Short Term Lease Agreements: What You Need to Know

Short term leases have a notoriously bad reputation in commercial real estate. The conventional wisdom says that short term commercial real estate leases are not a good idea.

Short leases lead to higher turnover, which means longer periods of vacancy and more frequent build-outs for new clients. Having too many short term leases can become a drain on your profits.

But, there’s more nuance to the situation than that. Short term leases aren’t always bad. There are certain times where you can benefit from short term leases more than long term leases.

This doesn’t mean you should dump all your long term tenants and seek out 2-3 year leases! Long term leases are still the lifeblood of commercial real estate, but you should reconsider the benefits of short term leases if you find yourself in a position to benefit from them, such as when you need a temporary stopgap.

Your portfolio should ideally consist of a large number of long term leases, as many as possible. However, there’s a case to be made for short term leases, and you may find it useful to open up some of your units to short term tenants when it plays out in your favor.

Related: The Importance of Lease Terms and Tenant Improvements

What Is Considered a Short Term Lease?

Time is relative in the real estate industry. What’s considered short term for residential or retail won’t be the same as short term for office buildings. It’s useful to divide leases into categories of similar lease types when you’re discussing the length of a lease.

Here we’re specifically discussing short term leases for commercial properties, not multifamily residential or industrial.

Short Term Leases for Commercial Buildings

City Center / St. Petersburg, FL

Commercial buildings encompass a lot of different types of businesses, but the lease terms can still be assumed for most of them. These time periods roughly apply to retail buildings, office buildings, medical office buildings, etc.

  • Short term
    • Leases from 1 to 3 years are typically considered short term leases.
  • Medium term
    • Leases from around 5 to 8 years are considered medium term leases.
  • Long term
    • Anything from 10 years and beyond is considered a long term lease.

These are rough assumptions. There are some grey areas where the lease length definition depends on the local market.

The important thing to remember is that with commercial real estate, short term leases are generally anything that is 3 years or less, while long term is 10+ years.

Commercial Leases vs. Apartment Leases

You won’t see 1-year leases very often in commercial buildings like you would in residential apartments. Residential leases are usually about 5 to 8 pages long, covering the basic responsibilities of the tenant and the landlord without going into too much specific detail. It’s unlikely that there will be a lot of negotiation about the terms.

Commercial leases are more complex. They are likely to be closer to 40+ pages in length, covering the legal responsibilities of each party more thoroughly. For short term clients, there’s a lot less wiggle room for negotiation compared to what there would be for a solid long term tenant.

Related:  How to Calculate Commercial Rental Rates

 

Short Term vs. Long Term Leases

City Center / St. Petersburg, FL

Commercial buildings tend to be leased out with the same lease types, be it a gross or net computation. All leases are written up the same way, no matter the length of the lease. The variations exist more in the lease term negotiations and landlord obligations.

In terms of responsibilities of a landlord, there are many distinct differences between long term leases and short term leases. For example, because they can’t amortize costs over a long period of time, a landlord wouldn’t offer the same tenant improvement build outs for short term tenants as they would for longer term tenants.

This is just one of the differences with these lease types. Let’s take a closer look at some of the advantages for property owners versus the disadvantages for the renters.

Advantages of Short Term Leases

#1 Flexibility

As mentioned before, short term leases give landlords the flexibility to fill up gaps that may exist in a building’s rent roll. A common example of this is when a large tenant moves in with a long term lease and plans to expand into an even larger space after a few years. Landlords may not want to fill the adjacent spaces with other long term tenants, because it may limit the growth of a very large and the future, so growing tenant.

In some cases, a large tenant may negotiate to have an option to expand into adjacent space in 2 to 3 years.

Instead, that space can be filled with short term lease tenants who operate as a stopgap. By entering into short term leases, it’s possible to avoid vacancies while still keeping the space available for the future of the long term tenant’s expansion plans.

First Central Tower / St. Petersburg, FL

#2 Rent Increase

When the market is on its way up, short term leases can help landlords capitalize on market rent increases every year. With a long term tenant there isn’t the freedom to increase rent during their lease period, whereas there is this flexibility for tenants with short term leases. This is great for more speculative landlords. At Feldman Equities, we don’t believe in that strategy but some Landlords love the idea.

#3 Lower Construction Budget

Because of the shorter lease terms, owners won’t take on as large of a burden for construction build-outs – tenant improvements – for short term clients. There’s no way to justify the spending, as there’s not enough time to amortize the costs over the term of the lease. At best, a short term tenant can expect to get carpet and paint.

#4 Reduce Vacancies

In a difficult market, it can sometimes be better to take what you can get. Beggars can’t always be choosers. If you have to choose between filling up some of your smaller spaces with short term tenants or leaving them vacant, the short term tenants may be the wiser choice to avoid costly vacancy periods.

#5 Faster Move-in Times

Tenants that choose a short term lease don’t often spend a lot of time negotiating the lease document and they because they aren’t usually doing any construction, the delivery times are quicker. Because of the reduction in complexity of short term leases, tenants can often start the lease and move in more quickly. If an owner needs a quick influx of cash flow, this might be a quick way to get a boost in revenues.

Disadvantages of Short Term Leases

Since we’ve already touched on the disadvantage of short term leases for landlords, let’s focus more on how they present a disadvantage to commercial real estate tenants as well.

#1 Instability/Impermanence

A tenant never knows when the landlord will need to make room for another tenant. If you’re signing and renewing short term leases every few years, most landlords would be happy to refuse your renewal if another tenant comes in seeking a medium or long term lease, or if an expanding tenant needs your space.

If you’re using the commercial space for your business, this sense of impermanence is not good. You never know when your business may suddenly become homeless, requiring you to pack up and move somewhere else. It’s inconvenient and costly in the long term.

#2 Lack of Negotiating Power

When you’re only staying in a building for 1-3 years, you have very little negotiating power to get anything done in your favor. It’s unlikely that a Landlord give you his best terms offers to induce you to renew.

#3 Paying at Market Costs

There’s no long term cost-benefit for short term leases. If you have a 2-year lease and the market happens to be up when you need to find a new place or renew your existing contract, you’ll be paying market rates when it comes time to renew. This could happen often, as you may have to figure out new pricing terms every 1-3 years. In a growth market, that means your rent will increase every time you start a new lease.

Conclusion

First Central Tower / St. Petersburg, FL

The traditional wisdom of avoiding short term leases in commercial properties still stands. They have their uses and in some situations they’re highly beneficial, but these circumstances tend to be uncommon. Having too many short term leases in your building will likely decrease the value of your building because it is typically less attractive to cash flow buyers.  Short term leases may cause you to pay higher interest rates to your mortgage lender and your lender may want to limit the amount of funds it provides you.

The value of commercial real estate is often judged in terms of the weighted average lease term (WALT). This measurement is found by dividing the years left in your leases by the square footage being leased. The higher the number, the lower the risk of damaging vacancies, the higher the value of your building, and the lower the cap rate.

Lenders would prefer to see a 15 year WALT and above, though it’s not always realistic in every market. That said, if you want access to lowest possible mortgage interest rates, you need to have more long term leases and fewer short term leases and the higher the WALT the better.

In conclusion, a short term lease is better than having a long term vacancy, but long term leases are almost always preferble. ‘Rent and Repent,’ my father always used to say. Find high quality, credit tenants who want long term leases and make it very attractive for them to sign up and stay when it comes time to renew. That’s how we’ve been so successful for the last 30+ years and it’s the way we intend to keep on doing it.

Related: The Ideal Holding Periods for a Real Estate Investment

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