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Contraction Right

Note: The location of this blog will move permanently to my law firm website starting in September 2010.  This post and all prior posts have been duplicated on the new website.  The web address for the new blog site is: http://rrlawaz.com/blog/

Contraction Right

In the current economic environment, companies are trying even harder to control costs and overhead.  Unfortunately, cost control efforts often include downsizing.  This has left several companies with too much space under their leases, which were signed months ago when the company was more profitable and had a larger work force.

Tenants and their brokers often consider requesting a right to expand, but rarely consider requesting a right to contract.  In a typical right to expand, the tenant would have a right of first refusal to lease contiguous office space if it becomes available.  The right to expand is important for a growing company that may need additional workers in the future and space for those workers.  However, tenants should consider requesting a right to contract, especially those entering into long term leases.  Following are important issues to consider when negotiating a contraction right:

1.  The parties must agree on the size and dimensions of the contraction premises in advance.  For example, if a tenant initially had 6,000 square feet, the tenant should not be permitted to arbitrarily contract to a smaller space of 5,000 square feet.  The space left over must be leasable by the landlord.  In the above example, the landlord may be willing to carve out 2,500 square feet to lease to another tenant, leaving the tenant with 3,500 square feet.  The size and dimensions of the contraction space should be attached to the lease as an exhibit.

2.  The landlord should limit the time window in which the tenant may exercise its right to contract.  For example, if the lease term is five years, the tenant should be permitted to exercise its right during the 37th month of the term.  If the contraction is too early in the term, the landlord may not recoup its initial tenant incentives.  If the contraction is too late, the landlord may be forced to wait for the overall term to expire instead of leasing a less desirable, smaller space.

3.  The landlord may want to require a contraction fee.  Since the tenant is lowering its overall payment obligation under the lease, the landlord should receive some compensation.  In addition, the contraction fee may be equal to the prorated tenant improvement costs and leasing commissions for the re-leasing of the smaller space.

The contraction right must be negotiated prior to lease execution and should be included in the letter of intent.

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 rrosensteel@rrlawaz.com.

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