As the office market tightens and landlords’ bargaining leverage increases, tenants need to make sure they understand when they have a deal and when they don’t. When the market was weaker and competition for space was not as great, it was usually safe to assume that when the parties verbally agreed to terms, executed a nonbinding term sheet or were negotiating drafts of the lease, the deal was going to go forward. Now, however, that is not necessarily the case with certain landlords. As a result, tenants need to be careful about how they proceed and who they proceed with.
In Pennsylvania, no contractual agreement for real estate is binding unless it is in writing (excluding short term leases). Thus, a handshake deal, a non-binding letter of intent, term sheet or even a circulated lease draft does not create a contractual lease right on behalf of the tenant absent something more. While a tenant may believe he has a committed deal, legally he probably doesn’t. The problem is that at some point short of a contractual right, a tenant may start to rely to its detriment on the promises of the landlord. For example, the tenant may forego other opportunities and run out of time to change course once they hear “we have a deal”.
Most landlords continue to honor their word when they say they have a deal. Even if a better deal comes along before the lease is signed, these landlords know, in the long run, it’s bad business to pull a deal once they have a handshake. Landlords who are materially invested in the market for the long term look beyond the return of a particular deal and take into account how their actions will affect future interactions with tenants and brokers. They know that if they say they have a deal with a tenant and then revoke that deal for something better, it could destroy their reputation in the market making it hard for them to compete for and complete deals in the future. Thus, while it may make short term financial sense to pull the deal from a 15,000sf tenant in favor of a richer deal for a 22,000sf tenant, in the long run, such behavior can actually work against the landlord if they have multiple assets in the market and expect to stay invested there for the long haul.
Whereas years ago real estate was primarily owned by long term investors including insurance companies, family owned operators and REITs, today, many properties are held by investment funds who operate on a much shorter term time horizon. Landlords who are looking to flip their asset in the short term may be more concerned with maximizing short term profits than building long term relationships. It’s not that they are doing anything illegal or wrong, it’s just that, based on their specific business model and time horizon, it often makes sense to go with the bigger or richer deal or the deal with the better credit even if it comes along after a handshake deal has been agreed upon with someone else.
What can tenants do to protect themselves? Two things. First, if and when a deal is struck, the tenant can insist that the landlord agree to deal exclusively with it for a period of time while the lease document is being negotiated. This is typically referred to as an “exclusivity provision.” While at this point in time, the parties may not feel comfortable entering into a binding letter of intent for the lease given the number of business terms that remain outstanding, the landlord can contractually agree that it will not actively market the premises for lease or solicit or entertain third party offers for a period of time. Likewise, the tenant can agree that it will not pursue other options during the exclusivity period while they are negotiating the lease. The parties can go even further and mutually agree to negotiate the lease document in good faith and stipulate that any attempt to change the express business terms in the letter of intent or term sheet shall be deemed to be bad faith. If the landlord is unwilling to agree to the exclusivity provision, it probably means that he intends to continue marketing the property and that he is willing to pull your deal if a better one comes along.
If a landlord is unwilling to stop marketing the premises as aforesaid, that in and of itself isn’t fatal; the good news is that the tenant now knows who and what it is dealing with. Knowing that the landlord isn’t truly committing to the handshake deal until a lease is signed enables the tenant to plan accordingly and manage its expectations. Thus, the second thing a tenant can do to protect itself in the current market is continue to run its competitive procurement process in the market even after it has reached a verbal agreement with one landlord. If the landlord is going to continue marketing its premises and shop for a better outcome after reaching a handshake deal with the tenant, the tenant should do likewise and continue to pursue its other options until the lease is signed.
When the office market was soft and most owners were invested in the region for the long term, landlords rarely pulled a deal after signing a term sheet or shaking hands with a tenant. However, today the market has tightened and some landlords are under extreme pressure to maximize profits in the short term. That means some landlords will continue to market space until an actual lease document is signed and there is some risk that the deal will be pulled if and when a better one comes along. Based on the foregoing, tenants need both to understand the position of the landlord they are dealing with and take the necessary precautions to protect their interests until the deal is completed.