Many years ago, I spent three summers at Interlochen Arts Camp. Nestled in the northern part of Southern Michigan (at the top of the “glove”), Interlochen has provided top-notch music and arts education to students since 1928.
Many alumni would describe rustic, dormitory-style cabins clustered near to scenic lakes, and the camp uniforms (which included Interlochen-issued navy corduroy knickers for women when I attended) as the quintessential Interlochen experience. But this year, due to COVID-19, Interlochen was forced to offer its program only online to students nestled in their own homes wearing the “uniform” of their choosing.
Interlochen wasn’t the only summer program from my past that had to shift gears this summer. While in college, I participated in Festival de Música de Camera (Festival) in San Miguel de Allende, Mexico. Despite being nestled in the mountains 170 miles from Mexico City, the Festival could not escape the COVId-19 pandemic.
San Miguel Festival President, Helenmarie Corcoran, refused to view COVID-19 as a catastrophe. Instead, she saw it as an “opportunity for the entire organization to undertake new thoughts and implement additional measures the crisis has revealed.”
Real estate owners and businesses have shifted to online meetings, virtual closings, electronic documents, virtual walk-throughs, and telecommuting. They may view these changes as temporary, needed only in the face of a once-in-a-century pandemic.
Yet everyone should, like the San Miguel Festival, use these experiences to challenge their business paradigms and reimagine their industry. Everyone should explore new ideas and implement improvements that will serve them today and allow their businesses to thrive in the future. This article predicts how the pandemic will change the office lease market and what landlords and tenants will need to do to survive.
How COVID-19 Has Changed the Office Real Estate Sector
The commercial office lease business model and commercial leases haven’t changed much in decades. The tenant selects a specific space for its use. The landlord advances funds so the tenant can customize the space for its needs.
The landlord maintains the common areas shared by all tenants and provides building amenities, such as parking, vending, fitness centers, retail, and valet. And the tenant pays rent, which includes base rent and common area maintenance (to reimburse the landlord for the amenities and other building operating expenses).
Before the pandemic, shared workspaces were already starting to challenge the conventional office lease model. The pandemic has created additional changes and stressors, necessitating changes to commercial leases.
Telecommuting is Here to Stay
The pandemic forced many businesses to implement telecommuting. Now that the businesses have the necessary infrastructure and know the model can work, many employees may never spend 100% of their time in an office again. Employees like the flexibility from telecommuting. Plus, businesses are realizing that telecommuting can allow them to reduce their office space needs (and overhead expenses) significantly.
CBRE reports that although the pandemic likely has changed the office sector forever, physical offices will remain relevant. Businesses need a central location from which to manage telecommuting employees. Plus, CBRE notes that surveys suggest that most employees want to work in the office two or three days a week to promote collaboration among their co-workers.
With increased telecommuting and migration of resources to the cloud, employers are likely to need less office space. And the office space they need may be configured differently.
Tomorrow’s office is likely to look more like a shared workspace, with private offices shared among employees in a “hotel” arrangement and flexible spaces to facilitate collaboration, which can be adapted to meet business needs as they arise. Real estate brokerage broker and research firm JLL predicts that companies will increase demand for flex space and flexible lease terms.
Open Offices Are a Thing of the Past
Before the pandemic, open offices with vast swaths of shared workspace were all the rage. The pandemic abruptly reversed the trend. Now tenants and landlords scramble to adapt open spaces to allow for social distancing and to add plexiglass dividers to minimize the likelihood of disease transmission.
My office building has expanded its no-touch entry systems using phone apps and fobs. Door handles have been replaced with foot pedals. Motion-activated light switches, which previously were popular for their energy savings, serve the additional purpose of allowing no-touch access to facilities.
Until now, economics, including tenant security demands, have driven whether building owners implemented these features. In the future, McKinsey predicts that officials may amend building codes to require measures designed to limit the risk of disease transmission–whether or not they make economic sense to the building owner.
Yesterday’s Commercial Leases Won’t Work in a Post-Pandemic Market
Standard commercial office leases have changed little in the past 20+ years. Perhaps that’s because the office sector hasn’t changed much during that time either. Now, office tenants (many of whom signed lengthy leases with little attention to terms beyond the monthly rent and length of the lease) are finding their leases inadequate to address their pandemic needs.
Who Pays for Pandemic-Related Upgrades
In Demystifying the Commercial Lease: Common Area Maintenance Charges, I wrote about why office tenants need to pay attention to their common area maintenance (CAM) charge lease provisions. Office tenants may be grateful for the care their landlords are taking to implement disease-prevention safeguards. But the same tenants may be shocked when they receive a bill for their share of those costs, through CAM charges. Many CAM provisions will allow the landlord to charge tenants for the entire cost of capital expenses even though the upgrades will benefit the building long after the tenant’s lease is over.
Loss of Building Amenities
Tenants also may face a drastic reduction in office building amenities, such as fitness centers, cafeterias, valet parking, and on-site retail. The landlord may heavily market those amenities to get tenants in the door, but leases rarely require the landlord to continue specific amenities. Plus, many times, tenants pay for the amenities via CAM charges, whether they use the amenities or not.
Tenants may realize some reduction in CAM charges (which the tenants won’t see until 2021) if those amenities are paid for by the landlord. But many times, the tenant will have no recourse, even if the amenities never return.
Flexible Space Needs
The pandemic has changed many office tenants’ needs. Due to telecommuting or economic downturn, some tenants never again will need as much space as they leased. Unless their leases include the right to give back space or end their leases early, tenants will be stuck with the extra space until their leases end.
What’s more, tenants may not even be able to sublet part of their space unless their landlord consents. Landlord consent may not be forthcoming from landlords faced with tenant defaults and vacant space due to the economic downturn.
Changed Buildout Needs
Most office leases include a landlord allowance for tenant improvements. This allowance is used to pay to configure the tenant’s office space (Buildout) at the beginning of the lease term. The tenant reimburses the landlord for the allowance over the term of the lease.
Many tenants now need significant changes to their office space to facilitate social distancing. Those changes will be at the tenant’s expense. Plus, the lease usually requires the tenant to obtain landlord consent to any changes. Landlords frequently condition that consent on the tenant’s use of a landlord-approved contractor, which may increase costs or cause a delay.
The Commercial Office Lease of the Future
Office tenants’ needs have changed. Commercial office landlords will need to adapt to the new environment to survive, and leases will need to reflect those changes.
Amenities as a Key Component of the Lease
As employees spend fewer days in the office, amenities like on-site vending or other pre-packaged food service may become more critical. Tenants who reduce their rental space may place a higher value on shared restrooms. Others, concerned about disease control, might want upgrades to accommodate individual mini-fridges or microwaves.
Other amenities, such as on-site fitness centers, may become less desirable. Tenants who have fewer in-person meetings and more online meetings may eliminate conference rooms from their offices. Those tenants may desire more shared conference room amenities for the rare instances when they need them.
Desired amenities need to be specified as crucial components of the lease. That way, failure to maintain those remedies will be a landlord breach, giving the tenant the right to a remedy.
Rent Expense Aligned with Tenant Benefit
Shared workspaces create competition for office tenants. Those workspaces enable tenants to pay a flat amount and then to pay extra only for the resources they use.
To compete with shared workspaces, landlords may offer a menu of amenities, which tenants can select, and price their rent accordingly. Or, amenities, like conference room space or food service, might be pay-as-you-go, like they are in a shared workspace.
Aligning CAM charges with tenant benefit has always been important, and frequently did not happen. As tenants focus more on amenities and receive upfront bills for pandemic-related building upgrades with a multi-year useful life, they will demand changes to CAM language to allocate those costs among both current tenants and future tenants who benefit from them.
At the same time, savvy tenants will include safeguards to limit annual or aggregate CAM increases for controllable expenses (traditionally, everything except for taxes, insurance, and utilities). Landlords, on the other hand, may be warry of unexpected Code and health regulation changes and want to exempt those changes from limits.
Most office leases say how frequently individual offices will be cleaned, but the focus is on vacuuming, trash removal, and bathroom cleaning. The leases don’t specify the type of cleaning supplies or other disease-prevention protocols, nor do landlords usually have an obligation to disclose this information to tenants.
With the pandemic, tenants now know that not all cleaning supplies are the same. Tenants now know the difference between cleaning, disinfecting, and sanitizing and are likely to specify protocols in their leases. Leases should be dynamic documents, which incorporate Centers for Disease Control and Prevent (CDC) and industry recommendations by reference.
Increased Tenant Flexibility
Office tenants have seen two recessions in 12 years that resulted in reduced space needs. Except for lucky tenants who negotiate early lease buy-outs up front, the tenant must commit to a certain amount of space configured in a specified way for five years or more. And restrictions on subleases can make it difficult for tenants to fill space they do not need.
The last recession saw tenants negotiate more favorable lease financial terms and space reductions in exchange for extended lease terms. Tomorrow’s tenant is likely to want shorter lease terms or early buy-out options.
Since landlords typically amortize tenant improvement allowances over the lease term, tenants may need to simplify Buildout needs to make a shorter lease term affordable. The answer to this dilemma may be for tenants to share costly Buildout items, such as bathrooms, perhaps in the form of amenities.
The Office Lease of the Future
Music festivals have been forced to dust off their decades-old operations model and embrace the future. Office landlords need to recognize that the office rental industry has changed. Not only do tenants have different needs, but landlords face competition not only from other landlords but also from shared workspaces, which provide greater tenant flexibility and economies of scale through shared amenities.
Some of the proposals in this article don’t differ much from the status quo. For instance, some of us have been negotiating tenant buy-outs and CAM charge language for years. However, other changes, such as amenities as a crucial part of the lease arrangement and increased tenant space flexibility, are more progressive and require significant negotiation.
Regardless, the COVID-19 pandemic has forever changed how businesses will operate. And if they are to survive, office landlords and their leases will need to adapt to meet tenant needs.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.