As a Toronto, Ontario based Canadian lawyer, I advise tenants and landlords in their industrial, retail and office lease drafting and negotiations. This article identifies some of the trends in those sectors that I see in my practice. I also anticipate some possible consequences of those trends on rent and the workings of other lease provisions and provide some concrete suggestions and solutions to incorporate into your lease negotiation. This article is for the commercial real estate leasing professional involved in lease negotiations.
The Ontario commercial real estate leasing market is looking unsettled. It strikes me that several trends will soon test the language and remedies in commercial leases. I suggest that tenants and property owners ("landlords") need to recalibrate their risk assessments and give these issues greater priority in their lease negotiations. It is time to challenge some of the "standard provisions" in commercial leases, especially regarding allocation of additional rent and the right of a landlord to make physical changes and changes to the character of the centre.
The relevance and possible impact of any trend will also vary by property type, location, size, landlord size and tenant identity and requirements The article leans in favour of tenant strategies when negotiating a lease. A standard lease prepared by a sophisticated landlord already gives the landlord the flexibility it needs.
Also, the office, industrial and retail sectors of the Canadian commercial real estate market are dominated in each case by a relatively small number of property owners, some of whom are dominant in more than one sector. Some have vast resources and, in many cases, are owned by or partnered with Real Estate Investment Trusts and Pension Plans. Microeconomic impacts are muted across large portfolios of these landlords. However, individual properties are generally managed as individual profit centres. Even though the landlord has deep pockets and is not worried, there could be an outsized impact on tenants in a particular centre.
Finally, future interest rates changes, and the direction of inflation will certainly impact businesses and consumers and thereby the severity and direction of these trends.
Economic Trends Impacting Commercial Leasing
The office market is the one I see buffeted the most lately and where these trends are most evident. My motivation for this article is partly the recent experience of acting for a tenant and bringing up the possibility of new vacancies in building with the landlord. We asked for protection from increases in additional rent. The response was that there will be no changes to the additional rent clauses by way of limits or exceptions and that it was a waste of time and "it is standard". Only time will tell.
1. Office Sector
The office leasing market is challenged by:
- historically high vacancy rates, the percentages have moved from low single digits to reported availability rates of 20% in older buildings in Toronto since COVID;
- historically low utilization rates (reflecting a divergence between a strong economy and job growth on the one hand and space needs on the other);
- a flight by major tenants to new buildings with attractive amenities;
- high construction costs and renovation costs; and
- traffic congestion and a struggling transit system in the GTA.
Office vacancy rates may get worse before they get better when low utilization rates (the office premises is rented but occupied only 60% of the time) catch up to expiring lease terms. How much space will tenants need when renewing their leases?1
As office vacancies rise in most of the office market, landlords will have more trouble selling or refinancing their buildings. A review of the financial pages of various news publications finds stories about banks increasing their provisions for commercial loan losses, including mortgages on office buildings and other commercial real estate, and limiting new loans on some of those assets. It is possible that certain sectors of the commercial real estate market will get sideswiped by stricter loan requirements because of the banks' much larger exposure in the residential and condominium markets.
2. Industrial Sector
Industrial lease vacancy rates have gone in the opposite direction to the office sector over the past 5 years. Basic rental rates for industrial spaces and warehouses doubled and tripled in the Greater Toronto Area (GTA) and broader Golden Horseshoe area in southern Ontario in the last 5 years while the sector experienced historically low vacancy rates, below 5% in many market segments.
The tenants who have renewed their leases in the last two years have experienced a surprise if not a financial shock. If there is a recession or the imposition of tariffs on Canadian products by the USA in the future, then some small unit industrial tenants in the Golden Horseshoe relying on access to the USA markets for their products could become candidates for default. If that happens, then the historically low vacancy rates in industrial units could turn upward. Whether property values will also drop is a different consideration. It is often the case in the GTA that there are many domestic and international purchasers looking for commercial and retail properties who are not concerned with vacancies. However, banks and financial institutions are concerned with vacancies that reduce net rental income from a mortgaged property.
The big box warehouse and data centre sector is hot and driven by logistics and retailer fulfillment warehouse centres. There have been many new buildings built in the GTA in the last 3 years. My understanding is many of the enormous buildings under construction along the highways in southern Ontario are pre-leased.2 Many of the tenant strategies discussed in this article apply to this market segment as well. Tenants must address unknown, future additional rent factors in their leases. I worked on a long-term warehouse lease for a client. It was a space consisting of several hundred thousand square feet which would utilize the most advanced robotics and environmental and sustainability features. I visited the site during the lease negotiations and took pictures – it was still a cornfield.
3. Retail Sector
Retail rental rates have apparently held up while consumers have continued to spend. Class A malls and specialty malls have enjoyed continued demand for space and Toronto, more than anywhere else in Canada, is still attracting new international retailers. Retail leasing in general has also benefitted from a Canadian market with traditionally lower retail square footage per capita than the USA. 3
However, online sales and a slowing economy could result in new vacancies, transition to non-retail uses, fewer renewals by tenants or tenants who may elect to lease less space.
Canadian traditional retail mall landlords are also facing the challenge of repurposing the space of lost anchor store tenants.4 The landlords continue to show great creativity but may have to redevelop and repurpose large portions of the retail mall property and parking areas for non-retail services, entertainment, and office and residential developments. While big and small landlords create their new visions, existing retail tenants may suffer from the disruption during the transition period, loss of revenue and potentially face rising additional rental rates related to redevelopment costs and fewer retail tenants.
Practical and Legal issues
Landlord standard leases give the landlord broad discretion including:
- to unilaterally reallocate the additional rent charges of the centre among the remaining tenants; and
- to unilaterally move the tenant to a new premises, add mixed uses, do office conversions, and terminate leases for redevelopment.
The Total Rent Amount is Elusive
I start from the proposition that tenants want certainty in terms of what they pay for rent.
"Rent" consists of the "basic rent" component negotiated as an amount per square foot per annum and an "additional rent" component consisting of the operating costs, utilities, property taxes and other charges which are not assigned a dollar cost in the lease as the basic rent is. Additional rent is estimated and then reconciled after the end of the lease year.
Landlords want certainty that their commercial leases are "net" leases or "triple net" leases, meaning the lease provides that all the additional rent charges incurred by the landlord or the tenant over the term of the lease for the entire centre are paid by the tenants of the centre as additional rent.
Commercial leases have at least a 5- or 10-year perspective and must anticipate the "what-ifs".
Rising vacancies could result in additional rent charges being reallocated to the tenants who stay! Redevelopment costs and expenses may find their way onto the additional rent ledger. The tenant is interested in the total rent it pays, and vacancies and redevelopment can increase the additional rent component, without limits. I have seen year over year increases of several dollars per square foot.
Some might assume it is enough that the lease provides that the tenant will pays its "proportionate share." I caution the reader here. One thing I have learned is you cannot assume you know what proportionate share means. Proportionate share means what the lease says it means. It is rarely the simple math you would expect. Proportionate share in net lease terms is most often defined as the allocation of all additional rent costs to the existing tenants, at the landlord's discretion, so as to cover 100% of the Landlord's expenditures and costs associated with maintenance, repair, and replacement of the centre.
Tenants need to make sure they understand the definition of proportionate share in the lease and amend it. It is important that it means what they thought it meant when they did their rent projections. Those projections can become unreliable very quickly if the tenant pays for anchor vacancies, low rent deals with major tenants and landlord redevelopment costs. Increased vacancies sound like an opportunity for tenants to negotiate a lower basic rental rate. That is certainly true, but those vacancies also result in fewer tenants to pay the additional rent.
Perhaps landlords will accede to requests for gross up limitations, credits for retroactive tax reassessments and reductions, and the exclusion of capital costs and redevelopment costs from additional rent payable by the tenant. While landlords need to maintain their centres, they also must keep their additional rent costs competitive.
Landlord and agent verbal or promotional statements which "estimate" operating costs and property tax rates for a premises may not be appropriate or reliable going forward. They may rely on outdated assumptions, out of date information, vacancy rates that are not current and tax assumptions that do not consider future improvements. The centre may experience vacancy rates that rise to levels not seen in the past and the landlord may elect (or already have plans) to make significant mixed-use changes and redevelop some or all the centre to deal with the changing demand.
Relocations, Conversions and Redevelopment
As for relocations, conversions and redevelopment, tenants need to negotiate minimum periods where their premises location and occupation will not be disturbed, options to terminate and compensation.
As a corollary to the rising vacancies and the pressure on valuation it creates, landlords will push back in the negotiation and seek to maintain flexibility.
Practical solutions for Tenants
- Do not accept the statement that a provision is "standard" if you are trying to address your legitimate concerns.
- Negotiate both the basic rent and the additional rent at the same time.
- Do not accept pure estimates on which you cannot rely. Tenants should ask for proof of estimates using recent historical data that incudes vacancy data, line-item expenses, and copies of tax bills to start.
- Tenants should try to cap the increases in operating costs and possibly property taxes at a maximum, non-cumulative percentage, on a year over year basis.
- Insist on annual statements from the landlord reconciling the additional rent budgets to the actual costs and taxes incurred. The statement should include enough detail for the tenant to be able to determine if the lease provisions constraining the allocation of additional rent to the tenant have been complied with. Tenants must insist on additional rent transparency when it comes to additional rent at the negotiation stage and throughout the lease term.
- If your organization is attracted by amenities the building is offering, then add to your lease the express requirement that the Landlord provide those amenities for the term of the lease, the required standards and work out how much they will cost you in different scenarios.
- Retail tenants can also ask for a combination of additional rent caps, detailed annual reconciliation statements and/or a co-tenancy clause. Co-tenancy clauses are based on the principle that a tenant pays the asking basic rental rate for a fully leased retail mall with lots of consumer traffic and pays a lower basic rent for premises in a mall once it suffers a certain level of vacancies. Under such a clause, when vacancies reach a certain level, the basic rent is automatically reduced, the rent is converted to a fixed gross rent, or converted to a gross rent based upon a percentage of sales. In return, the tenant agrees to stay open and avoid making the situation worse for the Landlord and other tenants by closing.
- A tenant may add provisions to address a future insolvency of the landlord. How do tenant and subtenant occupation rights work when the bank takes over a property under a non-performing mortgage? Read my earlier article [Landlord Mortgage Defaults: Ensuring Tenants have Security of Tenure, 2021] on the scenarios and strategies for when a tenant might be turned out and the lease cancelled, who the tenant pays the rent to and who maintains the centre.
Landlord Strategies
As a landlord you are concerned with the net effective rent generated from the leases of the property. This number is determined after all costs and expenses associated with tenant inducements are calculated and it is certain by the terms of the lease that additional rent is comprehensive and paid by the tenant. The Landlord is also concerned to be competitive and to keep the good tenants they have.
- I prefaced this article with the assumption that the landlord begins the negotiation with a well drafted lease. My first suggestion is for the landlord to maintain the "net" provisions and characteristics of the lease and keep all the leases in the same centre consistent with one another to avoid gaps in expense recovery.
- Be upfront about possible future plans for redevelopment and have a plan to address tenant concerns over occupation, disruption of their use, timing, and compensation.
- A landlord may also add a requirement that the tenant provide updated financial and other information during the term at regular intervals.
- In a market where tenants find it more difficult to pay the rent, due diligence on your tenant is critical. That extends not only to the historical financial covenant shown in the financial statements but also an understanding of the near-term market forces and prospects this tenant is dealing with in its business.
Conclusion
There are several trends that may result in a period of transition in the commercial real estate sectors over the next several years. Landlords and tenants should adjust for a combination of factors such as rising vacancies and landlords repurposing space and redeveloping existing properties. In particular, the well negotiated commercial lease should address those issues from the point of view of how it affects premises operations, character of the centre and each component of the rent.
Tenants should negotiate the basic rent and the additional rent at the same time and should insist on transparency when it comes to additional rent at the negotiation stage and throughout the lease term.
Landlords need to evaluate the tenant covenant based on financial statements and an understanding the economic trends impacting the tenant's business and prospects.
My purpose is not to presume to see the future or even understand how all the trends may impact these sectors of the commercial real estate market. It is enough to consider the possibilities and ask yourself a couple of questions.
Are any of these scenarios more or less likely than they were in the past?
What impact might they have on the character, use and enjoyment of the premises, the rental cost, or the rental income?
As a tenant or landlord, I suggest your review, update, and reprioritize your issues list for your upcoming lease negotiations to take new account of these trends.
Originally published by Retail Insider Media
Footnotes
1 Avison Young, Greater Toronto Office Market Report Q2 2024; https://www.avisonyoung.ca/web/toronto- gta/office-market-report
2 CBRE 2024 North America Industrial Big Box – Report, Review & Outlook dated April 2024 https://www.cbre.com/insights/local-response/2024-north-america-industrial-big-box-toronto
3 ICSC Industry Benchmark Reports 2024
4 Paterson, Craig: The Death of the Great Canadian Downtown Department Store: Retailer Insider Magazine, Vol 3 Issue 2 . https://issuu.com/retailinsider/docs/untitled-101
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be ought about your specific circumstances.
