When the business landscape is unpredictable, many commercial real estate or CRE investors try to create stability with iron-clad CRE contracts that guarantee long-term rental income. But this is only sometimes a good idea.
Embracing flexibility in your lease contracts — though it might seem counterintuitive — can be a much better approach. It allows you to adapt to economic shifts to mitigate market volatility and secure lasting profitability.
The problem with long leases
Traditional CRE leases lock tenants into fixed spaces for extended periods (usually three to ten years). This might seem like a secure income stream, but watch out. This rigidity can backfire and create financial strain if tenants go bankrupt, which is a real possibility when the economy is unstable.
Tenants who file for bankruptcy may be able to reject the lease as part of their bankruptcy proceedings (executory contract rejection).
The court will consider factors such as the value of the lease to both the tenant and the landlord and whether rejecting the lease would be in the best interests of the bankruptcy estate.
Remember the 2008 financial crisis? Many businesses faced severe financial difficulties and had to break their contracts, leading to higher vacancy rates in commercial properties and decreased rental income. Some tenants couldn’t even pay the early termination penalty.
This is why locking in CRE contracts is not always a good idea. Integrating flexible terms into your leases can keep your properties competitive and ensure a steady income stream.
The benefits of flexible CRE contracts
If you know how to use them correctly, flexible and shorter-term contracts in commercial real estate can boost your operational flexibility and financial strength as a landlord and CRE investor.
Here are just some of the ways by which pivoting to short-term leases can transform your property management and tenant relationships for the better:
Flexibility gains
When you’re free from the chains of long-term commitments, you can quickly react to economic swings, emerging trends, or changes in tenant demographics. This agility keeps your property competitive and relevant.
Short-term leases may allow you to test-drive new markets or property types. This approach lets you gauge tenant demand and evaluate your property’s performance under various market conditions. You can experiment with different locations and building styles without the long-term financial commitment.
For example, you can launch a boutique retail space in an up-and-coming urban area to see if there’s a strong market or try a co-working setup in a tech-centric neighborhood to assess demand for shared office spaces before investing in a larger, long-term project.
Short-term leases allow you to test the viability and profitability of various property types and locations with minimal risk and adjust your investment strategy based on the outcomes.
Flexible CRE contracts give you a reversible way to explore new avenues so that you can adapt your portfolio based on real-world data and proven success before making more permanent investments.
Financial upsides
Short-term CRE contracts often demand higher rent due to their flexibility, boosting your income across their lifespan. The freedom to renegotiate lease terms regularly ensures you can keep your rates in step with the market. If the economy suddenly turns bullish, this will work in your favor, as you can tweak lease conditions to reflect your property’s growing value.
Risk mitigation
Did you know that short-term leases can also improve your risk management?
They allow you to regularly evaluate and select tenants to reduce the risk of extended vacancies and ensure a good fit between tenant and property.
Is there a sudden boom in the tech sector?
When your CRE contracts are flexible, you can swiftly pivot your tenant mix to include more tech companies to capitalize on this surge and keep your property fully leased.
Flexible CRE leases can also be lifesavers during economic downturns.
You aren’t trapped in long-term commitments that may no longer be profitable. Instead, you can adjust lease terms or shift focus to more stable sectors to maintain occupancy and cash flow.
With this agility, you can better steer through market lows and sidestep severe financial impacts.
Tenant appeal
Shorter-term CRE contracts appeal to startups and companies navigating transitional phases, among many other tenant types. These leases provide them with the flexibility they need to venture into new markets in fast-evolving sectors.
The shorter commitment also attracts companies that are watching their budgets, as it offers them a way to maintain a professional space without a heavy financial anchor.
CRE market responsiveness
With flexible CRE contracts, you can swiftly adapt to the broader economy and the CRE market’s ups and downs. You can tweak lease terms to match fluctuating rates and maximize your property’s earning potential.
Short-term CRE leases allow you to line up lease expirations with market highs and upcoming property upgrades. You can time your contracts with anticipated increases in area appeal or redevelopment plans to boost potential returns and seize strategic opportunities.
For example, do you anticipate a significant commercial development nearby — like a new shopping center or public transport hub? Short-term CRE contracts allow you to time your lease expirations around these events. This strategy will enable you to renegotiate leases at higher rates once the area becomes more desirable.
Do you plan to make significant upgrades to your property? You can schedule these improvements to coincide with lease turnovers to minimize downtime and maximize the building’s appeal to new tenants.
How to infuse flexibility into your CRE contracts?
Weaving flexibility into your CRE strategy lets you capture financial opportunities and reduce the risks tied to long-term commitments. But how exactly can you do this?
How do you ensure that your CRE contracts help you keep your properties attractive and competitive while seamlessly adjusting to market and tenant shifts?
Here are some tips to infuse flexibility into your CRE contracts:
Offer flexible exit options.
Integrate vital termination clauses in your leases to broaden your tenant pool and make your properties more appealing to startups, tech firms, and fast-growing companies. These types of businesses often shy away from long-term commitments because of the rapid pace at which they scale and evolve.
When you offer the option to exit leases early in response to business shifts such as growth spurts or strategic pivots, you attract these dynamic companies while reducing your risk of prolonged vacancies.
Think about it: If a startup outgrows your space quickly and decides to move, the termination clause allows them to do so without a prolonged legal battle while freeing up your property for re-leasing. You can then market the newly available space to another tenant —potentially at a higher rate — to minimize financial losses and keep your property continuously occupied.
Examples of flexible exit clauses in CRE include:
- Break clauses that allow tenants to terminate the lease at predetermined points (with advance notice)
- Early termination rights that permit tenants to end the lease early for a fee (to compensate you for the unexpected vacancy
- Subleasing and assignment rights that enable tenants to sublease their space or assign the lease to another business and maintain rental income flow for you as a landlord
- Kick-out clauses that allow either party to terminate the lease if specific performance metrics (such as sales thresholds) are not met
- Contraction rights that allow tenants to reduce the size of the space they’re leasing to decrease rental costs without moving
By incorporating these flexibilities into your CRE contract, you are offering tenants both flexibility and security, and this combination will make them more willing to commit to the lease despite potential future uncertainties.
Provide flexible space provisions.
Support your tenants’ growth by allowing them to expand their leased areas as needed. This hits three birds with one stone:
- The tenant doesn’t have to move.
- You can maintain full occupancy.
- You both benefit from a stable, long-term partnership.
When you respond to your tenants’ evolving space needs without requiring many renegotiations, you can keep your buildings vibrant and fully leased.
Create flexible term lengths.
Introducing various short-term renewal options attracts tenants seeking temporary solutions and reduces vacancy risks.
For example, you can offer six-month renewal terms to startups unsure of their growth trajectory or provide annual renewals with flexible terms for project-based businesses that may not need a permanent location.
This flexibility does not just benefit tenants. It also lets you adjust rental rates more frequently to reflect current market conditions, potentially increasing your revenue.
The recent pandemic highlighted the risks of rigid lease terms. During this time, many tenants struggled to meet rigid obligations. It also underscored the importance of being a proactive landlord and CRE investor.
Now more than ever, you need to recognize the value of flexible leases in boosting tenant retention and enhancing your CRE property’s reputation as an accommodating and responsive option. This lets you attract a broader spectrum of prospective tenants and sustain your profitability regardless of the business environment.
Are you looking to make your CRE contracts more flexible? Be sure to work with experienced private commercial real estate lenders like Private Capital Investors who understand market dynamics and can help you structure flexible leases while safeguarding your returns.
