How to Protect Yourself When Giving Tenants an Option to Contract

By enabling tenants to surrender part of their space, contraction options can keep tenants viable, out of bankruptcy, and in their leases. This may be the perfect antidote to the staff reductions, stay-at-home orders, and uncertainty over future space needs created by the pandemic.

Giving tenants carte blanche to reduce their space, however, can lead to even greater chaos and uncertainty and impair the value of not only the leased space but also your entire office building, shopping center, or other multi-tenant commercial space. That’s why landlords must establish clear limitations and ground rules. We’ll explain how to draft a contraction option that does just that and give you a Model Lease Clause: Protect Your Interests When Letting Tenants Reduce Space, that you can adapt and use in your leases.

How Contraction Options Work

Contraction options are lease clauses giving tenants the right to give back a portion of the premises at a future date in the event they no longer need all of the space they originally leased. To exercise the right, tenants typically must provide a written notice (the “Contraction Notice”) of their intent to surrender the designated space (the “Contracted Space”) on a set date (the “Contraction Date”) and in exchange for a one-time payment (the “Contraction Fee”). Once contraction takes effect, the lease no longer applies to the Contracted Space but remains in effect for the remainder of the space not contracted.

INCLUDE 11 CONTRACTION OPTION PROTECTIONS

If you decide to grant a contraction option to a tenant, there are 11 vital protections to include in the option provision.  

1. Make Option One-Time Only

Make it clear that the tenant can exercise the option only once during the initial lease period, rather than on a multiple or periodic basis [Clause, Sec. A].  

2. Establish Time Frame for Exercise

The more advance notice you get, the more time you’ll have to market and, hopefully, secure another tenant for the Contracted Space on or soon after the Contraction Date. Also make sure the Contraction Date falls on the last day of a month well into the lease term. Otherwise, the tenant may contract its space immediately after signing the lease and after you’ve footed the bill for tenant improvements made to the Contracted Space before the lease took effect [Clause, Sec. A].  

3. Make Contraction Fee Payable at Time of Notice

Be sure to state that the Contraction Fee is due with the Contraction Notice. Tenants may request making the Contraction Fee due only on the Contraction Date. Don’t accept that. You want the exercise of the Contraction Option to be a simple, one-step operation. Allowing the conditions to be satisfied in multiple stages over time will only add doubt and uncertainty over the ultimate exercise of and fulfillment of all conditions related to the Contraction Option [Clause, Sec. A].

4. Define ‘Contraction Space’

Specifically define the space that can be contracted. If possible, the Contracted Space should be an entire floor because that’s easier to relet than a partial floor. And if the tenant is leasing three or more floors, try to keep the noncontracted space vertically contiguous to avoid “sandwich floors” that will be hard to re-let—for example, floors 1 and 2, or floors 2 and 3, rather than floors 1 and 3, leaving you with floor 2 to re-let [Clause, Sec. B].

5. Define ‘Contraction Fee’

Define the Contraction Fee as the unamortized portion of the brokerage commission paid by the landlord in connection with the lease, to be calculated on a straight-line, self-liquidating basis over the term [Clause, Sec. C].

6. Ban Assignment of Option

Clarify that the Contraction Option is personal to, and may be exercised by, only the tenant and can’t be transferred or assigned to anybody else [Clause, Sec. E].  

7. Get Right to Nullify Tenant’s Exercise of Option

Be sure to preserve your right, which you can but don’t have to exercise, to “unwind” or nullify the tenant’s exercise of the Contraction Option if the tenant breaches the lease, purports to assign the option, or ceases being in occupancy of the entire premises. Clever tenants may try to make the option automatically void upon occurrence of the breach rather than phrase this as a landlord right or option to nullify. But automatic nullification would give tenants who’ve exercised an option but then had a change of heart the power to unwind the option by deliberately committing a breach. That’s why nullification should be at your option, instead [Clause, Sec. D].

8. Adjust Post-Contraction Rent

Reducing square footage of the leased space will require adjustments to the tenant’s base rent and prorated lease payments such as CAM, electrical, and real estate taxes. However, you don’t necessarily have to agree to let the tenant reduce its security deposit after contraction [Clause, Sec. G].

9. Require Tenant to Leave Contracted Space in Marketable Condition

Make it clear that if the tenant exercises the option, it must vacate the Contracted Space on the Contraction Date and leave it in the same condition that the lease requires upon surrender of the Premises (as that term is defined in the lease) [Clause, Sec. H].

10. Require Holdover Rent for Failure to Vacate Contracted Space

You also want to be able to charge holdover premium rent on the Contracted Space if the tenant surrenders it late. But the Contraction Date isn’t the same as the lease expiration date upon which holdover rent becomes payable. So, you’ll need to specify that any retention of the Contracted Space beyond the Contraction Date will be treated as a holding over of the Premises under the lease [Clause, Sec. I].  

11. Get Tenant to Release You from Claims on Contracted Space

Last but not least, have the tenant release you from any claims or liabilities relating to the Contracted Space after contraction. If tenants demand it, you can make the release mutual, provided that you keep the tenant on the hook for claims related to the Contracted Space that occurred prior to contraction and which stay in effect once the lease ends, such as claims for incidents that occurred in the space before the Contraction Date. Of course, the tenant should also pay any outstanding operating expenses related to the Contracted Space after you’ve made a final reconciliation of those costs [Clause, Sec. I].