Long or Short? Think Hard About Lease Term

The lease on your facility is likely the first or second largest expense line item for your business. The lease term – the duration of the contract – is a fundamental as well as very strategic aspect of your lease. After thinking through your business plan and taking into account risks (and how to mitigate them), you will come to a natural conclusion as to what term length is best in your case. This goes both for franchisees assuming the liability by signing the lease as well as franchisors who create the master strategy for their brand.

Let’s look at two key dynamics of the lease term: long vs. short and options to renew.

Long vs. Short

The default lease term for a retail shop space is five years. This is a reasonable amount of time: long enough for a business to establish itself in a given location or, perhaps, demonstrate it doesn’t have the “legs” to keep going. From a landlord’s point of view, it is a “bankable” duration; that is, a sufficient amount of time for lenders to underwrite. Terms can be longer and shorter, of course, and there are pros and cons to both.

A long term lease – five years or longer – is more attractive to the landlord who covets a continuous stream of income without the interruptions of vacancy and leasing expense. In return, landlords will be more flexible with lease rate, lease concessions, and tenant improvement allowance when considering the possibility of a long term lease. There are benefits to the tenant, too. The negotiating leverage suggested above should also translate into lower rents, giving the tenant more control over what can be a very volatile expense item.

The “con” side of a long term is based on the precept of the lease as a liability. If circumstances change – which they most certainly can do – and you need or want to escape the lease because of business failure or the desire to move to a different location, a long residual term is a heavy weight to bear. The alternative is to sublease the space, but that puts you squarely in the real estate business, not doubt not what you envisioned when you installed your sign and opened your store. There is one instance where a longer residual term is a boon to the departing tenant: if the business is for sale, the lease term – assuming the rent is at market rent or lower – is an asset and adds value to the business.

The contingent liability of the lease is eased by a short lease term, but you will encounter more resilience from the landlord when it comes to rents, concessions, and the investment of capital for premises improvements. There is also the amortization of your own capital investments to consider, particularly for businesses such as restaurants, dental offices, or dry cleaners that require expensive electrical and mechanical systems for their operations.

Lease Options

Options to renew the lease are quite common: loved by tenants but not so much so by landlords. All of the benefits accrue to the tenant, since it is their “option” to exercise or decline. However, with the new FASB lease accounting standards coming down the pike, publicly traded companies will need to think twice about the complicated bookkeeping rules associated with rent expense projections before negotiating renewal options into their lease. But by all means, negotiate them and try to get the rent rate for the option period fixed in the lease, or at least adjusted by a defined factor such as the consumer price index.

In summary, let your business be the driver of the ideal lease term.