How to negotiate a termination clause when leasing commercial property
In the current economic climate, tenants are concerned more than ever about making careful decisions regarding their commitment to expenditures for their business. One of the largest costs to operate a business is the real estate component; whether it’s leasing or owning space. A strategic approach to gain a competitive rate and still have flexibility includes negotiating a termination clause within the lease. This allows the tenant to be released from their financial obligation at a specified period in time with predetermined costs. Landlords are typically willing to agree to a termination clause provided they are made whole for any costs they incur based on this longer lease term.
4 typical elements factored in to a termination fee are:
- The cost of any unamortized tenant improvement allowance
- The value of any free rent based upon a longer lease term may be reimbursed
- Percentage of the lease or number of months of rent as a penalty
- The cost of any unamortized real estate commissions that have been paid
Often this approach allows a tenant to enjoy the benefits of a longer term lease with the opportunity to cancel the lease prior to the expiration date. An example is structuring terms for a ten year lease with an option to terminate in five years with notification on the 4th anniversary of the commencement date of the lease. Also, a 5 year lease can be structured with an option to cancel after the 3rd year. These termination clauses typically offer the tenant a one-time option to cancel the lease within a specified time frame which if not exercised is lost and the lease remains in full effect until expiration.
Tenants request termination clauses for several reasons. They may be uncertain of their anticipated growth and do not want to limit their ability to expand into more suitable space by encumbering their company with a long term lease. In the event the company grows and needs additional space which cannot be accommodated by their current landlord, they consider the termination penalty worth paying. Another reason a tenant may negotiate a termination clause is if a tenant is unsure of the future sustaining power of their company and feel more comfortable arranging an early exit strategy.
A longer term lease usually allows for lower monthly or annual leasing costs. However, the benefit to a tenant who negotiates a termination option is they are able to enjoy the rental rates of a long term lease with the flexibility of a short term lease. In the event they exercise their termination option they pay a lower rent during the term and compensate the landlord at the end of the lease.