It is commonly known that location affects a property's value; if it's a commercial property with a high degree of accessibility, it makes sense for the asset to make a high rent. An important but typically ignored part of CRE investments is the lease and lock-in periods. Commercial properties, such as office buildings or warehouses, can be observed as excellent investments because they deliver high yields, are reliable, and escalate over time.
What is a lock-in period in real estate?
The lock-in period refers to the duration during which a tenant commits to occupying a space without the option to terminate the lease. A residential property can have a lock-in period of 6 months to 2 years but in case of commercial spaces, due to their less dynamic, the lock-in period is significantly longer, starting at a minimum of 3 years. If a space has a lease of 9 years and a lock-in period of 3 years, the current tenant has to keep occupying the space for 3 years. Should they choose to switch bases before the lock-in period is over, they have to pay the landlord the full rent amount of their remaining time.
Usually, lease agreements or rental agreements specify the lock-in term. This provision specifies how long the tenant must remain in the rented property without having the choice to end the lease. People should consult the rental agreement or lease that was signed by the landlord and tenant for information regarding the lock-in period.
It is imperative that the terms of the lock-in period, including its duration and any circumstances pertaining to early termination, are expressly stated in the agreement by both parties. The terms and conditions of the rental agreement sometimes include legal and justifiable lock-in periods.
The terms and conditions, and the length of the lock-in period can be modified via a supplemental agreement. A supplemental agreement is a legal document that enables parties to modify or amend the terms of an existing contract. This document allows signatories to add, clarify, or alter provisions within the original agreement. This offers the flexibility to adjust the lock-in period, allowing parties to mutually agree on ideal terms that suits them both.
Why is a lock-in period necessary?
A lock-in period is merely a failsafe. It is a hedge against inflation, where rent does not hike significantly and it ensures tenant stability in favour of the landlord. Take for example, during a real estate crisis, if a tenant is already locked into a commercial space for a period of time, the owner and the tenant are both mutually beneficial to each other because the tenant does not have to go out hunting for an affordable business space in a volatile market and the lessee has the security of a steady stream of rental income.
So, what is a GOOD lock-in period?
Lock-in periods vary from tenant to tenant and landlord to landlord. A residential property has a shorter lock-in period of 6 months to 2 years. In case of commercial properties, the industry standard is a minimum of 3 years for new companies to a maximum of 9 years for established businesses. This range depends on the type, size and scale of the tenant’s business. A brand new start-up, just testing the waters will have a lesser lock-in period as compared to an already well established industry player. An organisation that deals in manufacturing will need some flexibility when it comes to customising the workplace, hence a longer lock-in period makes more sense. Warehouses typically have the longest lock-in periods of 9-11 years.
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Pros and Cons of a Longer Lock-In Period
A longer lock-in period in rent agreements comes with its fair share of both advantages and disadvantages. Here's an in-depth look:
1. Pros:
Stability and Predictability: A longer lock-in period provides stability, ensuring that tenants cannot vacate the property abruptly, offering landlords a predictable rental income.
Prevention of Rent Hikes: Legal experts suggest that a longer lock-in period can prevent landlords from suddenly increasing rent, providing tenants with protection against unexpected hikes.
Guaranteed Residual Income: For landlords, a consistent lock-in period guarantees residual income over the specified timeframe, ensuring the property remains leased.
Security for Both Parties: The longer commitment benefits both landlords and tenants by providing security and stability in the leasing arrangement.
2. Cons:
Reduced Flexibility: Longer lock-in periods limit tenant flexibility, as they cannot vacate the property before the specified duration. This lack of flexibility may be inconvenient for tenants with changing circumstances.
Potential Disputes: Lengthy lock-in periods might lead to disputes if either party experiences unexpected changes in their situation, such as job relocations or financial hardships.
Market Changes: In dynamic real estate markets, long-term commitments may not align with changing property values or economic conditions. Both landlords and tenants might face challenges adapting to market fluctuations.
Lack of Negotiation Opportunities: Extending the lock-in period without periodic negotiations may prevent either party from revisiting and adjusting terms based on evolving needs or market conditions.
Final Thoughts
When making a decision to invest in commercial real estate, it is important to take into consideration the type of property as well as the lock-in term that can be associated with it, regardless of the tenant. It is possible that the tenant will not contemplate remaining in the property if the time is too short (for example, less than three years).
If, on the other hand, the lock-in period is excessively long, the tenant will be paying a rent that is lower than the average for the market. This is fine as long as the owner is able to maintain stable returns to the investment. In the event that you are contemplating making an investment in a business space in India, there are a number of other intricate aspects that need to be taken into account.
At Prop Returns, we will help you find your ideal Commercial Space and provide the best possible advice when it comes to every single aspect of your journey.
