Cut Losses on Office Tenants' Early Lease Termination
Working from home and other post-COVID business realities have made many office tenants reluctant to sign a long-term lease. One way to overcome this is by offering tenants the option to terminate the lease early if the rent becomes unaffordable or the space becomes unnecessary. But while offering early termination options can give you a significant competitive edge, it can also cost you a boatload of money. That makes it essential to ensure that you get fair compensation for providing termination rights.
The leasing strategy: Require tenants to cover the actual losses you incur as a result of termination, while identifying what those losses are and how they will be calculated. Here’s how to create a lease clause, like our Model Lease Clause: Get Protections When Giving Tenants Option to Terminate, to implement the strategy effectively.
The Costs of Early Termination
You invest a lot of money to attract tenants to your office building, including brokerage commissions, legal fees, improvement costs, rent concessions, etc. The return on these investments may evaporate if the tenant you spent so much to lure terminates early. You also might have to spend at least as much to get a new tenant to take over the space the original tenant leaves behind.
And then there’s the downtime. There’s no way of knowing how long it will take to find that next tenant or what rent that replacement will pay. All the while, the space remains vacant and generates no rental revenues.
HOW TO STRUCTURE EARLY TERMINATION OPTIONS
Offering a termination option makes sense only when the compensation the tenant pays to exercise it covers your losses. How you structure the option is also critical. There are three key issues to address in the lease:
- Timing and methods of termination;
- Required conditions for termination; and
- The fees the tenant must pay to exercise the termination option.
1. Timing & Methods of Early Termination
First, you need to decide how and when the tenant can exercise the option to terminate. Don’t leave things open-ended and let the tenant terminate at any time. Establish a specific termination date in advance. Depending on the situation and bargaining leverage, the tenant may get one or a choice of termination dates (our Model Clause takes the former approach) [Clause, Preamble].
Either way, require the tenant to notify you in advance so you can start your efforts to line up a replacement tenant and minimize the amount of downtime. The larger the space, the more advance notice you’ll need. Thus, while three months’ notice may be adequate for 1,500 square feet, space of 50,000 square feet or more will likely require at least 12 months and maybe as much as 24 months, attorneys say [Clause, Sec. 1].
2. Required Conditions for Early Termination
Require tenants to meet certain conditions to terminate early. To start, don’t let tenants exercise their termination option if they’re in default under the lease [Clause, Sec. 2]. While this condition is perfectly justifiable, attorneys suggest that tenants may seek to limit it to monetary defaults and require that the default continue beyond any applicable reasonable notice and grace periods. These are reasonable modifications, the attorneys add. In addition, specify that the option becomes null and void if:
- The tenant assigns the lease;
- The tenant subleases all or part of the premises;
- The landlord recaptures all of part of the premises;
- The tenant loses the right to possession of the premises; and/or
- The tenant fails to properly exercise the termination option by the required deadline [Clause, Sec. 6].
Practical Pointer: You might also want to add conditions that aren’t listed in our Model Lease Clause. One thing to consider is tying the tenant’s right to terminate to an event that would make the lease unduly burdensome for the tenant or eliminate its need for the space, such as the contraction of its business or the loss of an essential contract. Providing for adverse event conditions especially make sense in these times in which so many businesses face tough economic conditions and uncertainties about the future.
3. Tenant Termination Fee
The expectation is that tenants will pay some kind of compensation for the right to terminate early. The standard approach is to establish a flat fee during lease negotiations. But setting a flat fee in advance can be risky. For example, it doesn’t deal with the possibility that the tenant will expand its space before exercising the termination option. A flat fee may also not adequately account for inflation. That’s why attorneys recommend steering clear of flat fees and instead establishing a formula for calculating a landlord’s actual costs at the time the tenant exercises the option. Those costs should include:
Costs of leasing to the tenant: Such costs may include brokerage commissions paid upon lease signing, legal fees for negotiating and drafting the lease, income forgone as a result of rental concessions, and the costs of improvements to the space made on the tenant’s behalf. It’s unrealistic to expect tenants to pay 100 percent of these costs throughout the lease term; instead, require them to pay only the “unamortized” portion of the costs. Strategy: Assume that the expected benefit to the landlord from each expenditure is spread evenly over the lease term and have the tenant pay only the part that the landlord will actually miss out on due to early termination [Clause, Sec. 3(b)].
Example: A landlord lays out $100,000 in brokerage commissions, tenant improvements, and other lease costs to get an office tenant to sign a 10-year lease. The tenant elects to terminate the lease after year 6. The landlord thus received $60,000 worth of its anticipated benefits during the six years that the tenant stayed. As a result, terminating with four years left on the lease would leave the tenant responsible for only $40,000 in landlord leasing costs.
Expansion space costs: Tenants that get both termination and expansion options may end up exercising the former after exercising the latter. In that situation, the termination fee should include the landlord’s expansion costs. Like leasing costs, expansion and improvement costs should be amortized on a straight-line basis—but over the lease term after the space was expanded rather than over the entire lease term [Clause, Sec. 3(b)(iii)].
Interest: Landlords should also demand that tenants pay interest on both the full-term and expansion space leasing costs, especially if they had to borrow money to expand and improve the space. Even landlords that financed improvements without borrowing are entitled to an amortized portion of interest as compensation for the money they had to tie up to make the improvements.
Multiple of monthly rent: Regardless of how much advance notice the tenant provides, there’s a risk that the space will remain empty for some time after early termination. Attorneys advise that landlords estimate the number of months between the date of termination and the date a new tenant moves in and starts to pay rent. Three months is an unofficial benchmark, but estimates will vary depending on the market and other circumstances. The estimated vacancy figure should be inserted into the lease as a multiplier of the monthly rent losses [Clause, Sec. 3(a)].
Keep in mind, especially if you have significant negotiating leverage, that the higher the multiplier, the more reluctant the tenant will be to terminate the lease. If it’s high enough, the multiplier might even generate a modest profit for the landlord. Don’t be surprised if tenants push back by insisting that the monthly rent component of the termination fee be based only on base rent and not additional rent. The argument: Additional rent basically compensates the landlord for services not provided in the vacant space.
Difference between base rent and average rent for full term: Early termination can really backfire where a landlord provides concessionary rent rates at the start of the lease to be set off by above-market rent at the end of the lease. It will all even out in the end once rent payments are averaged over the entire term of the lease, the landlord figures. But that won’t happen if the tenant terminates early. So, you should require tenants to compensate you for the amount by which the base rent it pays falls short of the average rent it would have paid had it stayed in the lease for the full term [Clause, Sec. 3(c)].
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