The two years before COVID – before quarantine, before wide-spread work from home policies – represented the peak of the leasing market for office space. With a strong economy and high demand, landlords were generally able to negotiate favorable rents and terms. As we know, the state of office space has shifted since then. Similarly, post-COVID leases for other types of spaces – retail, industrial, etc. – have looked very different than their pre-COVID versions, as the behaviors of tenants, consumers, and employees have changed. With many leases that were signed from 2018 through the beginning of 2020 set to expire soon (particularly in the office space market), here are some key issues to consider when drafting and negotiating post-COVID leases.
Leases for Office Space
In a recent episode of the podcast, Plain English, host Derek Thompson, a writer for The Atlantic, and guest Dror Poleg, an economic historian, discussed how most COVID-era market trends – e-commerce, interest rates, etc. – returned to their pre-COVID trends. However, remote work is an exception to this trend. Research from Stanford economist Nicholas Bloom shows that before the pandemic, about 5% of the US work force worked from home. That number shot up to 61.5% at the beginning of the pandemic, and is still around 30% now. This will come as no surprise to anyone working in an office. Those spaces feel emptier.
The office leases that were signed 1-2 years before the start of the pandemic and still in effect will start expiring soon, and most of those tenants have already started to reconsider their space needs: “How many of our employees come into the office each day? How many do we want in the office? What should we do with our space to attract the desired amount of in-office time from our employees? When will the next recession start and how much overhead should we carry then?” As these tenants look at the terms of their current leases, they may also feel some remorse for the resources they have devoted to space they did not use.
With this in mind, office tenants coming out of pre-COVID leases are increasingly expecting shorter terms with more options to renew, lower rents, and (if possible) options to expand and contract their spaces. These conditions respond to concerns about the economy and continuing uncertainty about how employees will use office spaces. Tenants may also pay more attention to the amenities in the building or nearby developments, as employers try to incentivize time in the office. Buildings with or near amenities like gyms and cafes, where tenants may seek special perks from those neighbors, are appealing. These perks may be built into leases or the tenants may seek separate, mutually beneficial contractual partnerships with those companies: the tenants are able to offer the services to their employees and the other companies obtain steady cash flow.
While these terms and benefits may be welcomed news to tenants, they put more pressure on landlords. As Dror Poleg put it, “the quality of commitments that [landlords] get from the customers are going down” as office space is “going to become a much more dynamic market.” Depending on the state of their financing, some landlords may feel tension between the demands of their lenders and the demands of their tenants. Although this is hardly the best time to refinance, landlords that have pre-COVID leases expiring in the near future should begin discussions with both their tenants and lenders to give themselves plenty of time to balance their rent streams with their loan payments. In addition to new lease agreements and amendments, some landlords will need to negotiate refinancing, loan amendments, or workout agreements.
Leases for Retail Space
The impact of e-commerce on brick and mortar retail is well documented, but retail spaces are not going away. The needs of those tenants, however, are much different than they were a few years ago. As demonstrated by Bed Bath & Beyond’s recent bankruptcy filing, larger retail spaces are disfavored. Per a JLL report, in 2022 retail tenants absorbed more square feet of space than in any year since 2017, but that same report stated that the square footage of new retail leases continues to decline, with the average size being 3,185 square feet in Q4 2022.
The peak hours for retail have changed too. As more people work from home, retail and recreational visits that were isolated to weekends and out-of-work weekday hours (e.g., golf, hairdresser, gyms, etc.) now occur more broadly. For restaurants and bars in certain areas, the shift to remote work has meant that their busiest shifts are different: Friday happy hours and work lunches might see fewer customers, but the opposite can be true for Tuesday through Thursday nights. On top of this, employment trends continue to make it difficult for many service establishments to hire enough help.
These conditions can be reflected in post-COVID leases with smaller premises with expansion options, shorter terms with multiple renewal options, and more flexible operating hours where landlords impose requirements.
Leases for Industrial Space
Although the industrial lease market was robust pre-COVID, consumer demand during the pandemic combined with ongoing supply chain concerns have made industrial spaces even more desirable in New Hampshire. Vacancies can be hard to find. Tenants that were lucky enough to enter into industrial leases immediately before COVID are likely seeking to exercise their extension options, rather than terminating or renegotiating. To the extent that landlords and tenants seeking to amend existing leases or enter into new agreements, a key issue is rent escalation. Before the pandemic, landlords were more likely to accept a flat rate for annual increases rather than tying those to cost of living indexes, as inflation had been stable for some time. With inflation more of a worrying variable, landlords are less likely accept defined escalator clauses. A possible compromise position is setting a cap and floor on annual increases in the lease, providing some protection for both landlords and tenants.