Don't Get Burned When Letting Tenants Contract Their Space
Here’s a four-phase strategy for drafting a lease amendment letting a tenant contract its space.
In a post-pandemic world where a greater volume of work and business will be carried out remotely, many tenants will need the flexibility to not only expand but also contract their space. Accordingly, knowing how to negotiate and draft favorable contraction lease amendments can give your business a major advantage. And that’s what this analysis will show you how to do.
How Landlords Benefit from Tenant Contraction
Contraction is an arrangement that gives tenants that no longer need all of the space they originally lease the right to return a part of the space. Because it involves a rent reduction, landlords generally frown on contraction. At the same time, contraction may be necessary as a measure of last resort to keep a financially troubled tenant that can’t pay the rent from going bankrupt or picking up stakes and sneaking out in the middle of the night, especially if the resulting vacancy can’t be quickly or easily refilled.
Two Ways to Let a Tenant Contract
Historically, the most common form of implementing a contraction arrangement was via amending the original lease. But in the uncertainties of the post-pandemic world, it’s becoming more common for landlords and tenants to negotiate contraction options into the initial lease, just the way they traditionally do with tenant expansion options. While it introduces uncertainty about whether a tenant will remain committed to all the space it leases, handling contraction proactively gives landlords greater control. If you wait for the tenant to suffer a financial crisis, you may have far less leverage and end up scrambling just to minimize your losses. Although it considers the lease amendment perspective, much of this analysis also applies to pre-negotiated contraction options. (To find out how to create a legally sound lease contraction option, see “How to Protect Yourself When Giving Tenants an Option to Contract,” September 2020.)
HOW TO NEGOTIATE A FAVORABLE CONTRACTION AMENDMENT
Here’s a four-phase strategy for getting maximum business advantage and legal protection when agreeing to a lease amendment allowing a tenant to contract its space.
Phase 1: Get Maximum Concessions from Tenant
Recognize that the contraction option is a powerful bargaining chip and maximize what you get in return. For one thing, you can ask tenants to give up, in whole or in part, some or all of the concessions you provided to first lure them as tenants.
Square footage rent. In exchange for being responsible for less space, tenants may be ready, willing, and able to pay a higher rent per square foot on their current leased space.
Example: A tenant leasing 100,000 square feet at $20 per square foot ($2 million in rent) that wants to give back 25,000 square feet might agree to pay $25 per square foot on the 75,000 square feet it retains, i.e., $1.875 million, rather than $1.5 million. The tenant still gets a rent break of $125,000, but has to pay the higher square footage rate on the retained space as a premium.
Increasing square footage rent in exchange for agreeing to let the tenant contract is especially appropriate where the rent “steps up.”
Example: The rent on a five-year lease is slated to go from $10 per square foot in the first year, to $12 per year in the second year, and so on, until it reaches $18 per year in year five. The “effective rent” over the five-year period will thus be $14 per square foot ($10 + $12 + $14 + $16 + $18 = $70 ÷ 5 = $14). By accepting the contraction, you lose the full benefit of the higher rent in the final years, thereby lowering your effective rent, and forfeiting your right to an upward adjustment to the square-footage rate on the contracted space.
Caveat: Keep in mind that these are principles for negotiation and that you must consider what a tenant seeking to contract its space can actually afford to pay. In other words, while you want to get a fair return, taking too big a bite out of the tenant might defeat the purpose of contracting.
Tenant’s other options. Negotiating a contraction puts you in the position to take back or at least limit options you first granted the tenant to sign the lease, such as the option to expand, cancel, or renew, or a right of first refusal. Attorneys say that tenants will typically agree to trade off current lease options, especially if the original concessions were based on the large amount of space the tenant leased. The right to expand is highly tradeable, they say, as are renewal rate concessions, such as the right to renew at fair market value rather than at a below-market rate agreed to in the original lease negotiations.
Other concessions. Consider other ongoing concessions in play during contraction negotiations, including a shopping center tenant’s exclusive or breaks on CAM charges. Keep in mind that contraction may nullify part of the original bargain on which the concessions were originally based. Thus, ask whether it even makes sense for a tenant to continue to have an exclusive to sell certain goods and services after it contracts its space. Attorneys also advise requiring the tenant to pay the original CAM or operating expenses, rather than the prorated reduced amount, until you re-let the space the tenant gives back.
Lease extension. In exchange for getting relief on rent, a contracting tenant may be willing to commit to a longer lease term. These extra years of certainty may be worth the rent decrease that comes with contraction, especially if the market is soft and the lease is nearing the end of its term.
Relocation. Consider getting the tenant to agree to relocate (or grant you a future relocation right), especially if its current space is in a highly desirable part of the property for which there’s significant demand. Relocation may even become a necessity if the post-contraction remaining space isn’t suitable for the contracted tenant’s use.
Phase 2: Charge the Tenant a Contraction Fee
It’s customary to ask tenants to pay a contraction or surrender fee when contracting their space. It’s often expensive to take back and re-let the contracted space, especially if alterations are necessary to make the space marketable to other prospects. Asking for a contraction fee is also justifiable if the post-contraction rent won’t return the investment value you expected in performing construction on the space for the contracting tenant’s use. Be sure to clearly define the expenses the contraction fee covers, which typically includes repayment of:
- Any free rent offered to lure the tenant;
- Takeover obligations;
- Tenant improvement allowances;
- Costs to re-let the space; and
- Brokerage commissions.
It’s also not out of the question to at least consider asking the tenant to pay interest on these costs. Ask your attorney to adapt this model language for your lease amendment.
Model Language
1. Contraction Fee: For surrender of the Surrendered Space to be effective, Tenant shall pay to Landlord the “Contraction Fee,” which shall be an amount of money equal to the sum of:
(a) The unamortized amount of Landlord’s Lease Costs (as defined below) allocable to the Surrendered Space as of the actual Contraction Date, with Landlord’s Lease Costs over the term of the Lease straight-line amortized from the Commencement Date at a per annum interest rate equal to __ percent (__%); and
(b) Surrendered Space Alteration Costs (as defined below).
2. Definitions: For the purposes of the above:
(a) “Landlord’s Lease Costs” are defined as the sum of [insert all applicable lease costs];
(b) “Surrendered Space Alteration Costs” are defined as the sum of [insert all costs associated with re-letting the Surrendered Space].
There are also concessions you can make if the tenant can’t afford to pay these costs without totally sacrificing your contraction fee, such as asking for a portion of the costs in installments over a period of time. Another option is to amortize the total costs over the new lease term and increase the new rent accordingly.
Phase 3: Include Proper Legal Protections in Contraction Amendment
As with any lease or lease amendment, be sure to include the necessary legal protections in your contraction amendment.
Charge holdover rent if tenant surrenders late. You want to be able to charge holdover premium rent on the surrendered space if the tenant surrenders it late. Under the original lease, holdover rent likely becomes payable only if the tenant fails to vacate by the lease expiration date. So, you’ll need to specify that any retention of the surrendered space beyond the contraction date will be treated as a holding over of the premises under the lease.
Model Language
If Tenant shall fail to timely vacate the Surrendered Space, Tenant shall be deemed a holdover tenant as such term is described in the Lease with the same obligations as set forth in the Lease resulting from said holdover. Tenant shall indemnify and hold Landlord harmless from any damage to Landlord, including legal fees, resulting, or claimed to have resulted, from Tenant’s failure to timely vacate the Surrendered Space, including any claim for damages incurred by any prospective tenant for the failure of Tenant to vacate the Surrendered Space.
Require tenant to leave surrendered space in marketable condition. Make it clear that the tenant must leave the space it surrenders in the same condition that the original lease requires upon surrender of the total leased premises.
Model Language
Tenant shall vacate the Surrendered Space on the Contraction Date, leaving the same in the condition called for by the terms of the Lease.
Get guarantor’s affirmation. Lease guaranties generally remain in effect after lease amendments, as long as those amendments don’t affect the guarantor’s liability. But courts may also seek reasons for letting a guarantor off the hook. That’s why attorneys recommend placing a reaffirmation of the guarantor’s lease obligations on the same page as the tenant’s signature at the end of the contraction lease amendment. Guarantors should have no problem with such a reaffirmation, especially since the contraction actually reduces the extent of their liability under the guaranty. But they may also ask to lower the guaranty cap to reflect the reduced rent. Don’t agree to this request if the original guaranty cap was less than the full rent, attorneys suggest.
Model Language
REAFFIRMATION OF PERSONAL GUARANTY
The undersigned ______________ (“Guarantor”) hereby reaffirms his/her obligation under the Guaranty consisting of ____ (__) pages, which is attached to the Lease as Exhibit ___, acknowledging that he/she has read the foregoing Amendment.
Dated: ________________________
[Insert guarantor’s signature block, including a space for current address]
Guard against liens on surrendered space. The tenant may have ceiling fans, counters, lights, or other fixtures and decorations in the surrendered space that it plans to leave behind. If there are existing liens on those items, you may end up inheriting them. So, be sure that anything contained in the space has been completely paid for and belong to you and only you.
Model Language
Tenant hereby covenants that nothing has been, or will be, done or suffered by Tenant whereby the Lease or the estate of Tenant in and to the Surrendered Space or any part thereof, or alterations, decorations, installations, additions, and improvements in and to said Surrendered Space or any part thereof, have been, or will be encumbered in any way whatever; and that Tenant has, and will have, good right to surrender the same, and that no one other than Tenant has acquired, or will acquire, through or under Tenant any right, title, or interest in and to the Lease or any term and estate thereby granted in and to all or any part of the space covered by the Lease or in said alterations, decorations, installations, additions, and improvements in said Surrendered Space or any part thereof.
Keep tenant on the hook for outstanding costs. Get the tenant to acknowledge that the contraction doesn’t end your right to charge it for outstanding costs due to its use of the surrendered space before the contraction, even if billing occurs after the contraction date.
Model Language
Nothing herein contained shall be deemed to constitute a release or discharge of Tenant with respect to any obligation or liability incurred under the Lease and outstanding and unsatisfied as of the Contraction Date.
Phase 4: Adjust the Original Lease
There’s one final loose end to tie up: Review provisions of the original lease that may have to be adjusted to account for the contraction.
Reductions in parking. Consider reducing the number of assigned parking spaces or area of parking facilities the lease allocates to the tenant and its employees after the leased space is contracted.
Unusable options. The contraction may render certain tenant lease options moot. For example, the right of first refusal to expand into the space next door may become academic if the tenant is no longer next door to that space. To avoid confusion and disputes, have the tenant acknowledge surrender of those options as part of the contraction.
Floor plan. Annex a revised floorplan to the amendment showing the post-contraction dimensions, square footage, and locations of the contracted space.
Rent and operating expense reductions. Be sure the amendment accurately lists the post-contraction rent, CAM, taxes, and other tenant operating expense liabilities. Whether to also reduce the security deposit is an issue for negotiation.