Achieving Flexibility in Leases
Achieving Flexibility in Leases
by Bryan Mashian, Esq.
The long recession coupled with a decline in rents has created a new marketplace reality for commercial tenants and landlords. More tenants now ask for lease flexibility, such as the right to cancel their lease early, to fit with their business needs.
When negotiating flexibility in leasing terms, parties have four main options available:
Offering Cancellation Rights
Whether the parties will agree on a cancellation clause depends on a host of factors, such as the type of property involved, the tenant’s credit, the length of lease, rent increase methods and frequency, the cancellation compensation, and -above all- the relative bargaining strength of the parties.
Landlords can be reluctant to grant cancellation rights if they must bear the financial risks of rent decreases, added turnover and other associated expenses. Also, a cancellation provision adversely affects the property’s financeability and value, especially in a single-tenant property, such as an industrial facility.
Landlords can limit their risks by imposing conditions on the tenant’s right to cancel, such as requiring a minimum period of occupancy or proof of poor sales to exercise the cancellation options. Most landlords will also require the tenant to compensate the landlord costs associated with a cancellation option such as potential decrease in market rents, unamortized lease expenses, and rent during the reletting period.
Creative Lease Structure
If the parties can’t agree on a cancellation right, an alternative is to structure a short-term lease, such as three to five years, with one or more extension options. With short-term leases, the rent may be higher, and landlord may provide fewer tenant concessions, such as improvement allowances or free rent.
Negotiating extension options with fixed rents can be a point of contention between landlords and tenants. Few landlords are willing to give extension options with fixed rents unless the rent is set high enough to match forecasted future market rates.
Tenants are reluctant to agree to option period rent increases, especially if they are determined by the Consumer Price Index (CPI), since in the past few years, the CPI has still increased while market rents decreased.
A potential solution to avoiding future rent fluctuations is for landlords to offer option period rent at then-fair market rent.
Expansion and Contraction Options
Other creative lease structuring options include offering tenants an option to expand, a right of first refusal for leasing other space, or providing a tenant the right to reduce leased space.
In these cases, landlords may require tenants to pay a consideration for a contraction option, similar to a cancellation option, but apportioned for the cancelled space. Landlords may prefer this option to an out-right cancellation of the lease, since the tenant continues to pay some rent.
Whether this option is a practical solution depends on the tenant’s current space needs, their future potential needs, and the landlord’s space inventory. For example, these types of options can work well for leases in large office buildings where the landlord has relatively large amount of space.
A fourth solution for creating lease flexibility involves allowing the tenant to assign or sublet the premises to address any excess space. This option has two key disadvantages for tenants. First, the tenant must market the available space, handle payment collections, and mitigate any rent deficiencies, rather than simply cancelling the lease. Second, the tenant remains liable under a lease after an assignment or subletting, unless the lease provides otherwise. By contrast, when a tenant exercises a cancellation option, the tenant is released from further liability under the lease.
Tenants can use the allocation of profits from increase in market rent as a bargaining chip if the landlord is not willing to give a cancellation option. Since the tenant takes on the risk of rent decreases, correspondingly, the tenant is entitled to the profits from an increase in rent.
Conversely, if the landlord gives the tenant a cancellation option, then the landlord may maintain that he or she should receive all profits from increases in rents. In other words, the party that takes the risk of decrease in rents also receives the benefit of increase in rents.
Each of these four options offers landlords the means to satisfy a tenant’s request for lease flexibility by providing tenants options to address potential losses in the current unpredictable market. Even if a landlord isn’t willing to provide a cancellation option, the parties can consider structuring shorter leases, employing expansion and contraction options or negotiating appropriate assignment or subleasing rights.