Clark Hill 2025 Commercial Real Estate Outlook: Hybrid Work Models and Lease Restructuring

Although the COVID-19 pandemic has ebbed from the daily lives of workers, its impact on hybrid work continues. While no consensus has emerged, the hybrid work model, which requires splitting the work week between going into the office and working from home, has grown in popularity. The ongoing impact of remote and hybrid work arrangements has undoubtedly influenced not only office space demand, but also several legal considerations in commercial leases. These legal considerations for commercial real estate include the balance between a tenant’s need for flexibility with a landlord’s obligations to its lender as well as changes in the costs of an office building and how they are best allocated.

Hybrid Work Has Required Landlords and Tenants to Review the Flexibility of Tenants Under Leases

For companies leasing space in office buildings, frequently the decision maker targets flexibility in the lease. Oftentimes, this results from C-suite directives that can evolve over time. Tenants have several potential options for obtaining such flexibility, including most often, an option or right of first offer to lease space in contiguous space on the same floor or adjacent floors. When tenants negotiate this right, they should ensure that any such agreement includes all of the rights that the tenant has under the initial lease, including improvement allowances or any buildout obligations of the landlord. The converse of the right to expand is the right to contract space, potentially with a guaranteed buyout right after a certain amount of time has elapsed in the lease term. These provisions can give the tenant their desired flexibility, but directly contradicts certainty for landlords.

While flexibility is a prized right for tenants, for landlords, the rights of tenants to shift their obligations can create a problem for two reasons: a tenant’s flexibility can impact loans and flexibility can reduce resale value of properties. When landlords are working within the structures of an existing loan, they need to be cognizant of the percentage of their leased space that must be on long term leases versus short term leases, and how lenders consider early termination rights towards that ratio. Oftentimes, loans set covenants that a certain percentage of the leased space must be on leases of 3 years or longer.  Landlords can review with their attorneys as to how this calculation works within a particular loan, and oftentimes, a short amendment extending an existing lease can be treated more favorably than a new, short lease. Similarly, tenants vacating or contracting lease space will negatively impact income and therefore result in complications with a debt service coverage ratio covenant. Furthermore, landlords need to ensure that a tenant with termination rights, if it exercises such rights, will not force the landlord to violate its obligations under a loan. This is especially true as it is taking longer to lease out space, so existing 180-day lease termination rights might not give a landlord sufficient time to relet space.  Similarly, when selling properties to institutional investors, termination rights of tenants can reduce the purchaser’s valuation of the property as there is the risk of the revenue stream reducing rapidly.  It is important then for landlords to include in leases a longer period of time for tenants to provide notice of a termination or contraction, as well as negotiate higher buyout amounts that will at least provide landlords funds to modify the space for a future tenant.

Hybrid Work Has Implications for Cost Allocations for Office Properties

Additionally, in the post-pandemic office landscape, landlords and tenants need to efficiently allocate costs between the parties, particularly as vacancy rates remain high. One facet is the apportionment of utilities amongst tenants within buildings. Prior to the pandemic, when most employees were in the office 5 days per week, utility costs could be evenly apportioned between office tenants based on square footage without significant injustice. However, with the rise of hybrid work, many offices may require limited utility service only a couple time per week or reduced amounts throughout. This is further exacerbated by the rise of AI technologies and other data-heavy operations, which draw significant amounts of electricity. As such, Landlord should be more accommodating to tenants requesting submeters. Similarly, for landlords who provide in unit janitorial service, landlords will be well served to review which days janitorial service should be provided and potentially find cost savings by having limited janitorial services on a tenant-by-tenant basis.

A further expense that landlords must apportion relates to amenities. Many companies are using building amenities as a draw to bring employees back to the office. However, these amenities can come at great cost, both in the initial capital outlay and the longer-term maintenance. In negotiating leases, Landlords should take care to allow for the pass through of these amenity costs, both for the upfront cost and the extended maintenance obligations. Alternatively, if landlords are planning on building out particular amenities, tenants would be well advised to include such obligations in leases so there is certainty they are in fact build-out, given the importance they have become.

As we adapt to the new realities of office and hybrid work, the field of negotiating leases has changed between landlords and tenants. As such, the parties should make sure that they account for the desire for flexibility as well as the fair allocation of costs, while landlords maintain their investments and satisfy lenders. Our office stands ready to help parties to find the optimal solution.

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