Commercial tenants who leased space at the peak of the leasing market several years ago were generally more anxious to get into their space, and to negotiate expansion rights, than they were concerned about maximizing their options in the event of a downturn. As a result, many of these tenants, whose need for space has diminished rather than increased, regret having signed their lease without a provision that gives them the ultimate flexibility - a right of termination. Short of subleasing their space (most likely for substantially less than their rent obligation under the lease), assigning their interest in the lease (if they are even able to find an assignee and secure the landlord’s consent), negotiating a workout of the lease terms with their landlord (though landlords - and their lenders - typically will not entertain such discussions unless the tenant is in financial trouble) or defaulting under the lease (and risk damage to their credit), tenants are resigned to ride out the lease term at painful above-market rental rates.
Tenants who are in the market to lease space today are leveraging the continuing softness in the leasing market to act on their renewed awareness of the importance of a termination right, and many tenants are now insisting, and frequently getting from their landlords, the right to terminate their lease. Of course, this is not to suggest that such termination rights are commonplace in any market - in fact, in some markets, they are not even considered by landlords; however, it is safe to say that such rights are far more common today than they were five years ago. The appeal of a termination right is self-evident, particularly since obtaining the termination right costs the tenant nothing, even if exercising the termination right would not be cost-free. Unless a landlord enjoys above-market occupancy in its building, agreeing to a termination right may be necessary to get the tenant into its building. Landlords who are presented with a credit-worthy tenant in particular have a difficult time refusing such a tenant's request for a termination right.
There are, however, protections that a landlord can and should negotiate in the context of a termination right in an office or R&D lease. The most important protection a landlord can obtain (and which is common) is a lockout period before which the tenant cannot exercise the termination right. Typical lockout periods extend for one-third to two-thirds of the term of the lease (e.g. if the lease is for 60 month term, the tenant would not be able to terminate the lease before the first day of the twenty first or forty-first month), or longer. There is the obvious benefit here – namely, the landlord (and, significantly, its lender or purchaser) can expect to receive rent for approximately 1/3 to 2/3rds (or a longer fraction) of the period it negotiated its lease term, which allows the lender to establish an expected rental stream for at least that period in calculating the property's net operating income – and the not so obvious benefit – if the lockout period is long enough, the tenant may become sufficiently entrenched in the leased premises that by the time the lockout has expired the tenant has no need or desire to terminate the lease.
Another significant protection from the landlord's perspective is to require the Tenant to give notice as many months as possible before tenant intends to terminate its lease. This should provide Landlord with sufficient time to market the space. A long marketing is even more critical in a soft leasing market. Generally, tenants are willing to provide at least six months notice prior to the anticipated date of early termination, though some landlords insist on and sometimes obtain nine months, or more, prior notice.
Landlords should, and do, typically attempt to receive additional protection by insisting that the tenant reimburse the landlord for the following leasing costs if the tenant exercises its termination option:
i) brokerage commissions. The brokerage commission should include any portion of the commission the landlord pays upon lease commencement, as well as any portion of the commission payable after the lease commences or any portion the landlord is obligated to pay sometime during the lease term, unless the landlord is not required to pay such a deferred portion as a result of the lease termination. Typically, the tenant will negotiate this obligation so that its obligation to pay these amounts is limited to the unamortized portions, and typically the landlord will insist that these amounts accrue interest over the remaining term of the lease;
(ii) an amount equal to rent which would have accrued (at face rate) during any free or abated rent period (usually during the first month or two of the lease term), or, as a compromise, a portion of the free rent amortized over the initial term of the lease and attributable to the terminated portion; and
(iii) the cost incurred by landlord to provide the tenant improvements to the premises, or if the tenant is performing the tenant improvements, then the tenant improvement allowance. If a tenant insists on a termination right and there are tenant improvements to be performed in the space, the landlord should consider asking the tenant to pay for the tenant improvements itself, then providing the tenant improvement allowance over the term of the lease as a credit against rent, with the tenant losing the balance of the credit if it terminates the lease early. A landlord that takes back space with tenant improvements also may inherit the obligation of removing those improvements. The landlord should consider requiring the tenant to remove any tenant improvements if the tenant insists on the termination right (with the intended consequence of making the exercise of the termination right more costly for the tenant).
Landlords are often also able to negotiate reimbursement for an amount equal to the base rent that would have been payable by tenant, had the lease not been terminated, for a specified period (often as little as one or two months; sometimes a considerably longer period of time) after the lease is terminated. Ideally, for the landlord, the amount is tied to cost recovery plus an amount equal to compensate the landlord for the expected period to relet the space during which landlord receives no rent.
The landlord may also want to consider negotiating for its benefit a percentage of the cost savings the tenant may reap by terminating its above-market lease for the less expensive space.
Three other points that, although less frequently negotiated (though usually resulting from landlord's failure to ask), landlords should consider when negotiating lease terminations are: first, if the lease provides for extension options, the termination right should only be limited to the original lease term; second, landlords should add legal and administrative fees incurred in the negotiation of the lease and reviewing the credit worthiness of the tenant to the list of expenses to be reimbursed by tenant; and third, the landlord should consider requiring an additional security deposit to be applied against the lease termination fees if the tenant exercises its right to terminate.
Additionally, a landlord should attempt to limit the termination right to the named tenant. Depending on the tenant, this could be a hard-sell. Closely-held tenants have less trouble accepting such a restriction on an otherwise valuable right, but tenants who are publicly traded or who are otherwise susceptible to corporate reorganizations (including tenants who intend on assigning their interest in the lease to a subsidiary or parent company) may balk at losing the termination right as a result of a merger or affiliate transaction.
Another factor to take into account is the rights of the landlord's lender, if any. If the landlord has a mortgage on the property, the landlord should consult the loan documents to determine whether its lender's consent is required as lenders usually do not allow a landlord to terminate a lease without the lender's prior consent. If the loan documents do require the lender's consent, it is important to have the lender consent to the tenant's termination right at the time the lease is signed (and to have the letter of intent for the lease provide that the right of termination is contingent upon landlord obtaining its lender's consent and that landlord will use its commercially reasonable efforts to obtain its lender's consent prior to lease execution) as opposed to at the time the tenant exercises its lease termination, since the latter situation places the landlord in the uncomfortable position of being obligated under the lease to accept the termination obtaining its lender's consent once the landlord has already committed itself to accept the lease termination or face defaulting under the loan documents as a result of failing to obtain the lender's consent.
Ultimately, negotiating the right to have a termination right and the terms thereof is highly dependent on the landlord’s and tenant’s respective bargaining positions and is quite market specific. Having said that, the issues discussed above are some of the key principles of general application in negotiating a termination right.
This article has been prepared for general informational purposes only and is not intended as legal advice.
Copyright © 2003 Gibson, Dunn & Crutcher LLP