities were sparse, i.e., sundry shop, vending machine, and maybe a small fitness center.  Not long ago I saw one suburban building list one of their amenities as “the pond”; but, no swimming or fishing.  In today’s competitive environment, however, for office buildings to remain relevant they must step-up their game and offer amenities that will allow businesses to grow by attracting and retaining talented workers.

In Downtown Chicago, existing buildings are under added pressure to compete against the new buildings that are coming online.  That’s particularly the case where these buildings are losing major tenants who are moving into these new buildings.  Besides renovating lobbies, these buildings are removing “rentable space” from the building and converting it into common area space for use as large conference centers, fitness centers (that rival top gyms) as well as gourmet food courts.

While tenants benefit from amenity rich buildings as a recruiting and retaining tool, they also benefit from being able to be more efficient with their space.  For example, a tenant may be able to reduce its internal conference rooms where the building offers extensive conference facilities.  Likewise, we are seeing some tenants reduce the size of their kitchen seating areas where the building has tenant lounge areas.   Many of these building lounge areas are taking advantage of the great outdoors with roof decks.

Looking ahead, I think we will continue to see buildings ramp-up their amenity offerings particularly in urban areas. Suburban markets are starting to follow suit. For example, I recently toured an office building in Chicago’s western suburbs where the list of amenities included a full-service gym, café, on-site concierge and holiday gift wrapping service.  Suburban office buildings have been slow adopters as investors have been more attracted to urban office properties. That, however, is changing as investors are turning to suburban markets for opportunities offering a greater yield.  Suburban buildings, without the capital to provide such amenities, will be challenged absent location or some other inherent advantage. Last month, the Wall Street Journal (Suburban Offices Woo Millennials with Food, Fitness and Fun) reported on how suburban office buildings are starting to offer perks and amenities to their tenants.

Looking forward to a new chapter in your business, you just moved into your new office space.  Your old office building is, however, haunting you after receiving an invoice from your prior landlord for restoration obligations.  Most office leases contain a relatively innocuous provision commonly referred to as the “Surrender Clause” which spells out the obligations of the tenant to restore their premises to a certain condition upon lease expiration or termination.  Many tenants pay little attention to this provision in lease negotiations based on the conventional wisdom that the landlord will likely demolish their space and rebuild it for a new tenant.  In this post, I outline what tenants should consider in limiting their liability when surrendering their premises.

Earlier this month it was reported by Crain’s Chicago Business that Zurich North America, after recently moving into its new highly acclaimed HQ building, is being sued by its former landlord for its failure to maintain its former HQ (800K sf) plus holdover rent since the repairs were not completed by lease expiration. Here’s a link to the article: Landlord accuses Zurich of leaving former HQ in disrepair.

Surrender Provision.  This provision establishes liability for wear and damage to the leased premises during the lease term.  It typically requires the Tenant, upon lease expiration or early termination, to: (a) surrender the Premises in the same condition (excluding ordinary wear and tear) as of the commencement date of the lease; (b) remove from the Premises its furnishings (including telecommunications wiring) and trade fixtures, while repairing any damage resulting from the removal; and (c) remove any alterations.

In negotiating this Surrender Provision, office tenants should avoid assuming any of the landlord’s obligations.  Specifically, tenants should exclude from their restoration obligation:

• the removal of the initial improvements to the Premises and/or any requirement to return the Premises to a “white box” or shell condition;
• any damage resulting from casualty loss;
• damage caused by any repair or maintenance obligations of Landlord or a third party;
• any changes that may be needed due to a change in law after lease execution;
• alterations which do not require landlord consent or where consent is given but its removal is not required by such consent.

While this issue is rooted in the “Surrender” provision, it also impacts several other areas of the lease that need attention to provide consistency to capture these exclusions to the restoration obligation: alterations, tenant improvements (work letter), repair, casualty, signage provisions, holdover and sublease.

In negotiating the lease and to limit its restoration liability, tenants should be mindful of:

• any improvements or alterations, which are unique to the Tenant, where the Landlord is justified in requesting their removal and any incidental restoration work.  There, the parties should stipulate as to what improvements are to be removed and create an inspection process following removal to minimize disputes;
• the repair obligations of Tenant being limited in scope to the Premises;
• any signage that is installed within the Premises or, where permitted, on the exterior of the Building;
• any assignments or subleases entered should incorporate these “Surrender” obligations to prevent the subtenants (assignees) from running afoul of these obligations.  Also, tenants would be wise to end their sublease term 30 days prior to the lease expiration date to allow adequate time for restoration, if necessary;
• not allowing a breach of these “Surrender” obligations to trigger the “holdover” provision which can expose the Tenant to 150% (or more) rent as well as consequential damages (i.e., landlord’s lost leasing opportunities);
• removing their telecommunications cabling which is typically now a local code requirement.

While moving out is the last thing the prospective tenant is thinking about when negotiating a new lease, a thoughtful negotiation on the Surrender Clause and its related lease provisions will save the tenant considerable money and time in the end.

The trend of companies moving to urban areas in search of younger talent has challenged some suburban based companies, landlords and suburban governments in the Chicago area and across the country.  Earlier this year, I posted a blog examining the trend of urban migration in Chicago and nationally: Corporate Office Urban Migration – Chicago & Nationally.  While the Chicago area is well connected with mass transit (including an extensive rail system), the challenge has been for commuters to get to and from the rail line.  That’s particularly been a detriment for suburban companies trying to recruit “car-less” millennials whom live in Chicago.  While there’s train service for reverse commuters, the transit from the train to suburban office parks is a challenge.  Recently, however, a Chicago area based company, along with the support of DuPage County and the Regional Transit Authority (RTA), has piloted a car-share solution at a local train station to improve transit connectivity.

DuPage County has seen its share of companies move from the suburbs to Chicago and while recognizing that there is a robust train service to attract reverse commuters, the missing link has always been how to get commuters from the train to the office.  This car-share company, Innova EV, started a pilot program with a local commercial property owner, Hamilton Partners, to provide small electric cars as transit to and from their office complex in suburban Itasca.  Like other suburban office owners, Hamilton Partners lost some major tenants that moved downtown to tap a younger talent pool.

This Innova EV program, which operates from an App on your smart phone, will cost less than a traditional ride share service (i.e., Uber of Lyft) and, being 100% electric, offers the benefit of environmental sustainability.  In fact, it can help companies enhance their CSR (Corporate Social Responsibility) ratings. Innova EV was recently featured on Chicago’s WGN news.  Here’s a Video Clip.

DuPage County is working with the RTA on creating “mobility hubs” near major train stations to streamline the commute with such services as Innova EV, buses, van pools, bikeshare, etc…  While this post focuses on the “Last Mile” for reverse commuters, DuPage County and Innova EV offer solutions for the “First Mile” of getting commuters from their residence to public transit.  To learn more about what DuPage County is doing along these lines, please see Choose DuPage.

While this will bridge the gap for some reverse commuters, companies may still feel the pull of an urban location due to:

• Suburban locations being an added commute for the City resident;
• The City offering proximity to other customers and partners for external collaboration; and
• Some suburban office locations lacking amenities within walking distance.

With the continued rising costs in Chicago compared to the suburbs, as well as other fiscal issues, time will tell if the big city cost premium is worth it.  It also remains to be seen how well these last-mile solutions will be embraced.

Occasionally, we hear of a tragedy where a bomb explodes in a former war zone.  Likewise, in commercial real estate where most markets have recovered from the recession, there is a time bomb of building ownership that can be disastrous for office tenants.  That ownership structure is a TIC (Tenancy-In-Common).  In this post, I outline what is a TIC, the challenges they present and how tenants can safeguard their interests.

What’s a TIC?  Among the legal ways to own real property is “Tenancy in Common” (TIC).   In simple terms, Tenancy In Common is a form of shared ownership which can be in unequal sizes and freely transferable.  While the origins of TIC are rooted in old English law, about 15 years ago it became a popular investment vehicle for commercial real estate for two primary reasons: (1) capital gain deferral through tax-free 1031 exchange after issuance of a 2002 IRS guidance; and (2) access to larger investments outside the reach of many individual investors while being relieved of active management of the property.  While TICs, as explained below, have lost their luster, some buildings are still owned under this structure.

Here’s how it typically works.  A TIC promoter (“Sponsor”) finds a property (usually a large property) and the Sponsor sells TIC interests (analogous to purchasing stock in a corporation) to investors.  The Sponsor will then arrange for financing as well as management and leasing of the building.

TIC Ownership Challenges:  The IRS allows up to 35 TIC investors which is not uncommon for many office buildings that are owned by a TIC.  Another significant requirement that makes TIC ownership problematic is that all major decisions (i.e., financing, sale) require unanimous consent of all investors.  Where a TIC investor does not consent to a major decision after 80% of the fellow investors have agreed, that dissenting investor’s interest can be acquired by any other TIC investor.   For all other matters, a simple majority is needed for approval.  The daily leasing and management activities, however, are handled by an outside property management and/or leasing firm.

When the TIC Explodes:  When the building is well occupied and cash flowing, life is good.  Trouble occurs when there’s a major cash flow disruption, as most of these TIC owned buildings are financed with debt.  That cash flow interruption typically happens when the building loses a major tenant and is unable to meet debt service.  Alternatively, we have seen the slow-motion car crash where the anchor tenant has moved out and continues to pay rent, but the underlying loan is maturing which the TIC owner is unable to refinance due to the drop-in valuation after losing the tenant.

As a financing decision requires the unanimous approval of all investors, that’s a major challenge when there are likely 35 individual investors (who typically are complete strangers to one another) attempting to negotiate refinancing or loan modification as that typically requires that the investors contribute more equity to offset the drop-in value.  The refinancing becomes even more challenging when the underlying loan is held in a CMBS (a commercial mortgage backed securities) where there are multiple layers of lenders.  See our prior post on what tenants should know about CMBS financing.

As we all know what happens when we have too many cooks in the kitchen, these buildings typically are unable to refinance which leads to default and ultimately foreclosure. Without cash flow, the building is unable to be maintained which impacts existing tenants.  The vicious cycle begins as they are unable to lease space to any outside tenants to back-fill the vacancy because they do not have monies for leasing, e.g., construction allowances, brokerage fees, etc.…

How Tenants Can Safeguard their Interests: Here are some things tenants can do to protect their interests.

1. Know your landlord.  When exploring properties, have your broker provide due diligence on the buyer and thoroughly vet the ownership group.
2. Know your building.  When exploring properties, even where the building is not currently owned by a TIC, is the tenant base diverse enough to avoid the major cash flow interruption should a major tenant(s) leave?  What is the status on the debt?
3. Does your lease have service interruption remedy language in the event the landlord is not providing necessary services that are mission critical to your business?
4. Along those lines, does your lease offer limited self-help remedies for landlord default?
5. Does your lease require that the landlord obtain Non-disturbance agreements from current and future lenders which will preserve your lease in the event of foreclosure?  See our prior blog on Non-disturbance agreements.

On the heels of the great recession in December 2010, I wrote about whether the trend of office tenants moving to urban areas is a secular shift or an aberration (“Downtowns Drawing Tenants Over Suburbs: Secular Shift or Aberration?“), concluding that companies that are location neutral (i.e., don’t need to be suburban or urban) will be driven by qualitative factors including, most importantly, labor.  Here in Chicago and many other markets nationally, we’ve seen an increasing number of companies relocating all or a portion of their operations to the Central Business District (or surrounding areas).  Most recently, it was announced that McDonald’s Corporation will relocate their HQ from west suburban Oak Brook to Chicago.  With urban office rents being considerably higher than suburban, these companies are not looking at real estate from purely a cost perspective, but rather how it can be a strategic tool in driving their core business.  In this post, I summarize the reasons underlying this trend, what we can expect in the future and what is happening in Chicago as an illustration of this national and global trend.  I also explore why some companies have decided to stay in the suburbs.

1. What’s Driving the Urban Migration?

• Talent.  For the same reason companies fled cities to the suburbs in the 60’s – 80’s, they’re following the talented workforce whom are mostly younger workers preferring to live and work in urban areas.  For many companies it’s a “coming home” as they originated in the urban core, e.g., before Oak Brook, McDonald’s HQ was in Chicago from 1955 to 1971.  We’ve also seen a resurgence of empty nesters return to city living; however, as explained further below, suburbs hold value for families for quality of life and education reasons.  Many of these younger workers are putting off having children until later in life.
• External Collaboration.  As most products and services these days are a joint effort with external partners, many companies see value in being down the street from existing and future business partners.  A suburban campus, by contrast, promotes a sense of isolation.  Along these lines, there was a recent article in the Harvard Business Review (“Why Today’s Corporate Research Centers Need to Be in Cities” ) about a trend among major corporate research centers relocating from the suburbs to be near urban universities and forge relationships with external partners.  Historically, many big companies innovated in silos; but today that is not feasible.  For example, in the past decade, Midtown Atlanta’s Tech Square has attracted the corporate research centers of 12 Fortune 500 Companies, due in part to the area’s proximity to Georgia Tech.   Another example is here in Chicago where UI Labs recently created a $320 million, public-private partnership aiming to boost our nation’s sluggish manufacturing economy through encouragement of digital innovation.  UI Labs houses university researchers and teams of private sector engineers and software developers working to help integrate digital innovations into the U.S. manufacturing infrastructure.
• Walk, Bike & Public Transit Friendly.  As many younger urban workers do not own cars, they are looking to commute to work by a short walk, bike and/or public transit.   The Chicago metro area has an extensive mass transit system of trains feeding the suburbs into Downtown Chicago, allowing companies to tap the widest possible labor pool; however, the reverse commute (Chicago residents commuting to the suburbs) is not as efficient and the suburb-to-suburb commute is mostly car dependent.
• Reinvigorate corporate culture.   For many mature companies, the move downtown reinvigorates the company’s culture.  Anytime a company moves offices, it reenergizes the company and it’s more the case when moving from the suburbs to downtown.
• “Juniorization”.  Frankly, it also is an opportunity for the company to rid itself of older, more expensive workers and replace them with younger, less expensive people.  As recently reported in the Wall Street Journal, (“Juniorization: When Young Workers Replace the Old”) this is a concept that first began in investment banking, where veterans where laid off for less experienced and cheaper talent.  It has now spread to other industries.
• Reduce Headcount.  Along with bringing in younger, less expensive workers, many companies making the move are also reducing their overall headcount.  Kraft Heinz, for example, in relocating from the north suburbs to Chicago’s East Loop, has downsized from 2,100 to 1,500 employees, which is partially driven by their merger.  We also saw Hillshire Brands reduce their headcount from 1,000 in Downers Grove to 544 in Chicago, which is also related to some divestures.  Crain’s Chicago Business had a great article about this trend “The Incredible Shrinking HQ“.

2. What’s happening in Chicago

Having tracked this urban movement over the past 9 years, suburban companies have leased 6.2 msf of office space in Chicago.  That has included complete HQ relocations to establishing satellite offices in Chicago.  As the total Chicago Downtown office market is 134.8 msf, the suburban migration represents 4.6% of the total inventory, so it has not been a major demand driver; but has garnered headlines and has been a major punch in the gut to the suburban office markets.  The trend is supported and made more convenient by the extensive metro mass transit, which allows companies to reach virtually the entire metro area’s labor pool.

As reported by Crain’s in their article, “The Incredible Shrinking HQ”,  regionally, these moves have not resulted in a net gain of new jobs for the area.  Also, the amount of space leased in Chicago is less than their prior suburban location, which is in keeping with the increasing trend towards densification of office space, as well as outsourcing of non-core functions.  For a summary of those companies that have moved to Chicago, see “Who’s Moving to Chicago“

For annual perspective of this migration since 2007 tracking which suburban submarket these tenants are leaving, see Graph Chicago Urban Migration.  The greatest migration we’ve seen is from the North and Northwest suburban office markets.  The table below summarizes the impact to each suburban submarket of those tenants moving (all or partial operations) to Chicago since 2007.

 3. Future Trends: Urban & Suburban Office

We expect the urban migration trend to continue, however, the universe of major companies located in the suburbs is limited.  Some of the challenges facing tenants, whether in Chicago or any other major city are:

• Rising costs, particularly in Chicago with its significant financial issues and a credit rating of junk status due primarily to deferred pension fund obligations.
• Rising Rents
• Overtaxed public transit
• Crime
• Low quality public schools and pricey private schools, which will drive the majority of the younger workers to the suburbs when they have children as have prior generations.

Suburban office space will still remain relevant and in demand.   From speaking recently with companies that have elected to stay in the suburbs, here’s what we are hearing:

• “Moving Downtown was never on the table as our CEO believed he’d lose key people in doing so”
• “Our suburban location gives us a competitive advantage in hiring talented mid-career people who live in the suburbs and are tired of commuting to Chicago.”
• “Chicago is too costly”
• “Convenience of O’Hare Airport”
• “There is still an equal or greater migration to the suburbs as families grow and over concerns about high taxes in the city”
• “We find that keeping a small footprint in the city along with a larger suburban presence helps to balance RE costs and find many people (who live in the city or suburbs) spending time in both facilities depending on work/life needs.  The talent pool is becoming less geographical – not only city/suburban, but also national.”

While your ultimate decision on leasing office space will be based upon how it supports your business goals, the building tour is an initial litmus test.  A thoughtful inspection of a building and space may identify potential issues that you can address early on in negotiations as well as avoid dead-ends.  Before you look at new office space, here are some “do’s and don’ts” to consider based upon my 20+ years representing office tenants in Chicago and nationally.

Do’s

1. Hire a tenant representative and have a signed agreement with their firm defining scope of agency, roles and responsibilities, etc. Crossing the building threshold without a signed agreement may create legal liabilities if your broker relationship sours.
2. Know how much space you need. Have your tenant rep develop a preliminary space program or, if you’ve already engaged an architect, have them develop a space program. You may be surprised at how efficient you can become with today’s new workspace standards.
3. Have your tenant rep preview the spaces you originally short-listed to tour. While experienced tenant reps will have likely been in all the buildings you’re considering, they may not be familiar with the specific spaces. To gather more intelligence as well as eliminate any dead-ends, having your tenant rep preview the spaces in advance is an invaluable exercise.
4. Include the decision maker or decision influencer on the tour. Also, include key project team members, project manager and architect for their added perspectives.
5. Limit the tour to preferably 3 or 4 buildings. With 5 or more buildings, there is usually inadequate time to tour each building and the buildings begin to run together.
6. Include buildings with different owners to foster competition.
7. Listen to the building agent’s presentation. For better or worse, the building agent is usually the prospective tenant’s first impression of the owner. If the building agent is a dud, that may likely say something about the owner, as they hired that agent. Note: if the building’s owner and/or asset manager is present, that is a good sign and demonstrates the interest level of the owner.
8. Ask questions. Preview with your tenant rep questions you plan on asking at each building. While building facts and deal terms will be fleshed-out in an RFP, there are essentially 4 categories of questions that you may want to consider:
   1. Owner & Property Manager.
      1. Owner’s history with the building and other buildings?
      2. Owner’s vision for the building over the next 5 years?
      3. Individual property management team’s history with the building?
   2. Location.
      1. Commuter access including public transit options.
      2. Proximity to coffee shops, lunch spots and restaurants.
      3. Any planned developments in the immediate area?
   3. Neighboring Tenants.
      1. Any competitors?
      2. Who are the major tenants and what are their plans?
      3. Are there any tenants that are dense users or those with high customer traffic?
   4. Building.
      1. What are hours for HVAC?
      2. Building security and after-hours access?
      3. What capital plans do they have for the building?
      4. Signage opportunities?
      5. Are there back-up generators for the entire building or just   life-safety systems?
      6. Is there a redundant power station supply?

      7. What level of internet connectivity is in the building? See my earlier post about WiredScore building certification

      8. With today’s building amenities “arms race”, what amenities do they have and what, if any, are planned?
9. Use your smartphone to take pictures and videos. In doing so, observe what level of signal strength you receive in the building and in the space you are  touring.
10. While in the space, pay attention to noise levels as well as amount of natural light. Sun exposure on the south could be a challenge to adequately cool. Along those lines, look at the exterior windows and glazing. Also, observe the condition of the window treatments.
11. Your architect will be looking at the window mullion spacing (if window offices are planned) as well as the depth of the space and column locations.
12. As a growing business, you will want to see if there are potential expansion spaces.
13. Look around and inspect restrooms and common areas (including parking areas). Besides looking for the level of quality and maintenance, your architect should see if there are any ADA issues. If so, these should be raised in the RFP.
14. Revisit the building during peak hours, in the morning and late afternoon.
15. Survey tenants. If the building becomes a serious option, have your tenant rep survey tenants in the building to get a first-hand account of their experience with the building, ownership and management.

Don’ts

1. Avoid showing excitement about building or space. Keep a “poker face” so as not to tip your hand.
2. Don’t be distracted by existing improvements in the space.  Try to look at the space as a blank canvass, unless there’s value to some existing improvements that you would like to retain.
3. Unless there’s a tactical advantage (i.e., creating competitive heat for a lease renewal), consider not disclosing tenant’s identity.  Instead, provide a generic description with assurances about stability, e.g., Fortune 500 financial services company.  Otherwise, word will spread quickly which may cause some unintended consequences, e.g., employees become concerned about moving.  If the building makes the short-list to issue an RFP, then the tenant’s identity will be disclosed.
4. Savvy leasing agents will try to elicit information from the tenant.  Tenants should say little and deflect questions to your tenant rep.
5. Don’t say which or how many other buildings are being toured.
6. Avoid answering any financial questions (e.g., “what’s your budget?”) and again deflect those to your tenant rep.  They will be addressed in an RFP, if they make the cut.