A business had leased a commercial building for five years. A few months later, the owner approached the tenant to extend the lease by an additional five years in exchange for a cash payment. Rutledge Company was asked to analyze the financial implications of the lease extension.
A lease extension would give the tenant additional security of occupancy for the extended term. The immediate payment to the tenant as consideration for the extension would be helpful to the tenant.
The downside of the extension, though, was the loss of flexibility. The original lease gave the tenant the opportunity to leave after five years, and the extension would remove that opportunity. Presumably the tenant desired that flexibility when the original lease was negotiated.
We surmised that the owner was seeking the extension to make the property more attractive to either a lender or buyer. The extended term would eliminate the risk of a vacancy at the end of the first five years.
A vacancy would cost not only the loss of rent during the vacancy but would impose costs on the owner for taxes, insurance, utilities, and maintenance during the period of vacancy; a leasing commission for finding a new tenant; and capital expenses for updating the premises to meet the needs of the new tenant (tenant improvements). A high vacancy rate in the area indicated that a long vacancy could be likely, and the owner would stand the risk of a lower rent in a subsequent lease.
We analyzed estimates of the owner’s cash flow projections under alternate scenarios: (A) the current lease expiring and related vacancy expenses before a new lease could be negotiated and (B) an extended term without those costs.
The analysis revealed that the owner’s offer was a small fraction of the benefit they would achieve by extending the lease. With this information, our client (the tenant) was able to negotiate compensation for the extension more effectively.
Rutledge Company LLC
License No. 481.000176
John K Rutledge, Managing Broker
License No. 471.004599