Include Nine Protections in Termination Option Clause

Despite an uptick in the commercial real estate market, many owners are still trying to fill vacant space. There isn’t an endless supply of big-box tenants to fill large vacant space, so when previously reliable chains like Blockbuster and Circuit City began moving out of their spaces, many shopping center owners were left with spaces designed to accommodate expansive businesses—but no similar-sized tenants to replace them.

Faced with the prospect of collecting no rent, some owners resorted to trying to offset some of the cost of expansive vacant space at their centers by renting to smaller tenants. But as the economy improved in some areas of the country, so did the number of big-box stores looking for space again. Unfortunately for owners that signed leases with small tenants for large spaces and didn’t include a termination option, they couldn’t lure big tenants to their centers.

There is a way to have the best of both worlds—and minimize your losses: A termination option clause can give you the opportunity to rent to a small tenant while still looking for—and ultimately leasing to—the larger tenant that will pay full rent.

Carve Out Right to Remove Small Tenant

Tenants generally are concerned with negotiating a termination option that will help them if they need to leave their space. Termination options can be hotly negotiated. Some owners feel that allowing a tenant to terminate its lease should be the last resort and that they should reserve a termination right only for large or national tenants that have the leverage to demand it. But in cases where you’re forced to rent to a tenant that you don’t want to commit to in case something better comes along, a termination option can help you carve out the right to end things.

Here are the nine owner-friendly protections you can negotiate for your termination option clause with a small tenant that you may later want to replace in favor of a large one. We’ll also give you a Model Lease Clause: Continue Search for Big Tenant While Collecting Rent, that incorporates these protections.

Protection #1: Make tenant acknowledge your termination option. Make the tenant acknowledge in the lease that you’ve got an option to terminate the lease. That way, the tenant would have a hard time arguing that it didn’t understand you could do so. The termination should take effect on the “termination date”—which is a day that you select to terminate the lease. The termination date can occur at any point before the lease expires. It’s a good idea to pick a termination date that occurs on the last day of a calendar month within the lease term or extension term so you’ll get the full month’s rent [Clause, pars. a(i) & a(ii)].

Protection #2: Give limited advance notice to tenant. Say in the lease that once you’ve set a termination date, you’ll alert the tenant to it by sending the tenant a written notice. You’ll need to send this notice some time in advance of the termination date. You and the tenant may need to negotiate how far in advance. You may want to give the tenant as little advance notice as possible—say, 30 days—but expect a tenant to want more time. For example, the tenant may want 90 or more days’ notice so that it has enough time to find new space and prepare to move [Clause, par. a(iii)].

Protection #3: Tie tenant’s compensation to month option is exercised. A savvy tenant—even a small one—probably won’t let you have the option to terminate without giving it something in return. That may be fair. So consider agreeing to compensate the tenant if you exercise the termination option. For example, the tenant may demand that you agree to make a “buyout” payment—that is, a fixed cash payment to buy out its lease. You might agree to a buyout payment equal to 12 times the tenant’s monthly minimum rent [Clause, par. c].

If you tie the compensation amount to a monthly minimum rent figure, say that you’ll use the monthly minimum rent figure charged during the month that you send the notice exercising the termination option [Clause, par. c(ii)]. That will help to keep the amount down—as rent typically escalates as the lease goes on. For example, if you send your termination notice in September 2013, you would multiply the September 2013 minimum rent by 12. But don’t be surprised if the tenant insists that the payment be calculated using the monthly minimum rent charged in the month in which the termination date occurs. What’s the tenant’s motivation? The rent will often be higher at that later date.

Protection #4: End tenant’s lease rights on termination date. Say in the lease that the tenant will have no further rights under the lease or interest in the space after the termination date other than those that the lease says will survive the end of the lease. The tenant should treat your termination of the lease as if the lease had expired naturally [Clause, par. a(iv)].

Protection #5: Keep tenant on hook for outstanding obligations. Make sure the tenant understands that even though you’re ending the lease prematurely, it’s still on the hook for its outstanding lease obligations—including those obligations that survive the lease. For example, it’s still responsible for paying minimum rent, additional rent, and any other charges accruing up to the termination date. And if the lease has an indemnification clause, the tenant still must indemnify you—that is, defend and hold you harmless—after the lease ends [Clause, par. a(v)]. If you don’t have this protection, the tenant could claim that once you terminate the lease, all of its outstanding lease obligations will immediately terminate, too.

Protection #6: Make tenant meet three conditions to surrender space. You’ll want the tenant to surrender its space on or before the termination date so you can make the space available to the big tenant. When is the space actually “surrendered”? Set three conditions the tenant must meet for the space to be considered surrendered, and say that you alone determine whether they’ve been met:

• The tenant has cured—that is, corrected—all outstanding lease violations;
• It gives you possession of the space; and
• It cleans the space and removes any remaining occupants and property from it [Clause, par. b(ii)].

Protection #7: Charge special fee if tenant doesn’t surrender space on time. If the tenant hasn’t surrendered the space on or before the termination date, require it to pay a special holdover fee. This special holdover fee is different from the holdover rent charged under your lease’s standard holdover rent clause. And it replaces the holdover rent clause if the tenant holds over in the space after you’ve exercised your termination option.

How much should the special holdover fee be? Set it high enough to give the tenant an incentive to surrender its space on time. But don’t set it so high that a court could call it an unenforceable penalty. You could charge a special holdover fee that’s a multiple of the tenant’s minimum rent then due (prorated for each day until the tenant surrenders the space) [Clause, par. b(i)]. It’s not unheard of for the special holdover fee to be set at double the tenant’s minimum rent.

Protection #8: Reaffirm that tenant must leave by termination date. No matter how effective the special holdover fee may be at discouraging the tenant, you still want to make sure that the tenant doesn’t think that it can stay in the space after the lease terminates, as long as it pays the holdover fee. So clarify in the lease that the tenant doesn’t have your permission to stay in the space after the termination date. And say that if the tenant refuses to surrender the space on or before the termination date, you can use any and all of your legal remedies against the tenant to regain possession of the space [Clause, par. b(iv)].

Practical Pointer: Try to use the loss of compensation for the termination as another possible remedy against a tenant’s remaining in the space. Say in the lease that the tenant won’t get any termination compensation if it doesn’t surrender the space on or before the termination date [Clause, par. c]. But expect the tenant to put up a lot of resistance to this remedy. The tenant will most likely argue that it’s unfair and onerous.

Protection #9: Make tenant indemnify you for third-party claims. Have the tenant agree that in addition to paying a holdover fee if it refuses to surrender the space on time, it will indemnify you from all damages, costs, claims, and expenses you incur from third parties as a result of the tenant’s failure to surrender the space [Clause, par. b(iii)].

This protection becomes important if you sign a lease with a big tenant for the space. The small tenant’s refusal to surrender the space could delay the big tenant’s move into your building. And the big tenant could end up suing you for failing to deliver the space to it on time.

Prepare to Sweeten the Deal

Do small tenants typically agree to this type of termination option? If you explain to the small tenant that you really want to rent the building to a much bigger tenant and that you need a termination option so you can get back the space if you find such a tenant, it might be easier than you think—if you’re willing to pay for it. It’s not uncommon for small tenants in this situation to agree to give the owner a termination option in return for some form of compensation, so be prepared for this request.

The compensation package you negotiate with a small tenant will depend on your and the tenant’s negotiating power. Since the tenant is small, you’ve probably got the upper hand in the negotiations—although the small tenant may realize that you need its rent payments to help pay your bills. But whatever the amount of compensation you and the tenant agree to, it will probably be well worth paying because it will free the space for a bigger, more lucrative tenant.