Compared to owning a building, leasing space should be relatively secure. After all, tenants usually aren't directly exposed to the fluctuating value of real estate assets, changes in the commercial mortgage interest rate market or liability for major capital expenditures on the buildings they occupy. However, tenancy isn't always the smoothest situation either. Below are some of the underlying risks associated with lease transactions.
Rent Fluctuations
Rents can fluctuate both when a lease gets signed and during its life. The market sets the rent when the lease is signed, but the terms of the lease usually define what happens during its life. While a flat lease or one with fixed increases is relatively safe, leases with escalators tied to the Consumer Price Index can be very risky. If the CPI escalator isn't subject to an annual cap, rents could skyrocket in times of high inflation.
Co-tenancy Conflicts
Most tenants have little or no ability to influence with which other tenants the owner of the building signs leases. As such, a white shoe law firm could end up sharing a building with a collection agency. Another risk is that the landlord will sign a lease with a tenant that has a dense floor plan, causing parking problems for everyone else.
Inability to Renew
Tenants run the risk of being unable to renew their spaces if they want to stay in the building beyond the expiration of their leases. In some cases, renewals become impossible because the market rent has increased so much as to be unaffordable. In others, the landlord simply decides to lease the space to another tenant. While tenant-controlled renewal options can help to alleviate the latter issue, many options set the option rent as a function of fair market rent and do nothing to protect tenants from market shifts.
Negligent or Inefficient Management
Tenants with responsibility for building operating expenses and CAM charges are at the mercy of the building's management. If the manager is conscientious and works with good vendors that offer competitive pricing, this could be a benefit. On the other hand, managers that are less conscientious or that are looking to squeeze every penny out of the building could lead to tenants absorbing above-market costs.
For example, if a management company uses their own subsidiary that charges rates at the high end of the market, to do building repairs and maintenance, tenants pay for it and the manager pockets the extra. A building's ownership or management may also simply be hands-off and fail to aggressively manage expenses. If the tenants pay for 100 percent of the cost of janitorial service, for instance, the owner and manager have little incentive to spend their time and effort to reduce a bill that they aren't paying.
Vacancy
A full building brings a sense of vitality, vibrance and energy that many tenants find desirable. However, if an owner mismanages a building, tenants could move out, leaving the remaining occupants in a building with empty spaces on its directory and dark floors. In many cases, amenities and services can also get cut back. While having lease clauses that require the continuation of building services can help mitigate some of the problem, being stuck in a fully- or partially-empty building is a real risk. It can be particularly damaging to companies that require foot traffic from complementary adjacent tenants to drive their sales.
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