One of the most important things any landlord can do is negotiate leases with tenants. A lease that is structured in a way that balances the objectives of the landlord and tenant will allow both sides to do well. One of the strategies that can help the landlord to retain good tenants and allow the tenant to profit is known as a blend and extend lease agreement.
In this article we are going to discuss the concept of a blend and extend lease agreement. We will describe what it is, how it can affect rental income and tenant retention, and when investors should think about using this strategy. By the end of the article, readers will have a solid understanding of what a blend and extend lease is, how it works, and when to use it when managing commercial property.
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What is a Blend & Extend Tenant Agreement?
A blend and extend tenant agreement is a lease renewal strategy used by landlords to extend a tenant’s lease in a commercial space at a blended rent rate. As a tenant’s lease expiration nears, the landlord and tenant might negotiate an arrangement where the tenant agrees to extend the lease for a period of time, and in return, the landlord agrees to a short-term reduction in the base rent and sometimes an allowance for tenant improvements. Let’s walk through an example to see how this works in practice.
Let’s suppose that a real estate investor owns a small office building that is leased to one tenant. The tenant initially signed a five year lease and has one year remaining. The tenant leases 1,000 square feet of office space, and the original lease was signed at a rate of $10 per square foot. This means that the investor shows gross rent of $10,000 per month.
The tenant believes that they might be able to negotiate a more affordable commercial lease if they choose to sign a new lease at a different property. The landlord feels that this tenant has been upfront and easy to work with over the last several years and would prefer to extend their tenancy. One way to do this is for the landlord to offer to blend and extend the lease agreement. Under this arrangement, the landlord might offer to extend the term of the lease for another five years at a reduced rate of $9 per square foot. The landlord might also agree to blend the rent on the remaining one year lease term at $9.50 per square foot. The tenant obviously benefits from a rent reduction, but the landlord might also feel that they have benefited by retaining a good tenant and avoiding the cost and hassle of leasing to a new tenant.
How a Blend & Extend Can Affect Rental Income
On the surface it appears that a blend and extend strategy would negatively impact the landlord’s rent roll. However, it is not always so straightforward. For instance, if the landlord expects rental rates to decrease, then they might be more inclined to offer a blended lease extension. While doing this will reduce the monthly rent in the short-term, it might actually benefit the landlord in the long-term if rental rates decrease below the newly negotiated, blended rate.
A blend and extend strategy can also have a positive effect on rental income and can actually help to increase the value of a commercial property over the course of the lease term. An example will help to explain how this works.
If a property is currently being rented at $10 per square foot and market rent is $12 per square foot, the property owner is not maximizing the potential rent for the property. One strategy they could pursue would be to offer to extend the lease at a blended rate for the next five years. The landlord could negotiate to have the tenant pay more in rent over the remaining one year term of the current lease (let’s say $10.50 per square foot) and then pay a slightly below market rate for the duration of the new lease term ($11.50 per square foot). The tenant would have an incentive to lock in a long-term lease at what appears to be an advantageous rental rate for the next several years in return for paying more under the short-term lease.
Tenant retention is an important part of property management, and savvy landlords understand the value in retaining tenants over the long-term. First, there are costs involved in searching for a new tenant to lease space that was vacated by a tenant in search of more affordable rent. Sometimes it is worth letting the tenant walk away, but sometimes the property owner can negotiate a new lease that works for both sides. Reducing vacancy can be a big benefit to investors, especially during a time when market rents are lower than normal or economic conditions are less than ideal.
Second, not all tenants are created equal. Some tenants are more cooperative than others and some do a better job of maintaining the space compared to others. For this reason, it might be advantageous for the landlord to retain a trustworthy tenant at a lower rental rate because it will result in lower operating expenses (especially maintenance costs). Sophisticated commercial real estate investors understand that gross rent isn’t the only consideration when leasing a property to a tenant, and using a blend and extend strategy can be a great way to retain good tenants and keep expenses down.
Is Blend & Extend a Good Idea?
Knowing when to use a blend and extend strategy requires experience in different market conditions. This type of strategy is most often used when vacancy rates are higher than normal or when market conditions force landlords to make concessions on rent in order to keep their property leased. In this case it can be a great idea to use a blend and extend strategy because occupancy is always a concern during market downturns. Keeping space leased and generating rental income is usually a better option than letting the space sit vacant for an extended period.
As we discussed above, one key thing that many investors don’t understand about a blend and extend strategy is that it can actually help to increase the value of a commercial property over the course of the lease term. If a property is being leased at below-market rent, a blend and extend strategy can help the property owner to generate higher rent over the longer term without having to release the space to a new tenant.
Blend & Extend in Private Equity Real Estate Investing
Doing a blend and extend lease agreement can be very beneficial to the landlord and tenant when done at the right time and under the right market conditions. But, it takes a lot of market knowledge and familiarity with lease terms to draw up a commercial lease, especially one that uses a blended rental rate. Many individual investors struggle to find the time and resources needed to master the details of the blended lease strategy.
The risk for an individual investor when trying to negotiate a blended lease is that they could end up locking a tenant in at a rate that ends up being far below the market rate for a long period of time. Under this scenario, the investor has lost a lot of potential income over the course of the new lease.
One way to avoid this risk is to invest with a private equity real estate sponsor. Some private equity real estate firms choose to outsource the leasing function to third party property managers who advertise themselves as leasing experts with strong market knowledge.
Other private equity firms, like us, choose to build an in-house leasing team that constantly researches the markets where we choose to invest. Teams like this work hard to understand market trends and use that knowledge to choose the best leasing options for each property. Many individual investors choose to invest with a private equity real estate firm to benefit from their leasing expertise and experience negotiating with tenants.
Summary of Blend & Extend in Commercial Real Estate Investing
Blend and extend is a type of lease agreement where the landlord attempts to retain existing tenants by offering to lower the rental rate on a square footage basis in the short-term in return for a term extension that keeps the tenant in the space for the longer term.
Blend and extend lease agreements can be used with any type of commercial property, including multifamily residential, industrial, and office space. If done properly, this arrangement can keep operating costs in check and allow the property owner to continue to generate cash flow, even during difficult market conditions.
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