Add Protections to Make Tenant's Contraction Option Airtight

During the economic downturn several years ago, contraction options—which let tenants give back part of their space during their leases and pay a lower rent—became popular because downsizing was one way for tenants in trouble to scale back costs. But two now-common commercial real estate trends have made the contraction option desirable for tenants that aren’t in financial trouble. Retail tenants that have the option of capitalizing on an online presence for sales need less floor and inventory space; many employees of office tenants are given the option of working remotely, from locations outside of the office. 

Depending upon the specific prospective tenant, you might be tempted to give it a contraction option. But this is risky. Don’t give a tenant carte blanche to cut back its space. Plug this loophole in your lease by building protections into the contraction option provisions.

Mitigate Danger of Unfettered Right

A liberal contraction option poses several risks. For instance, a contraction option reduces a lease’s value. And if the tenant contracts its space too much, your building’s or center’s market value can go down. But letting the tenant contract its space may prevent it from trying to get out of its lease altogether or going bankrupt if it can’t afford to pay its current rent. So there’s a tradeoff to be made for owners.

Typically, a tenant would exercise its contraction option by sending you a written notice, called a “contraction notice,” indicating that it intends to terminate the lease on a set date, called the “contraction date,” with respect to the portion of its space that it will give back to you, called the “terminated space.” If the tenant gives back the terminated space by the contraction date, the lease will no longer apply to the terminated space but will continue to apply to the remainder of the tenant’s space.

But the key is to make sure the contraction option clause gives the tenant a one-time option only to contract its space and sets a fixed date for the contraction during the initial lease term but not any renewal terms. Like our Model Lease Clause: Carefully Draft Provisions for Tenant to Cut Back Space, yours should ensure that the tenant has not only just one shot at contracting its space, but also loses its option forever if it doesn’t exercise the contraction option on the contraction date [Clause, par. a].

This avoids a situation where the tenant signs its lease and then immediately contracts its space, perhaps after you’ve footed the bill for tenant improvements or other items common at the beginning of a lease. So make sure the contraction date falls on the last day of a month well into the lease term. And require the tenant to send its contraction notice long before the contraction date—for example, 12 months or more in advance [Clause, par. a]. That way, you’ll have ample time to find a new tenant for the terminated space.

Choose Application of Option to Space

If the tenant is leasing several floors in a building, allow it to give back only one or more full floors—not partial floors [Clause, par. a]. A full floor is easier to re-let than a partial floor. If the tenant is leasing three or more floors, make it choose to give back either the top or bottom floor it’s leasing, so that the tenant’s other floors will be kept vertically contiguous—that is, next to each other. This is especially important if a new tenant wants to lease two or more floors in your building but doesn’t want one of its floors sandwiched in between the tenant’s other floors.

Be prepared for a tenant to demand the ability to give back only a partial floor if giving back a full floor doesn’t suit its needs. If you agree to this, ensure that each portion must be in a reasonably marketable configuration—that is, each portion has adequate access, is separately controlled and serviced by the building systems (such as an HVAC system), and has exterior windows. If the tenant gives back more than one portion, make sure those portions are contiguous so you can relet them more easily.

Specify Contraction Fee Payment

Because getting the space ready for reletting can be expensive, charge the tenant a fee for contracting it. Require the tenant to pay the first half of the contraction fee—the “initial contraction fee—with its contraction notice [Clause, par. b]. The initial transaction fee should be equal to a set number of months—typically between three and 12 months—of base rent and additional rent prorated for the terminated space.

The second part of the contraction fee—the “additional contraction fee”—should be paid after your notice for the unamortized amount of your “transaction costs” for the terminated space. Transaction costs include free rent concessions and credits; the unamortized portion of the tenant improvement allowance; and any brokerage commissions, reasonable attorney’s, engineer’s, architect’s, and other professional fees you incurred in preparing and negotiating the lease, reviewing construction plans, and supervising construction work at the tenant’s space. Remember to charge interest on these costs, because that’s money you spent on the tenant, which could otherwise have earned interest for you.

Set Conditions for Termination

If the tenant exercises the contraction option, don’t let the lease terminate with respect to the terminated space unless, in addition to getting the contraction fee:

• The tenant moves out and gives you back possession of the terminated space, in the condition required by the lease;
• The tenant isn’t in default of the lease at two points in time—when it sends you a contraction notice and on the contraction date; and
• You and the tenant sign an amendment to the lease reflecting the contraction of the tenant’s space soon—for example, within 10 days—after the tenant exercises the contraction option [Clause, par. c].

Remember to make it clear that the tenant’s or your failure to sign the lease amendment won’t affect your or the tenant’s lease rights and obligations.

Make Rent Adjustment Accordingly

Realize that a difference in the size of a space a tenant is leasing will affect several other items it’s charged for. To reflect the contraction, you’ll need to adjust the tenant’s base rent and any prorated financial obligations—such as real estate taxes, operating expenses, and other charges—because of the tenant’s decreased square footage. That way, there will be no dispute as to what the tenant owes after it gives back the terminated space [Clause, par. d].

Although the tenant’s rent will be lowered after its space is contracted, don’t give in to a tenant’s demand to lower its security deposit. Although contraction options are a solution for retail and office building tenants that are flush with cash, they are still a fallback for tenants in trouble. So, especially if the tenant is financially unsound, you’ll want to hold on to the amount you already have.

Alternatively, you could offer to lower the security deposit in proportion to the new monthly rent, but only if the tenant gives you an additional month’s rent for the security deposit.

Practical Pointer: You’ll need to change a number of other lease provisions to reflect the contraction, such as the parking clause—now that the tenant’s space is smaller, you should decrease the number of its parking spaces—and the signage clause. If you named your building after the tenant, change the building’s name if the tenant’s stature and presence are sufficiently diminished. A contraction option affects nearly every other part of the lease terms.

Only Tenant Can Take Advantage of Contraction Option

A contraction option is a special perk and it takes time to negotiate and draft it. So it’s important to make it clear that you’re agreeing to give the contraction option only to this particular tenant. You don’t want the tenant abusing the contraction option by transferring it to anyone else. Say in the lease that the contraction option is “personal” to the original tenant and that it will automatically terminate if the tenant assigns its lease or sublets its space [Clause, par. e].

Don’t Get Left on Hook for Terminated Space

You’ll want to be released from any claims or liabilities that relate to the terminated space after the contraction date. Expect a savvy tenant to demand that the release be mutual—that is, you must agree to release the tenant from any claims and liabilities relating to the terminated space. But make sure the tenant stays on the hook for the lease provisions affecting the terminated space that are supposed to stay in effect after the lease ends.

For instance, the tenant should still have to meet its obligations to indemnify you—that is, defend and hold you harmless—if someone sues you for an incident that occurred in the terminated space before the contraction date [Clause, par. f]. Plus, the tenant should have to pay any outstanding operating expenses related to the terminated space after you’ve made a final reconciliation of those costs.