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OPTIONS TO TERMINATE
Not in every lease, but essential to understand and timely address
When we think of the many leases we have worked on, from letters of intent through completed leases, a tenant’s option to terminate just doesn’t come up very often. More attention is rightfully given to the lease term, and of course, the rent and rental increases. But unless a lease term is somewhat longer than most (say in excess of five to 10 years or more), the right to terminate just doesn’t make it into the parties’ lease negotiation. However, things change (pandemic), tenants outgrow their space (it still happens with mergers and acquisitions), businesses are sold, and space originally deemed so essential becomes excess and a financial drain. Negotiating the termination of a lease with no fixed termination right isn’t pleasant; tenants don’t have much leverage, or worse, they may be in a position of weakness. For these reasons, the right to terminate—i.e. a termination option—usually at a price is worth considering at the outset when the tenant has some leverage.
Yes, we say at the outset, meaning at the outset of lease negotiations, and perhaps earlier, in the Request for Proposal (RFP). One story comes to mind, highlighting the potential costs to a tenant which failed to raise the issue until deep in negotiations (rent fixed, term fixed, lease in its fourth draft). This tenant sought to lease a 500,000 square foot space in a transaction where both landlord and tenant intended to spend significant funds on tenant improvements. The initial lease term was 10 years, but the tenant insisted on extension options for an additional 20 years in four, five-year increments. When the tenant’s well-meaning CFO insisted that the tenant have the right to terminate the lease after the first three years, it appeared this would doom the almost completed negotiations. The good news is that as the tenant contemplated the cost of the termination fee, the changing rent, and tenant improvement allowance, the real estate and operations folks explained to their CFO that a termination right wasn’t worth its cost and wasn’t likely to be exercised either. The deal was put back on track: the tenant chose the longer term, many options to renew, and fortunately the parties put aside the thought of early termination.
But in another recent transaction, again with a longer than average lease term set forth in the letter of intent (LOI), the landlord sought a termination fee in exchange for the termination option. The tenant was a Turkish company and was not used to transactions with different brokers representing different parties. As the landlord spelled out the components of the termination fee, the tenant was astounded to learn how large the commissions would be to both the landlord’s broker and its own broker. The tenant simply terminated negotiations, terminated its representation agreement with its broker (nothing in writing of course), and decided to continue its search, or possibly return to the original deal without representation. Put aside (for a moment) the potential commission or damage claims that could be asserted. Rather, consider the failed deal, the lost time, and what pitfalls lie ahead for the unrepresented tenant.
Lessons learned? Actually, there are two: Early consideration of a termination option, not something to drop into negotiations at the eleventh hour, just as we learned from the first example. But also, the brokers should have had a full and frank discussion with their client as to how brokers work, how they are paid, how much they are paid, and how brokers provide value to clients, as well as why brokers deserve their fees. These conversations are sometimes avoided, but experienced brokers don’t shy from these issues. Instead, they relish the opportunity to demonstrate their value early on. Had our broker friend who lost this tenant rep assignment taken the opportunity to explain all of this, the commission component in the termination fee would not have been a surprise and the deal might still be on track, with the tenant rep broker still in the deal.
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In summary, consider these thoughts to demonstrate your value to your tenant clients:
- Market knowledge
- Experience
- Negotiation skills
- Leverage
- Incentives
- Help with choice of contractors for tenant improvements
- Move management
The fact that in most markets with sophisticated landlords, the commission paid to a tenant rep doesn’t cost any party more, except for the listing broker who intends to share the fee in most cases. It’s a fixed and included cost of the deal, once the landlord signed a listing agreement with its broker.
All these points are more easily made at the outset, rather than when dealing with a tenant’s sticker shock at the size of commissions, recovery of TI costs, and the like; not to mention the parties’ overlooking why an option to terminate should (or should NOT) have been part of the deal from the outset. Lessons learned, with the tuition far too high for the unfortunate broker.
By James Hochman, David Liebman, SIOR, JD
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