Tenant Termination Options in Commercial Leases

by | Jun 25, 2024 | Article

Tenant Termination Options in Commercial Leases

Commercial real estate leases generally do not include a right for the tenant to terminate the lease early. However, in certain circumstances, a commercial tenant may negotiate with its landlord for the inclusion of an early termination option in a lease. Understanding the mechanics and implications of such a provision is crucial for both tenants and landlords.

Negotiating the Right to Terminate Early

Early termination rights are not standard in most commercial leases. When they are included, it is generally the result of a specific negotiation between the tenant and the landlord. Tenants may seek this flexibility for various reasons, such as business uncertainties, expansion plans, or potential relocation needs. For landlords, granting an early termination right can be a way to attract desirable tenants or close a deal that might otherwise fall through. 

In practice, the termination options function almost as the reverse of extension options.  You could think of a 10-year lease with a one-time option to terminate at the end of year 5 as being in effect a 5 year lease with a 5 year extension option.  The primary differences between the two structures are that: (i) frequently an extension option will provide for the rental rate under the lease to be reset to fair market value at the time of the extension, whereas the rent for the initial term is most commonly fixed in the lease so in the case of a termination option, the tenant’s “extension option” (i.e. the tenant’s option not to exercise the termination option) is at a fixed price rather than being marked to market, and (ii) in the case of a termination option, the landlord will likely be responsible for paying rent for the entire term upfront, whereas with an extension option, the landlord will generally initially only be responsible for paying the leasing commission for the initial term of the lease, with any applicable leasing commission for the extension only payable in the event the tenant exercises its extension right.  This discrepancy in the payment of upfront leasing costs is part of the reason an early termination right typically provides for a termination fee to be paid by the tenant.

Timing Requirements

Each early termination right is generally specifically negotiated, and while this is not always the case, in many instances the tenant’s termination right is not evergreen (i.e. the tenant cannot terminate at any point that the tenant wants), rather the option to terminate is only exercisable by the tenant at a certain point in the lease term. If the tenant does not elect to terminate the lease at that point, the tenant waives its right to terminate the lease and the lease term will continue until its original expiration date. 

In addition to only being exercisable at a certain point in the lease term, it is common for a tenant’s early termination right to require that the tenant provide significant advance notice to the landlord of the tenant’s intention to terminate the lease. This notice period is designed to give the landlord ample time to find a replacement tenant and mitigate potential financial losses that the landlord might otherwise incur upon the loss of the tenant.  Frequently, a lease will provide that a tenant must exercise its termination right within a certain window of time (e.g. no earlier than 12 months prior to the termination date and no later than 9 months prior to the expiration date). 

Termination Fee

Along with advance notice, an early termination option usually includes a termination fee. This fee serves to compensate the landlord for the costs incurred in establishing the lease, which were incurred by the landlord based on the expectation of the lease running its full term. The termination fee often covers the unamortized leasing costs, including leasing commissions, tenant improvement costs, and legal expenses.

Frequently, a termination option will provide for these leasing costs to be amortized over the lease term on a straight-line basis, with an interest rate factor applied. For example, if the landlord spent $100,000 in leasing costs for a ten-year lease, the amortized cost would be $10,000 per year (i.e. $100,000 / 10 years). If the tenant terminates the lease after five years, the remaining unamortized cost would be $50,000.  If the applicable interest factor was 8.0%, the termination fee would then be $54,000 (i.e. $50,000 x 1.08). 

A common formula for calculating a termination fee is below.  Whenever possible, it is helpful to include the actual formula in a contract so that if the termination option is exercised, there is no dispute between the parties as to the calculation of the applicable termination fee.

Additional Fees for Lost Rent

In some cases, the parties may agree to include within the termination fee an additional fee to compensate the landlord for potential lost rent during the time it takes the landlord to find a new tenant following the tenant’s termination. This fee is typically measured in months of rent that the tenant would have otherwise paid if they had not terminated the lease early. For instance, the agreement might provide for an additional fee equivalent to six months’ rent to cover the expected vacancy period.  The inclusion and amount of such a fee is negotiated by the parties on a deal-by-deal basis taking into account factors including (i) the anticipated challenge and cost of releasing the space, (ii) the applicable notice period for the tenant’s exercise of the termination option, and (iii) the rental rate under the subject lease relative to market rate for such space.

Practical Considerations

For commercial tenants, negotiating an early termination right requires consideration of the potential costs and benefits. While a termination right provides flexibility, it is also a significant “give” to receive from a landlord and a tenant must consider whether their negotiating capital is best spent pursuing the termination option or on other deal points that may be of more value to the landlord.  The tenant also needs to ensure that, if the termination option is only exercisable by the tenant at a certain point, that point is likely to align with the tenant’s business needs and the tenant will likely be able to make an informed election as to whether or not to exercise the termination option within the window allowed by the lease.

Landlords, on the other hand, must evaluate the risk of agreeing to an early termination clause. While it can make the lease more attractive to tenants, it also introduces uncertainty and potential financial exposure. Landlords should ensure that the applicable notice period and termination fee are appropriately calculated to compensate the landlord for any lost rent the landlord is likely to incur due to the tenant’s exercise of its termination right.  If the landlord intends to sell or refinance the building during the course of the lease term, the landlord should also take into consideration the likely impact on the value of the property to have a lease with an early termination option rather than a fixed term.  Landlords also need to be cognizant of the upfront leasing costs of entering into a long-term lease with an termination option rather than entering into a shorter term lease with an extension option.

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