Lease flexibility for a price for corporate occupiers?

I’ve got used to booking my train tickets in advance online to get a good discount on the fare. I reach the final payment screen and I’m prompted to pay an extra £2 per journey to allow flexibility on travel times. Each time I decline! Usually, I can keep to my pre-booked times but plans change, trains are missed, and I end up paying for new full price tickets. Paying a bit more upfront to allow for future flexibility and potentially make larger overall cost savings is something I will be giving more consideration to in future – at least for the sake of my diminishing bank balance.

My travel dilemma is similar to that facing office occupiers when it comes to obtaining flexibility on their leases. Let me explain…

Over the past 20 years or so we have seen a long term trend towards shortening average lease lengths. According to The IPD lease Event Report 2013 lengths for commercial property fell to an historic low in the year to June 2013 when over 80% of UK leases signed were for a period of five years or under (a 55% increase from a decade ago). On the whole this has been good news for occupiers resulting in increased flexibility, although in some specific instances companies have favoured longer leases in order to secure core buildings for a longer term.

This structural trend towards shorter leases gathered further pace following the recession, when, owing to tenant favourable market dynamics landlords were often required to make concessions and more generous offerings. As well as shorter leases, other concessions included: more flexible break options, contributions to refurbishment works, caps on service charge, altering lease language to build in flexibility to sub-let or assign and removal of dilapidations liabilities.  In the context of a new low growth business reality these flexibilities were an essential survival component for many occupiers, allowing them to restructure and streamline property portfolios. Those with break options or lease expiries during this time were able to leverage market conditions to realise significant cost savings by divesting of surplus space or re-negotiating rather than moving.

At the present time however, the tide is turning markedly and conditions are becoming landlord favourable. Rents, especially for good quality space are pushing upwards primarily due to a shortage of Grade A supply in a number of key CBD locations. Developers are starting to respond to the shortfall (confirmed by The JLL and Glenigan UK Commercial Construction Index). However there is an anticipated pressure on material costs, salaries and land prices over the next year, which are all expected to continue rising. New office space will be more expensive to build and it is likely that as well as raising rents, landlords will increasingly seek to lock tenants into longer leases to protect their investments and guarantee profits.

It seems to me the key ingredients are in place for a reversal of the long term trend towards shorter lease lengths. If I am right and longer leases become the pattern I think a number of things will happen. Some landlords will spot a market opportunity by offering higher levels of flexibility and shorter leases but at a premium cost to occupiers. We could see an expansion of flexible lease providers as well as an explosion of the serviced office sector. From the occupier perspective it is clear they will have to accept and adapt to new market conditions. Those in need of shorter leases should be prepared to pay higher premiums (in similar fashion to my paying extra for flexibility on my train tickets). Others, wishing to stay in certain key locations will be forced to concede some flexibility, accepting longer lease terms.

This is so far hypothetical of course. The only caveat I would add to my thinking here is that the investment market is moving and the weight of money means that investors are more likely to be flexible on their purchase criteria, so landlords in some instances could afford to offer an early break as the yield damage is limited.

At the current time, longer lease lengths are not yet the norm and so, despite current market conditions favouring landlords, occupiers who plan well ahead of a lease expiry or break and are willing to commit to a long lease term, still have a great opportunity to achieve cost savings by negotiating lower rents and realising more favourable lease terms. There is still plenty to play for. Now I must dash – I am booked on a train that leaves in 2 mins!