Lease: time to cut costs?
Need to make occupancy cost savings? RODNEY TIMM writes that you need an appetite to make some hard decisions when it comes to lease strategy.
During the business planning cycle, often the occupancy costs of leases are identified as excessive, needing to be reduced to maintain financial sustainability. A cost saving review will succeed best if there is a systematic approach and hard decisions able to be made.
Each location and lease agreement needs to be assessed to identify occupancy cost savings that can realistically be realised. In some cases, it may be necessary to spend money to save money. These proposed savings need to be tested with the operating units; to work out the impact on the business and the actions required must be meticulously planned.
Many of the cost saving strategies may require new or revised lease agreements to be negotiated with existing landlords – not an exercise for the faint-hearted.
COST SAVING STRATEGIES
Lease cost saving strategies will likely vary significantly across a portfolio of operating facilities based on factors such as:
- rent structure and current rent compared to market rents
- unexpired term of the lease and renewal options that exist
- terms and conditions of the lease agreement
- nature of the operations on sites and future requirements
- opportunities to consolidate or co-locate operations
- specialised nature of fitout and equipment
- market conditions including supply and demand, rental and vacancy levels, and
- relationship with and characteristics of each landlord and their key objectives.
These strategies can usually only be considered in detail once there has been a review of the terms of the lease and inspection of the premises. It is also necessary to have an understanding of local market conditions and future operating requirements for the site. Potential portfolio savings can vary significantly, dependent on the specific conditions.
The review usually indicates that there are unlikely to be any cost savings across a large portion of the portfolio because
of the lease terms, intransigent landlords or unfavourable local market conditions. It is not worthwhile focusing on these sites. There will also likely be a significant portion of the portfolio where relatively low-cost savings are possible related to tardy and poor lease management practices, both internally or by landlords.
Although these need to be pursued, they’re probably not a priority. However, there is always a group of leases, often about a quarter of the portfolio, in which potential costs should be pursued rigorously. This may be because of imminent lease expiries, landlord profiles or local market conditions.
The best time to realise cost savings is when a lease expiry or renewal option date is imminent, usually a year or two prior to the termination. Dependent on market conditions and specific landlord plans for the property, this is the opportunity to renegotiate the terms of the lease or renewal option.
This may include a size reduction, space reconfiguration, rental and outgoing recovery structure changes, building improvements
or changed make-good provisions. Key to success is the early commencement of these negotiations and being able to ‘go to market’ if the landlord proves to be intransigent.
If creating more efficient operating layouts is possible, recurrent savings over 30 percent can generally easily be achieved. In revised lease agreement negotiations, it may also be possible to ‘write-back’ some make-good provisions, reduce bank guarantee requirements and fix future outgoing costs.
EARLY LEASE RENEGOTIATIONS
Typically, these renegotiations are initiated three to five years prior to the lease expiry, based on changed requirements and
the landlord seeking longer lease tenure financial security. Lease adjustments will likely include reduced leased area, extended lease tenure (for example, an additional five years), static or marginally increased rental rates, reduced bank guarantee, removal of make-good provisions, and building services improvements by the landlord.
The advantage to the landlord is an extended lease tenure underpinning their financing provisions, and potentially an increased property valuation based on an increased rental rate agreed, applied across the entire property. Recurrent cost savings of 30 to 50 percent can be achieved dependent on successfully operating from a reduced floor area, the specific property details and the landlord.
Early lease renegotiations usually only work in certain situations; for example, in market oversupply situations and with smaller regional private landlords, who may be experiencing financing pressures from their banks.
ASSIGNMENT AND/OR SUB LEASING
Subleasing of unused premises, either in part or full, is usually the ‘go to’ strategy in most lease cost reduction strategies, but in reality these approaches tend to be more far more difficult to implement than initially thought.
The remaining term of the lease, the specifics of the market conditions, the layout of the premises (if these are to be sub- divided), the lease agreement conditions and support of the landlord all contribute to or limit the success of subleasing campaigns.
The remaining term of the lease is critical to success. Few sub-lessees are willing to move to new premises for less than three years knowing that their occupancy cannot be extended without negotiating separately with the landlord. This is particularly problematic if the sublease is for a part floor and requiring significant capital costs in reconfiguring the premises.
With a lease assignment, the challenges are usually more problematic. The assignment will need to be for the entire premises, with the full lease benefits and liabilities moving to the third-party assignee. As such, the landlord has the right to approve whether the incoming assignee is of equivalent or better financial standing than the lessee wishing to assign.
Landlords are not always reasonable in approving the incoming assignees or even sub-lessees, particularly if there are other vacancies in their building. Among the other challenges that need to be addressed includes funding the tenant leasing incentive for the fitout changes to meet their requirements or rent subsidies, if these are required.
LEASE EARLY TERMINATIONS
There are often some locations that the business no longer requires, or where there are duplicate premises (usually resulting from a merger or acquisition), or where the premises are significantly too large or not suitable for the operations.
If the possibility to assign or sublease the premises is likely not to be successful, an early lease termination to be negotiated with the landlord may be considered. This approach can be difficult to implement and is dependent on specific details of the site, market conditions and the landlord’s attitude.
The landlord’s usual starting position in these negotiations is to indicate that an early termination is only acceptable on receipt of a payment equating to the full amount of the remaining rent and outgoings payable, payback of any incentive received related to the remaining term of the lease, and a make- good settlement amount.
In certain circumstances, and with good fortune aligned with strong negotiations, a successful early lease termination can be realised based on lower payment. However, unless the premises are significantly ‘under rented’ (below market rents), or there are alternative plans for the property, landlords are seldom willing to accept payment of less than 75 percent of the outstanding amounts. Early lease terminations negotiations seldom provide much comfort for tenants.
RENTAL AND OUTGOING INVOICE AUDIT
In most lease agreements, there will be opportunities to find savings based on undertaking audits and reconciliations to identify inaccuracies in actual rentals and outgoings invoiced by landlords, against the terms of the lease and actual building expenditures.
Typically, these errors in lease management processes (somehow mostly tending to be in favour of the landlord) relate to rent reviews, outgoing recoveries or fixed charges. For example: fixed and CPI (consumer price index)-based rental increases calculated may be based on incorrect indices or bases dates; notices of market rent reviews and determinations may have been inappropriately issued; outgoing recovery pro rata apportionments may be inaccurately applied or include asset renewal capital costs; or there is incorrect invoicing for additional charges for car parking, cleaning or out-of-hours air-conditioning.
With thorough audits and reconciliations, cost savings will likely be identified, although these will tend to be in a range lower than five percent. Recovering these excessive costs from landlords, particularly retrospectively, is the next challenge.
COST SAVING REVIEW PRIORITIES
To achieve meaningful success, lease cost saving reviews need to be determined based on:
- non-property operating priority changes as determined by the organisation
- terminations in the next year to 18 months
- highest total costs of occupancy leases
- duplicate locations in proximity to each other
- locations identified as surplus or excessive to operating requirements
- sites in high demand and relatively low supply markets, and
- leases with reasonable termination provisions.
Rodney Timm is a director of Property Beyond Pty Ltd.
This article also appears in the Feb/Mar issue of Facility Management magazine.