The rise of coworking means that more and more tenants are demanding flexible office space on flexible terms – space which can be easily adapted to suit their business needs. Such space can take on numerous forms such as serviced offices and plug-and-play space. Whilst the benefits for tenants are clear, the ramifications for landlords who fail to plan ahead are significant.
The reason for this is because of the consequences of what happens at lease end. Historically, landlords have been able to bank on a healthy dilapidations pay-out from the tenant at the end of the lease to compensate for the tenant’s failure to maintain the building in the way set out in the lease terms. This money would then be used by the landlord to spruce up the building, ready for the next tenant.
Leases for serviced offices and coworking are structured totally differently. They are usually ‘all-inclusive’ with little or no opportunity for the landlord to recoup anything from the tenant at lease end. There lies the conundrum: just how is the landlord going to fund property repairs and upgrades and ensure that the property remains attractive to incoming tenants?
The answer is for landlords to plan ahead. Rents for serviced offices and the like are usually higher, to balance out the fact that the tenant will not be responsible for repairs. We would recommend having a specialist assessment carried out that forecasts what the level of dilapidations might be, for example, on a three-year term. The costs identified could then be built into the rent demanded, but that ‘extra’ money must be put aside, ready for use at lease end.
Sometimes modern leases also set out an exit fee based on floor area – but, if proper forecasts have not been made, this might not be adequate to cover the cost of necessary works. It may be, for example, that the tenant leaves the space in worse than anticipated condition – or perhaps they’ve carried out significant alterations. The obvious answer in the latter scenario is to build into the lease clauses specifying what they can and cannot do – and what is expected at lease end if the alterations remain in-situ. This is something that needs to be thoroughly thought through during pre-lease negotiations.
Another consideration is this: historically it has been rare for landlords to fit out properties prior to new tenants taking occupation. Fit-outs were left to tenants who would carry out work to suit their own needs, rather than the landlord trying to second-guess what an incoming tenant might want. Today, it is very different. Landlords are carrying out significant works to provide attractive spaces for tenants: spaces with meeting rooms and break out areas that are ready for tenants to move in and do little more than plug in their computers.
But there is a risk here. Will the next tenant want the same layout and facilities? Whilst the rent will be higher, is it high enough to fund a redesign/refit when the lease ends? Indeed, has the landlord been proactive in ring-fencing the extra rental income, in readiness for end of tenancy works – or have they just enjoyed the extra income ‘making hay while the sun shines’? Landlords must be disciplined or otherwise find themselves short at lease expiry when faced with a big refurbishment bill.
We would advise that, when fitting out a ‘plug-and-play’ space, it is best to keep the scheme as neutral as possible to future-proof the space. A good example is fitting dividing walls to create meeting rooms – as this provides better flexibility.
Flexible leases in other sectors
The rise of the flexible lease is not confined to the office sector. The model has spread to other sectors including retail and industrial. We see that industrial operators are starting to offer small units on flexible terms so the company can take more space as they grow. The contract usually stipulates that if they do take on more space they won’t be pursued for dilapidation costs.
Whilst the landlord clearly benefits from a growing business leasing more space the fact remains that, at lease end, someone will still have to pay to refurbish the space for the next tenant – so, much of what we’ve discussed in relation to offices also applies to property in other sectors.
Being proactive and planning ahead is certainly the best strategy for landlords. To avoid a financial shock at lease end landlords need to change their mindset away from the expectation of lease end dilapidations claims funding future plans for their property. We should also be mindful of the fact that, whilst the rise of coworking seems currently unstoppable, fashions do change. If the coworking bubble bursts, landlords can certainly not rely on tenants to fund adaptations to their property to suit the next occupier trend.
Landlords should adopt strategies that enable them to accommodate change when it arrives. That things will change is the only certainty.