As economies or business goals change, many leaders ask whether or not it makes sense to get out of their commercial lease agreement early. Some may be looking to expand and need more space, while others could be undergoing a merger or acquisition that requires the disposition of excess space. And as a result of the COVID-19 pandemic, many tenants are evaluating how they will use space going forward and their current leases may no longer fulfill their needs.
Regardless of the reason, you as a real estate tenant need to consider what’s best for your business.
And as you look to optimize business operations, it’s critical to weigh the risks and benefits of leaving a lease agreement early, often through a lease exit strategy. Lease exit strategies generally fall into one of three categories:
- Early termination options.
- Tenant friendly assignment, sublease, or transfer rights.
- Arms-length lease buyout negotiations.
If you’re looking to exit your commercial lease early, there are a few questions to consider with your landlord first:
- Which early termination options or tenant friendly rights make the most economic sense?
- How should tenants pursue a negotiated lease buyout or sublease pursuit?
- What type of research and analysis is required to prepare for these decisions?
Understanding Early Lease Termination Options
Typically the most straightforward way to get out of a commercial lease is through the early termination clause.
Ideally, your real estate transaction will include a formulaic approach to early termination penalties (i.e., liquidated damages). Consult with a trusted real estate advisor to review the commercial lease carefully—these rights are often hidden in less than obvious provisions or in exhibits, addenda, and side letters. Once you find the rights, review the language to determine if it is reasonable in present market conditions. If so, exercise it according to the requirements of the lease.
Required Document: The Exercise Letter
Tenants can work with a trusted real estate advisor to draft their exercise letter. The exercise letter needs to reference the commercial lease, establish the effective date of the early termination, the penalty due, the circumstances of payment, and the condition of the premises upon vacation.
Alternative Strategies to Terminate a Commercial Lease Agreement
An alternative, though frequently less desirable, strategy is to leverage your assignment, sublease, or transfer provision.
How to Transfer a Commercial Lease
A Fortune 1000 corporation may want to investigate transferring its obligations to another corporate division or related entity.
Assuming this potential transferee has an equal or stronger credit rating, the provision may allow this type of transfer without being subject to a landlord’s reasonable consent. In situations when a related entity transfer is not feasible, review the tenant-friendliness of the sublease and assignment language.
It’s likely the landlord will have some degree of approval, ranging from reasonable to arbitrary consent. Hopefully, you negotiated a list of relevant exceptions that are subject to a landlord’s consent.
Assignment and Sublease Defined
Occasionally, a tenant will have the opportunity to earn a profit through assignment or sublease. However, subleasing a property does not relieve a tenant of their lease obligations. They are still responsible for paying rent and managing repairs or damage to the property.
Further, tenants should engage a tenant-focused real estate broker, without conflicts of interest, such as the landlord’s representative who may come with the risk of a “hit or miss” marketing process.
Required Document: Sublease Agreement
The sublease agreement tends to be more complex than a prime lease because it is a three-party transaction. In particular, the tenant (assignor / sublessor) needs to be mindful of the following issues.
In both sublease and assignment (except for novation scenarios), the assignor or sublessor retains the primary liability and obligations under the prime lease. This means the sublessor must conduct adequate due diligence on prospective sublessees’ financial condition, space usage, and operational issues. The sublessor continues to be liable for any monetary and non-monetary defaults by the sublessee, as well as other sustaining liabilities, such as environmental impairment.
The sublessor needs to ensure the sublessee is willing to comply with all of the applicable terms of the prime lease.
Prime Lessor’s Consent
The process of consummating a sublease transaction can be particularly cumbersome because of the timing of the transaction. Because all negotiated transactions grow stale by the minute, the unmotivated prime lessor can put the deal in jeopardy. The sublessor should take this potential bottleneck into consideration and set the sublessee’s expectations accordingly.
Required Document: Listing Agreement
Once a real estate broker is selected to market the property, a listing agreement must be negotiated to protect the tenant / sublessor’s interests. You need to address issues such as the scope of services, term (considering the tenant’s finite control of the space), termination, rights after termination, standard of care, and indemnities.
What Is a Commercial Lease Buyout? Where Is It Useful?
In circumstances where a sublease or assignment is not practical, tenants can proceed with negotiated lease buyout discussions. Even when a sublease or assignment is feasible, a decision analysis should be conducted to determine which avenue is more desirable.
A decision analysis is needed to evaluate the comparable pros and cons of a termination option (if it exists), a sublease or assignment, and a negotiated lease buyout. Although it is often an expensive option, a negotiated lease buyout should always be considered.
For instance, a commercial lease buyout will relieve the tenant of further liability for its unoccupied space. Sometimes, the landlord may need the tenant’s space to incorporate into a larger transaction or may have plans to redevelop or re-image the site.
To fully evaluate a commercial lease buyout, a market study is required that assesses both basic real estate market supply and demand, and sublease supply and economics. As soon as you have a clear understanding of local market conditions, contact the landlord to discuss your client’s plans and to determine the landlord’s position.
Regardless of market conditions, the landlord stands in a contractually strong position (absent arguments for landlord default). It is always best to have the market data and facts to support your position.
What Formula Does a Landlord Use to Calculate a Commercial Lease Buyout Penalty?
Ultimately, the penalty is the main issue to resolve in a commercial lease buyout. Below is the formula used to calculate the penalty.
- The balance of base rent through expiration;
- The balance of additional rent or triple net expenses to be recovered by landlord;
- The unamortized lease-up (leasing commissions, tenant improvements, and concessions from the original lease negotiations) based on a negotiated discount rate;
- The value of the lease compared to current market conditions; and
- The remaining term of the lease and the projected downtime lease-up costs to secure a new tenant.
In strong economies, these types of negotiations often begin with the tenant paying 50 cents on the dollar. In soft economies, these negotiations quickly turn to the tenant paying closer to the total remaining rent obligation, including using a very low discount rate to calculate the present value given the current interest rate environment.
While the value of the lease buyout is primarily based on market conditions as presented by both parties, it is strongly influenced by the landlord’s financial situation and plans for the property.
Unfortunately, the tenant doesn’t know these factors until negotiations start. While an attorney is capable of assisting in structuring and documenting this type of transaction, a properly motivated real estate advisor (consultant or broker) plays an essential role by evaluating market conditions, uncovering landlord motivations, conducting comparative financial analysis, and facilitating the negotiations.
Required Document: Lease Buyout Agreement
The lease buyout agreement needs to reference the lease and any amendments, and establish the effective date of the early termination, the penalty due, circumstances of tenant’s obligations, and the condition of the premises upon vacation.
Planning for the Future
At Allegro Real Estate Brokers & Advisors, we have looked at strategies for tenants who may want to exit early from an existing lease. Going forward, however, you can position yourself for possible early exits, before the lease is even signed.
From a tenant’s standpoint, all new leases should include early termination options. At most, early termination options need to contain definitive formulas and detailed processes to provide a quick resolution to future space issues. At the very least, the liquidation damages formula will serve as a baseline for future decisions and negotiations.
Align Your Real Estate with Your Business Strategy
There’s a lot to think about as you optimize your real estate portfolio for sustainable success. Whether you’re planning out weeks, months, or years ahead of time, the best solution to optimizing your real estate portfolio is to have a trusted partner on your side to advise and help manage your assets.
Download our free guide, Corporate Real Estate Portfolio Strategy: Your Business’ Competitive Advantage, to help you through your asset evaluation today.
Editor’s note: This post was originally published in 2015, and has been updated and republished.