Congratulations! If you’ve gotten this far, you probably know everything (and more than) you’ll ever need to know about leasing space. The topics that follow are not for the faint of heart, and not necessary (unless you’re a real estate professional), but they are important and could wind up saving you real time and money if you take the time to understand them.
What you need to know: 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.
Pro Tip: 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.
Need to know: Contraction options are like termination options except that they only allow tenants to “give back” a portion (usually 10 – 20%) of their space at various stages during the course of their lease. Also like termination rights, contraction options are specific to each individual lease and may be granted under certain specific circumstances or after a certain period of time. Similarly, tenants may have ongoing contraction options (e.g. “at any time after”) or have a one-time option (e.g. “upon such time as”).
Tenants most commonly exercise contraction options for one of the following reasons:
“Reduce real estate costs Reduction in force Relocation of certain employees”
A fairly standard contraction option might read like this:
Upon no less than nine months written notice to landlord, tenant may terminate its lease with respect to the 2,000 sf depicted on the attached exhibit at any time after the 36th month 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: In our ten-year lease example above, the remaining rent payments (on that 2,000 sf) at the end of the third year of the term through the end of the tenth year would have been $420,000. The termination option payment is $96,190, or 19 months of rent on the 2,000 sf. A savings of $323,810 over the term if you don’t need the space.
What no one tells you: Landlords need to re-lease the space they get back from you to another tenant. If you agree up front to give back more desirable space (e.g. a building corner with good window-line space), you may be able to increase the amount of space you can contract (e.g. 20% vs. 10% of your space), or at least get the option Of course, because landlords need an uninterrupted rent stream for five years or more, the larger the contraction option you ask for, the later and less flexible it’s likely to be.
ASSIGNMENTS AND SUBLEASES
Need to know: Subleasing is a bad option… it is hard to find sublease tenants, landlords would prefer not deal with this, and except in rare cases it will cost you a lot of money. Your lease may have lots of fancy language about splitting sublease profits with the landlord… don’t spend a lot of time or legal fees negotiating this one, unless you are in market like Manhattan, the odds of this happening are low, very low.
Pro tip: You have to defend yourself here; your advisors typically will downplay the difficulty of subleasing.
Landlords will generally ask for “consistent use” in your lease in order to prevent “bad boy” behavior like leasing to highly undesirable tenants as a means to cause the landlord to terminate the lease and let the tenant off the hook. Just make sure this language isn’t so restrictive that you can’t lease to anyone else. Similarly, make sure your landlord does not include language that you cannot compete with other their prospective building tenants to sublease your space.
The difference between an assignment and subleasing is that an assignment theoretically completely replaces the old tenant with the new tenant, while with a sublease, the sub tenant is your problem and the landlord has no direct relationship with them. In practice, the landlord will not let you replace your tenancy unless the new tenant’s credit is pretty spectacular. In sum, once you sign a lease, plan on being there for the duration.
What no one tells you: The best defense is a good offense, so get the best termination option you can and don’t worry about subleasing.
Pro Tip: In the event you cannot avoid subleasing your space, give your landlord the option to release your space directly and agree to pay his releasing costs. Landlords love having a new, transaction-cost-free tenant at a market rent (that might renew) versus you and your discount-rent subtenant who is going to leave. Check out the Subleasing Option Agreement in our Resource Center. We actually invented this transaction structure and have used it successfully numerous times. It gives the landlord the option to lease your space for a percentage of your remaining rent, and you can terminate the option if you find a subtenant or you don’t think they are trying to help you. This is truly a win-win structure. Remember, if you try to sublease your space, there is usually a big difference between your rent and the subtenant’s rent. That means that the subtenant is counting on your credit and that you will pay the landlord. If you don’t pay, the landlord can kick them out. Since subleasing often goes hand in hand with a tenant’s financial difficulty, and since subtenants don’t want to sublease from a bad credit tenant, subleasing is not typically a great option. With the landlord option attached, the landlord gets to help you and themselves by getting you out of the property. Note: lenders loathe subleases as the below market sublease space competes with vacant space in the building and they know the tenant is not staying.
RENEWAL OPTION AND NOTICE PERIOD
Need to know: Renewal options give a tenant the right to renew their space when the lease expires. The notice period is the amount of time before a tenant’s lease expiration that they must notify their landlord of whether or not they intend to renew and stay in their space.
A fairly standard renewal option clause might say the following:
Upon not less than twelve months written notice to landlord given prior to the expiration of the existing term of the lease, tenant may renew the term of the lease for two additional periods of five years each. Each renewal term shall be on the same terms and conditions contained in the lease except that rent for each renewal term shall be market rent. Market rent shall mean the rent for tenants of comparable buildings in the geographic area where the premises are located. Each renewal option can only be exercised if tenant is not in default of the lease.
Pro tip: Landlords greatly value having 12 months’ notice as it gives them time to find another tenant… and they will pay you for that! We see so many tenants fight for six or nine month’s renewal notice instead of 12, and then the landlord just counters with a five-year renewal option. But they should be in the market looking for space a year in advance anyway (see Chapter 2).
Always trade notice for flexibility! Set up your notice period such that you must give notice to renew your lease 12 months before your lease expiration. Landlords love renewals as new tenants are much more expensive to obtain and, if you give them a year’s notice, they’ll often give you flexible terms on your renewal.
What no one tells you: Ask for two renewal terms of 3, 5 or 7 more years at your option with sliding scale concessions and build outs. No one ever thinks to ask for this, they just default to a five-year renewal. However, this flexibility can be very important and is typically an “easy give” for a landlord. Retailers ask for it all the time.
Always negotiate for a fixed-rent renewal term. Don’t accept a market rental rate renewal, as you can always re-negotiate your deal in a down market. And landlords hate renewals at “95% of market rate” because they disproportionately impact the value of their building when it is sold.
Whether you have a market renewal or a fixed-rate renewal, always ask instead for “market tenant improvements and free rent” in your option. Make sure there are some minimum allowances for these numbers.
Pro Tip: Determining market rent, tenant improvements and free rent typically is left to a complex process in the lease where the tenant and landlord each pick a broker or an appraiser and they “duke it out” over these numbers. However, in our decades of real estate experience, we have seen this type of arbitration process actually used once. Typically, the landlord and tenant just work out a deal or not. Of course, if the landlord doesn’t want you to stay (e.g. because a neighboring large tenant wants to grow into your space), they can make it very difficult for you. The key is to have specific fixed renewal rates and minimum free rent and tenant improvement allowances so you always have terms for a deal that you can just take. This provides material leverage in a dispute situation.
RIGHTS OF FIRST OFFER (ROFOS) AND RIGHTS OF FIRST REFUSAL (ROFRS)
Need to know: ROFOs and ROFRs as they’re colloquially known give tenants the right to take additional space in the building in the future. While these rights are a headache for landlords, they protect tenants who need to grow from being “jammed” by their landlords – who know they’re in a bind – into a bad deal on the additional space.
• Right of First Offer: ROFOs give tenants the right to take additional space in the building in the future. This option space typically is limited to space that is contiguous with your existing space. The landlord is required to give notice of available space periodically, typically annually. Make sure they hold up their end of the bargain, otherwise you risk missing out on availability in the building and your only recourse is a tenuous lawsuit.
Sample ROFO language might read as follows:
If space in the building horizontally contiguous to the premises becomes available during the term of the lease, landlord shall provide written notice of the availability to tenant. Tenant shall have ten days to respond to landlord’s notice to either elect to lease the offered space or decline to lease the offered space. If tenant fails to elect to lease the offered space within such ten day period, tenant’s right to lease the offered space shall be deemed to have expired. If tenant elects to lease the offered space, all the terms and conditions of the lease shall apply to the lease of the offered space except that rent for the offered space shall be market rent. Market rent shall mean the rent for tenants of comparable buildings in the geographic area where the premises are located. If fewer than three years remain in the term of the lease at the time of tenant’s election to lease the offered space, the term shall be extended so that three years remain after the lease of the offered space. Tenant’s right to lease the offered space is a one-time right and can only be exercised if tenant is not in default of the lease.
Pro Tip: Don’t let the ROFO go to market terms and conditions for as long as possible. As noted above, determining “market” is not a great process. Have the terms be the same as your current lease (with pro-rated tenant improvements) for as long as possible. No one ever asks for this. We would as for five years versus the two above.
• Right of First Refusal: A ROFR requires that a landlord give a tenant notice before they lease a specific space (usually contiguous with their existing space) to a new tenant. Tenants typically have 10 – 15 days to decide whether they want to take the new space. ROFRs generally require that existing tenants take the entire space in question and match the terms of the potential new tenant’s lease.
Sample ROFR language might read as follows:
If landlord received a good faith third party offer to lease space in the building horizontally contiguous to the premises, landlord shall provide written notice of the offer to tenant. Tenant shall have ten days to respond to landlord’s notice to either elect to lease the offered space or decline to lease the offered space. If tenant fails to elect to lease the offered space within such ten day period, tenant’s right to lease the offered space shall be deemed to have expired. If tenant elects to lease the offered space, all the terms and conditions of the lease shall apply to the lease of the offered space except that rent for the offered space shall be the terms set forth in landlord’s notice. If the length of the term set forth in landlord’s notice is longer than the remaining term of the lease, the lease term shall be extended so that the remaining term is the term included in landlord’s notice. Tenant’s right to lease the offered space is a one-time right and can only be exercised if tenant is not in default of the lease.
Both are headaches for landlords to manage, but landlords really hate ROFRs because they impair their ability to lease the space. If a potential tenant knows the space in question is subject to a ROFR, they are likely to look elsewhere rather than waste the time trying to negotiate terms with the landlord only to have the existing tenant take the space.
Pro Tip: Ask for good faith notice if the landlord is actually negotiating with a tenant and then accept a 10-day notice period. The landlord will know weeks in advance if they have someone truly interested. Landlords would gladly give notice of strong leasing activity to shorten your decision time. Accept the fact that it might be a “false alarm”, and remember if you need the space you always have your ROFO if their deal dies.
What no one tells you: “Market terms” and “market rent” are not the same thing. Same “terms” means same rent and same concessions (e.g. TIs and free rent). If your ROFO says you have the right to take new space under “market terms,” you are also entitled to the same concessions. If your lease says you are entitled to take new space under “market rent”, you will NOT be entitled to any concessions.
Similarly, “market terms” for new tenants may provide for different concessions than market terms for a renewing tenants. Generally speaking, new tenants receive larger concessions than renewal tenants. However, if the new lease is very short term (i.e. less than 3 years), your landlord may argue there are no “market concessions” for that type of lease, but there are for a renewal!
Lastly, when you have options to take additional space, even if it’s in another building or project, make sure your leases are coterminous, i.e. that they all expire at the same time. This is worth everything to you because you can go back to market when your leases are expiring and cut a new deal to consolidate all of them. And, if you want to extend for a few years, your landlord will be happy to offer to refresh the rest of your lease to be coterminous with the new space.
And don’t forget, if you are growing, the free rent and other concessions offered on your next deal may enable you to move early. For example, if you are growing from 10,000 sf to 20,000 sf and need the space now, but you have a year remaining on the 10,000 sf term, your new landlord will pay for the remainder of that lease as part of your new deal.