Termination options, as the name indicates, give tenants the option to terminate their lease under various different circumstances. From the perspective of your business, these rights will prove hugely valuable should you need to relocate, contract, expand, find cheaper space or leave your space for any other reason.
Most commonly, termination rights give the tenant the option to terminate their lease either at, or after, a specified period of time. Ongoing rights are obviously more favorable to the tenant, but landlords generally insist on giving tenants a fairly narrow window within which they must choose to exercise their right.
Regardless of which structure is written into the lease, tenants generally prefer to have their termination option set closer to the front or middle of their lease, while landlords usually try to push the option as far out as possible. If a tenant exercises their termination right, they are usually required to make a termination payment to the landlord, which is generally a fee equal to the dollar amount of any unamortized brokerage commission and free rent given at the onset of the lease.
A fairly standard termination option on a ten-year lease might be structured as follows:
Upon no less than nine months written notice to landlord, tenant may terminate the lease at the end of the 5th or 7th year of the lease term by paying to landlord the sum of all unamortized lease concessions (such as free rent and moving allowances), tenant improvements and brokerage commissions at an 8% interest rate. This termination option can only be exercised if the tenant is not in default of the lease.
What this means: You have to pay the landlord back the costs of doing your deal that have not yet “burned off” at an 8% interest rate. For example:
If your lease is for 10,000 sf at $30 per sf per year, and if your tenant improvements were $50 per sf and your total brokerage commissions were 6%, then at the end of five years you would owe ~$405,000, or 16 months of rent. For a termination at the end of year seven, the cost would be ~$261,000, which equates to 10 months of rent. However, if the initial lease term was seven years instead of ten, the payment at the end of year five would be ~$214,000, a savings of $191,000! That’s nearly 8 months’ rent. Your next landlord likely would pay the 8 month termination fee to get your business. No one, including you, is likely to pay the 16 months!
Now you know why we recommended seven-year deals. Talk to your broker for a calculation of your termination payments. You can also download the Lease Termination Payment Calculation from our Resource Center, or just email us!
What no one tells you: First, if your landlord offers a lower rent in exchange for no termination or contraction options (see below), take the higher rent and maintain your optionality… greed is NOT good here. Remember, landlords want fixed, reliable cash flow for their financing. So, the more flexibility you want, the worse the deal they can offer you. However, they are in the real estate business, and you are not. They will always price taking your flexibility risk at less than it will cost you to try to sublease your space.
Second, landlords need a minimum five years of “actual” rent (that is, not free rent) to finance leases, so termination options are almost never sooner than after five years of paid rent (i.e. after any free rent). The exception is a three-year termination option for small spaces with limited tenant improvements.
EXPERT LEVEL: If you want the best terms from the landlord, offer to tie your termination or contraction option to a specific event (like losing a contract with an important customer). Landlords like this because you just can’t walk away from the lease and they know you will try to keep the contract. The less the landlord thinks the chances are that you will exercise the option, the better their financing and the cheaper the option to terminate can be for you.