Don’t let attractive lease terms blind you to potential problems

Steve Schnur

Steve Schnur

Guest post by Steve Schnur
Senior Vice President, Midwest Operations, Duke Realty

Would-be tenants of industrial buildings usually are concerned with lease rates, operating expenses and tenant improvement (TI) allowances. While these items certainly are important, there are additional areas that companies should consider before signing a lease.

Let’s start with some basics. A tenant’s industrial space should provide a working environment that facilitates employees performing at high levels and delivering superior results. Thus it should have an infrastructure that is state-of-the-art to support today’s technologies. Lighting, floor strength, fire-suppression systems and electrical service should be supportive of the operations that will be conducted in the building.

The building also should emphasize greater productivity per square foot through taller ceiling heights, increased dock-high and drive-in doors, and wider bay widths that allow improved stacking and loading capabilities. For efficient distribution there should be large truck courts, ample trailer parking and nearby, if not direct, access to rail lines.

The building should be clean and have well-maintained interiors and exteriors. It should be easily accessible and have convenient parking options. It should either include amenities or be close to others for workers’ convenience.

Beyond these basics, prospective tenants also should also consider the landlord’s business position including its financial condition and reputation. It can be disastrous for tenants if building owners fail to perform.

Attractive lease terms can present tremendous opportunities for tenants. However, landlords may be offering incentives for not-so-good reasons. Perhaps the owners are struggling financially and are desperate to lease space. Deep discounts, especially as part of long-term leases, may be indicative of a landlord’s inability to obtain financing for new developments or to generate sufficient operating income to refinance or service the debt on existing buildings.

If landlords are overextended financially or under financial pressure, they might not be able to raise the capital needed to meet their obligations, which can cause significant difficulties for tenants.

For example, let’s say a manufacturer needs to ramp up production to serve a major new client. To facilitate that, the manufacturer depends on being able to move into a newly constructed warehouse and distribution center by a certain date. If the developer fails to obtain financing and construction is delayed or cancelled, the manufacturer’s delivery schedule, reputation and very existence could be threatened.

In the case of an existing building, tenants who were recruited or retained by attractive rents and generous TIs might find that the landlord is unable to meet its debt service for that building. Or perhaps that property is performing, but the landlord is being squeezed by other properties in its portfolio. In either case, those financial pressures can result in deferred maintenance and repairs or TI funding delays, all of which can have a negative impact on the corporate image and operations of the tenants.

Before the financial crisis in 2008, it seemed as if financing was within reach for nearly any commercial real estate project. Whether the capital was used for new development, renovations, TIs or operating expenses, credit was readily available. However, today’s underwriting standards are much tougher, a condition that is not likely to change as financiers remain cautious about their lending practices.

So what’s a prospective tenant to do? Here are five ways you can reduce leasing risk:

1. Know the developer or landlord. Who owns, or will own, the building? What is the company’s track record with respect to similar projects? How much experience does the company have with this specific product type? Would you normally consider this developer or landlord if the professional wasn’t offering such attractive lease terms?

2. Dig into their finances. Conduct careful due diligence into the overall financial position of the developer or landlord, as well as the status of the specific building under consideration. What kind of access to capital do they have? Is financing in place for a new development? Is the mortgage current or up for renewal for an existing building? Who is the lender? What is the lender’s financial position and current strategy with respect to commercial real estate?

3. Do a reality check with the market place. What are current and projected market conditions with respect to vacancy rates, lease rates, TI allowances and other lease terms? How do the terms being offered by your potential developer or landlord compare? Are they significantly below market and, if so, will the net operating income (NOI) be enough to support a well-managed, well-maintained building?

4. Understand the specific lease terms. What penalties are in place if a landlord fails to perform? Do tenants have the right to terminate leases? What protections do tenants have for quiet enjoyment if a lender forecloses?

5. Find out about property management. Who is going to be responsible for managing your property and taking care of maintenance issues? Do they have experience with bulk industrial properties? Can they provide you with a list of references to check?

As senior vice president of Duke Realty’s Midwest operations, Steve Schnur is responsible for all development, marketing and leasing activities in Chicago and Minneapolis-St. Paul. Duke Realty owns and operates more than 154.1 million rentable square feet of industrial, office and medical office space in 22 major U.S. metropolitan areas. In Chicago, Duke Realty owns and manages more than 11 million square feet of space. Duke Realty Corporation is publicly traded on the NYSE under the symbol DRE and is listed on the S&P MidCap 400 Index. More information about Duke Realty is available at www.dukerealty.com.

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This entry was posted in Chicago Commercial Real Estate, Illinois, Illinois real estate, industrial real estate, Minneapolis commercial real estate, Minnesota real estate and tagged , , , , , , . Bookmark the permalink.

One Response to Don’t let attractive lease terms blind you to potential problems

  1. Bob Hennessy says:

    Knowing the landlord/developer is key.
    A little bit of research will save many headaches down the road.

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