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Early Termination Options

Early Termination Options

About half of the commercial lease deals I have seen over the past year included a tenant’s right to early termination of the lease with no termination fee or a small termination fee (e.g., an amount equal to the unamortized leasing commissions and tenant improvement allowance).  Four years ago, early termination options were rarely accepted by landlords, and if accepted required a hefty termination fee (e.g., an amount equal to half of the rent remaining on the lease plus the amounts referenced above).  Landlords dislike early termination options because it shortens the term of the lease and therefore shortens the period of recovery for initial tenant incentives such as abated rent and tenant improvements.  In addition, early termination options diminish the value of the “lease asset” if the landlord desires to sell the property.

The most obvious reason for an increase in the use of early termination options are the current market conditions favoring tenants.  Tenants are receiving abated rent, tenant improvement allowances, renewal rights, rights of first refusal, etc.  However, another reason for an increase in the use of early termination options is that landlords are constructing more “spec suites” with generic tenant improvements.  This means that the landlord is not heavily invested in a particular tenant with unique tenant improvements.  If the tenant moves out early, the landlord can put down new carpet and a fresh coat of paint at little expense and get a new tenant in the generic space.  In a spec suite lease, it still is fair for the landlord to require a small termination fee equal to the costs directly paid by the landlord in connection with the lease, including partial recovery of the abated rent, leasing commissions and tenant improvement allowance.

In contrast, early termination options still are uncommon in retail or restaurant leases where the landlord makes significant unique tenant improvements.

Since an early termination option is a business term, it should be negotiated by the real estate broker in the letter of intent as part of the business deal.  If it is not included in the letter of intent, it becomes very difficult to negotiate later, because the landlord has probably lowered the rent rate or made other concessions that require the landlord to lay out cash at the beginning of the lease.

Following is an example of a simple early termination right provision:

Provided Tenant is not in default under this Lease beyond the applicable cure period, Tenant shall have the right to terminate the Lease, in Tenant’s sole discretion, at the end of the ________ lease year by providing the Landlord with ninety (90) days advance written notice.  The Tenant shall pay a termination fee of $_______ for early termination, which amount shall be due on the effective date of the early termination.

Other issues to consider when negotiating an early termination option include: (1) timing of payment of the termination fee (i.e., at time of exercise of option or on the effective date of termination); (2) free rent to tenant if tenant does not exercise the early termination option; (3) timing of exercise of option (i.e., number of advance written days’ notice); and (4) conditions to tenant’s exercise (e.g., tenant must show revenues below a certain threshold).

Prior to using any language or concepts from this blog entry, consult with an attorney.

Ryan Rosensteel is a real estate and construction attorney licensed in Arizona. You can contact him at ryan.rosensteel@azbar.org.

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