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Has the pandemic changed office leases?

10.12.2020

Not until long ago we seemed to be living on what was referred to as a “green island.” The economic boom might have seemed unstoppable. Companies kept growing, recruiting and expanding their office premises. Developers were reacting accordingly by building, constructing and delivering new office units to tenants.

If this article was a blood-chilling thriller, the next sentence would be something along the lines of “and then the mysterious SARS-CoV-2 virus struck, with the pandemic arriving and changing everything.” But this is not a thriller; we are focusing on facts, and there are two crucial facts to consider here.

The first one is that the pandemic has indeed struck. At first, it seemed that the story of the new virus would resemble that of bird flu – it will come, stay for some time (though many people would be inclined to believe that this does not concern them as the virus is only somewhere in Asia, and nobody really knows anyone who contracted it), and the whole thing will blow over as soon as the parliament adopts a new act, and farmers, miners or nurses (*delete as applicable) hit the streets. But this was not the case. The pandemic and the ensuing restrictions have become an intrinsic element of our daily life. We wear face-masks, wash hands more frequently than ever and avoid overcrowded locations.

The other fact is that the pandemic has indeed influenced much more than just the commercial real estate market. It has affected the economy in general. There were many different reactions at the beginning – from anxious and cautious (“OK, we are suspending all processes, let’s take a deep breath and keep monitoring the situation”) to more balanced and methodical ones (“Chill out, nothing is really going on, the HQ has made a decision, and we have secured financing – we will complete the project as planned”).

After the initial dust has settled, it is worth making a broader analysis of how heavily the pandemic has weighed (or will weigh) on office leases.

The first conclusion that comes to mind naturally is that if tenants are more cautious in their decision-making processes related to long-term lease agreements, and the demand for office premises is consequently lower, the market will respond by reducing base rents. It is hard to make any long-term predictions but one thing is for certain: we should not expect any bargains in buildings that are being delivered now.

Developers have incurred specific costs to prepare the investment projects as they are offered to tenants – they acquired land, developed buildings of a pre-determined standard (and for a specific price), and secured external financing whose conditions impose minimum requirements with respect to rent rates.

Secondly, it is not a groundbreaking statement to say that we have all learned to work from home to some extent. Many companies have found that this works perfectly fine, and the office, as we know it, will no longer be necessary. The pandemic has also affected the financial condition of numerous enterprises. Tenants are wondering if their pace of growth will stay the same or whether they will have to reduce headcount. We can safely say that the pandemic has forced companies to rethink their needs, leading to a drop in the area of leased premises.

We do not know what is going to happen. All that matters is here and now; anything else is just an option.

An option, that’s just it. Tenants are now increasingly looking for greater flexibility of the space occupied.

Needless to say, solutions ensuring such flexibility have always been used in lease agreements. We have frequently seen different expansion options with respect to a given building or complex (reservation right, option to lease additional space, priority right). However, such rights/options tended to apply to specific premises, over a definite period, and under pre-determined conditions. Right now tenants seem to be looking for greater freedom in that regard, and lessors are usually willing to accommodate such needs.

An increasing number of tenants want to be able to reduce the lease area after some time or even to be given the break option. However, developers are less willing to compromise here. Moreover, not that long ago, such solutions involved a certain fee for lessors, which was supposed to compensate for the lack of profits in the long run. Now the focus has shifted to cancellation of redundant incentives that were given to tenants with respect to the originally intended (i.e. longer) lease term (without entirely disregarding the compensation factor, though).

The flexibility sought by tenants is not limited to the lease area or term. Increasingly often, it applies to the manner in which tenants can use the leased space – from fewer restrictions on sublease, through interior arrangement, to a change in purpose (e.g. from office to retail or the other way round) and flexible management of incentives offered by the lessor (e.g. conversion of the fit-out budget into rent-free periods and the other way round).

Has the pandemic itself made an imprint on lease agreements? Do both lessors and tenants expect lease agreement to include provisions that govern the impact of the epidemic/pandemic (or coronavirus, specifically) on their contractual rights and obligations? Well, it seems that after the initial shock, when both parties (and their advisors) felt the instinctive need to address these issues in agreements, it turned out that (as is ever the case) this had done more harm than good. It is better to terminate the agreement or make an additional sacrifice than to insist on pandemic-specific provisions. Even more so that adequate provisions governing the parties’ liability or force majeure are sufficient, and there is no need to address COVID-19 specifically.

Two questions remain. Are typical clauses, such as the right to get a rent discount or terminate the agreement, negotiated more fiercely now than in the pre-pandemic times? Will the current trends become a permanent feature of the office property market? I am going to respond like lawyers often do – it depends. And though it is hard to say what the future holds, one thing is for sure: as of now, the market favors tenants, and it seems that this situation will persist at least until the end of the pandemic or until a drop in the supply of office spaces (which might soon turn out to be one of the pandemic’s outcomes).

Alicja Sołtyszewska

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