Pros and Cons of Long- Versus Short-Term Leases in Commercial Real Estate and the Impact of COVID-19 on Each

Industry experts define short-term leases as those with terms of one to two (and sometimes up to five) years. Long-term lease terms can be 10, 20, or 30 years — and even longer. While they have the potential to carry additional costs, longer leases often offer a more economical option, especially when tenants negotiate favorable rates.

Tenants that opt for short-term leases can see higher expenses because they require landlords to amortize transaction expenses over a shorter period. And landlords pass those expenses — which property improvements/ modifications, legal fees, and commissions may generate — to their tenants by way of a higher rental rate.

Benefits of Long-term Leases

Signing long-term leases offers longer stability and allows tenants to lock in the lower payments with steady increases over time. The long-term nature of these leases allows landlords to amortize their investment in the project for a longer period, which enables them to reduce annualized costs to their tenants. While it’s common for rents to increase each year, a multiyear lease protects budgets with its predictability.

Long-term leases give tenants the ability to negotiate more favorable terms. Tenants with good credit who enter into long-term leases provide added value to landlords because lending institutions look at them more favorably. Borrowers (landlords) also get favorable rates, amortization, and payback periods with improved borrowing power.

Generally speaking, landlords want to retain tenants for longer periods and avoid the hassle of negotiating new leases. A company’s willingness to commit to longer-term leases may lead to more flexible conditions — and lower rental costs over the long term.

Drawbacks of Long-term Leases

Tenants should analyze future needs before they enter a long-term lease to ensure they’re renting enough space to meet their company’s needs. Tenants who anticipate those needs inaccurately may find themselves in one of two possible scenarios: paying for too much unused space or needing to relocate to a larger space to accommodate growth. Long-term leases offer landlords less administrative hassle but less flexibility — and more consistency but fewer opportunities to adjust rent if market conditions change, since the market direction can shift positive or negative.

Benefits of Short-term Leases

Short-term leases offer flexibility for both tenants and landlords. And landlords can change terms, conditions, and rental prices more frequently.
A start-up company often doesn’t need as much space as a more established business. Short-term leases offer the freedom to grow while preserving capital which is put to better uses than paying for unused square footage. Leases with shorter terms also benefit companies who may not have as much success as originally projected.

Short-term leases make sense for property owners looking to redevelop their property. These property owners can still generate some income during the approval process, which can take up to several years to complete.

Drawbacks of Short-term Leases

Landlords may charge higher rental rates to companies who opt for short-term leases. Those businesses also have less leverage to negotiate clauses and terms. A short-term lease can impact future predictions about company growth, making it difficult to determine costs should space requirements increase.

Landlords who don’t work with a commercial real estate (CRE) brokerage or property management firm may find themselves responsible for advertising for new tenants, verifying references, and preparing space for new tenants.

Lenders and potential purchasers of commercial properties tend to value ultra-short-term leases less highly than long-term leases, which provide more stability for an asset. That stability translates to a higher value, although it does depend on the investment. Short-term leases are normal for multi-family units, for example, whereas office, industrial, or retail spaces tend to attract tenants for the long term.

Leasing in the Time of COVID

COVID-19 continues to affect different real estate sectors, whether office, industrial, retail, or other commercial real estate endeavors. Outlooks of the CRE markets include the following insights:

  • Office Space Leases: The market continues to utilize a “wait and see” approach. Tenants are reevaluating their space requirements. Companies are redesigning spaces to meet new guidelines to protect the health and safety of employees and clients. Historically, office rents lag 6 – 12 months behind the U.S. stock market as markets adjust to economies.
  • Medical Space Leases: This market appears to be moving forward at a steady pace. Because healthcare practitioners cannot effectively work remotely, they require physical locations to provide patient care. Most healthcare transactions involve significant amounts of capital, and longer-term leases typically used for these transactions yield less movement in the sector. Longer-term leases also help to amortize construction costs over a longer period.
  • Industrial Space Leases: Industry experts predict that landlords will become bullish as manufacturing returns to the U.S. and the role of e-commerce continues to play an even larger role in the asset class. Landlords are looking at short-term transactions as they anticipate future growth in demand.

Commercial real estate investors will likely need to navigate various trends in the coming months and years, which include:

Declining retail and office rental rates

Demand for space determines rental rates — but if demand falls, rates will likely decline. Retailers and restaurants unable to meet their pre-pandemic numbers will struggle to meet the burden of their lease agreements. These businesses may ask landlords to provide alternate rent structures.

Some tenants are requesting additional space – in the office sector – to implement more effective physical distancing practices. But in the long run, companies that have found success in the work-from-home model may continue the practice, long after the pandemic has passed.

Other tenants who’d previously favored communal or shared office spaces may rethink those set-ups. Decreased demand from this sector will translate into lower rents for these properties.

Non-monetary lease terms shifting unfavorably for landlords

Some experts recommend lengthening lease commitments and locking in current rental rates. New lease agreements have already begun to incorporate future pandemic response provisions. New tenants may expect more protection in lease amendments — and more contract flexibility.

Investor attitudes in risk vs. reward based on property type

ROI correlates to risk profile, and when the use or demand of CRE assets changes, their risk profiles also change. Experts predict that investors will continue to reassess their risk tolerance for different types of CRE acquisitions.

Investors may view multi-family units, offices, and properties that house critical operations (like data/ logistics centers) more favorably than high-density assets like restaurants, retail spaces, theaters, or high-rise residential properties.

The CREA United members include skilled professionals who are adept at understanding the unique needs of both tenants and landlords. Our member brokers — including Darren Lizzack and Randy Horning of NAI James E. Hanson — help with business analyses, searching for the best-fitting commercial space, and negotiating favorable terms for their clients.

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