The CRE Termination Clause

And why it may not work

 

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There are many terms and clauses in commercial real estate leases. Sifting through all the legalese can be quite daunting. Various responsibilities and rights exist for the benefit of both tenant and landlord.

One term that rarely makes it into the lease, but may be asked at the offer stage, is the termination clause. Landlords typically shy away from it. Let me tell you why.

Guessing game

Many tenants will request a termination clause if they are uncertain of their future expanding or contracting needs. If a business is rapidly growing, for example, tenants have a difficult time estimating what they’ll need in a few years. They don’t want to lock into a space they may outgrow quickly.

I worked with a client who was contracting space and faced a similar issue the other direction. Their work force was phasing out use of traditional office space and more employees were working from home. The tenant recognized they had a need for space, but how far that would narrow in a matter of years was hard to foresee.

The tenant ultimately decided to take a shorter term with a minimal amount of investment of improvement into the space. They understood the need to sacrifice some of the comfort they would have normally invested into a space because they may not be there long to justify the cost.

Long term shrinks before your eyes

For tenants, the solution to size uncertainty is requesting the ability to opt out. To them, it solves the uncertainty issue and allows them to present a longer term offer.

Landlords, and their bankers more specifically, see this from another angle.

The long term lease that a tenant feels they are offering diminishes in its appeal when the landlord realizes the tenant can walk with a few months’ notice. The deal has effectively became a three to six month term or whatever the stated notice period is.

I mention bankers because they are involved in determining asset value for the landlord. They most certainly look at the covenant of the tenancies and the value they bring to the property.

An attractive lease rate is important but term is almost as valuable. They cannot fairly assess risk of lending on a property without terms from tenancies. A tenancy with an out clause holds little value for them.

Re-adjust the plan

I recommended a solution this week that gave both the tenant and landlord a fair alternative. We adjusted the term to a shorter span and tied in future lease rates into a couple of options to renew.

The tenancy was provided the ability to leave but the landlord also negotiated his terms down the road. If the tenant stays, the landlord has already determined a satisfactory return.

If the tenant leaves, the landlord has a minimum acceptable term. This solution buys both parties room to plan with some of the negotiation out of the way.

As with all our blog posts, I want to add that there are always special case scenarios where you can pitch everything I’ve just stated! No deal is alike.

There definitely exists a time and place for termination clauses in commercial leasing. That’s why we have them in the first place. But it’s important to know that sometimes as real estate professionals we are able to offer other options when the termination clause does not work.

Posted by Kelly Macsymic

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