Early termination rights in commercial leases
It’s best to determine an exit strategy before you sign a deal
What if your business plan gets sidetracked, and you find that you need far less space than you leased?
What if your company gets acquired by a larger company and decides to shut down your location and consolidate operations elsewhere?
For a number of business reasons, tenants like to negotiate the right to terminate a lease early if certain conditions should occur. In most cases, the tenant just isn’t sure how the business will fare, and wants the right to get out of the lease before it terminates.
Some other reasons for wanting an early termination right include:
• A concern that there might not be adequate space for expansion
• A change in the neighborhood that impacts the tenant’s business or the security of its employees
• A failure of the landlord to make major repairs or conduct proper maintenance
Although a tenant will not know whether any of these events might occur, the time to negotiate an early termination provision is during the discussions held with the landlord prior to the lease being signed.
In general, landlords will resist such provisions, because the economics of the lease are based on the tenant occupying the space and paying rent for the full term of the lease. This is especially so when the landlord pays brokerage commissions on the full term of the lease, and invests money into fit-up needs of the tenant.
So a landlord will generally require some kind of early termination penalty, usually in the form of some additional rent and a reimbursement of costs expended by the landlord at the start of the lease.
Determine a formula
In general, tenants must occupy the space and pay rent for some minimum period of time before being able to exercise the right to terminate. For example. In a five-year lease, a tenant may be required to wait until after three years of the lease have been completed.
Once the minimum period is completed, the tenant is then generally required to provide written notice to the landlord of its intent to terminate.
Since a landlord’s primary concern with an early termination is loss of rent, these clauses virtually always impose an obligation on the tenant to pay some additional rent.
For example, in the five-year lease noted above, you might find a provision requiring the tenant to give a six-month notice to the landlord, and an obligation to pay rent during that time period.
In this way, the landlord recoups some rent, and gets the opportunity to market the space to other prospective tenants. The landlord would hope to find a new tenant that could move in around the same time that the first tenant is moving out, thereby mitigating loss of cash flow.
As noted above, the landlord will also want to recoup some of the costs it expended in getting the tenant into the space in the first place. Generally, early termination clauses require the tenant to reimburse the landlord for “unamortized” brokerage fees and fit-up costs.
It’s wise for both parties to specify these costs in the lease, or at least a formula for determining them, so that no questions arise at the time of the exercise of the right.
Referring again to the five-year lease in which the tenant exercises its right to terminate after the end of the third year, with a six-month notice and rent obligation, there would be 18 months of unamortized brokerage fees and fit-up costs left for the tenant to cover.
Since there is no “crystal ball” available to either party, this lease feature allows the parties to structure an early-exit scenario in which all of the respective concerns are addressed up front, with a specific formula for determining their respective rights and obligations.
Dan Scanlon, a senior associate with Colliers International in Manchester, focuses on business tenant representation and investment sales. He can be reached at 603-206-9605 or email@example.com.