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As we come out of the pandemic, the outlook for office leasing remains uncertain. Unlike other commercial leasing sectors such as industrial, life sciences, and health care, office tenants are still determining space needs, back-to-the-office policies, and staffing requirements. Nonetheless, new office leases have been signed during the pandemic and trends are starting to emerge from those deals.
Due to the pandemic, many landlords and tenants reviewed their leases to determine if they contained a force majeure provision, and if so, whether the provision excused the payment of rent. While a standard pre-pandemic force majeure provision excused performance by the parties in the event of unexpected events outside of a party’s control (such as natural disasters, labor unrest, war, insurrection, etc.), often the clause provided that the payment of rent was not excused by force majeure.
Parties entering into new leases now pay much greater attention to the force majeure provision. Tenants are seeking to scale back the exclusion for payment of rent, while landlords continue to resist. Moreover, some landlords are seeking to limit the scope of the force majeure provision, and also, to the extent enforceable, requiring tenants to waive various common law theories, like frustration of purpose, impossibility and impracticability, as well as statutory pandemic-related tenant protections.
Some leases are also starting to contain an additional pandemic-specific provision. While it is still relatively unusual in office leases, some tenants with significant bargaining leverage are requesting such a provision. If a pandemic or virus-specific provision is negotiated, it is usually tied to specific government-mandated restrictions on use that last a specified period of time with an agreed upon amount of rent either abated or deferred. The relief typically only lasts for a limited period of time with a return to full rent after a set date and often includes an extension of the term or a future repayment obligation.
While the pandemic has caused downward pressure on rents, the impact of inflation has become an important topic in office leasing as applied to rent through consumer price index (CPI) adjustments. Leases negotiated over the past decade often contained annual rent increases tied to changes in the CPI. This typically was not much of an issue with CPI increases only averaging under 3 percent per year since 2010.
However, substantial inflation over the past year means a CPI provisions in leases now take on added importance. It is becoming more common for tenants to request caps on CPI increases to limit the exposure to substantial future rent increases in the event inflation continues to surge. Some landlords who had fixed increases in their leases (without referencing CPI), are adding language making annual rent increases tied to the greater of the fixed amount or the CPI increase.
Tenants are still determining space needs, and landlords are fearful of getting locked into long-term below-market leases. Both can be hesitant to enter into the usual five- or ten-year leases in the current market.
As a result, many landlords and tenants are finding it mutually beneficial to enter into leases with fairly short terms of one to three years. In some cases, these short-term leases represent extensions of existing leases. By doing this, landlords are able to mitigate the risk, and tenants are able to retain space. Each is buying time to evaluate how the leasing market will evolve over the next few years before making longer-term commitments.
To the extent tenants enter into longer-term deals, some are requesting the ability to terminate early before the end of the regularly scheduled term – often by providing an early termination payment in the form of several months’ rent and reimbursing landlord’s unamortized brokerage commissions and tenant allowances. Even with these concessions, landlords are often reluctant to grant these early termination rights. Although still fairly rare in office leases, early termination rights are sometimes found in retail or restaurant deals. Nonetheless, at the letter of intent stage, tenants are starting to request early termination rights in office leases.
Although more of an issue with site selection than in lease language, building ventilation systems are now important in commercial leasing. The Centers for Disease Control and Prevention (CDC) and the American Society of Refrigerating Engineers (ASHRAE) recommend commercial buildings install filters for heating ventilation and air conditioning (HVAC) systems with a Minimum Efficiency Reporting Value (MERV) of 13 and many landlords are installing filters with even higher MERV ratings. Ventilation is now a key for tenants when looking to lease new space.
As tenants start to have more visibility on return-to-office policies and space needs, and landlords become more confident that rents have stabilized, the volume of office leasing will undoubtedly increase. As that happens, recent trends in office leasing will likely continue and new trends will arise.