Leasing in Uncertain Times: Key Terms to Provide Flexibility for Tenants

The “new normal” of social distancing and working from home is changing how companies evaluate their needs for office space.  With demand for office space in the United States expected to decrease through early 2021^[1], companies that are in the market for space must be mindful of key lease provisions that can provide flexibility for their businesses during times of uncertainty.  Below are some common lease provisions that should be considered, ideally at the letter of intent stage, and incorporated into the lease.

Expansion and Contraction Rights.  In light of the uncertainty about future space needs that many businesses will face, tenants should bargain for expansion and contraction rights in order to provide flexibility in the size of the space.  Expansion rights can take the form of a specific right to expand, a right of first refusal (ROFR), a right of first offer (ROFO) or a right of first negotiation (ROFN).  An expansion right will often be limited to adjacent space and have a fairly narrow period of time within which the tenant must notify the landlord of its desire to expand.  This provision will also address the rental rate for the expansion space (current rental rate or market rate), the condition in which the landlord must deliver the space or any improvement allowances provided by the landlord, the timing for the delivery of the space (particularly if the expansion space is occupied by another tenant), and the term of the lease for the expansion space, which will typically be coterminous with the term for the initial premises.

Rights of first refusal are generally disfavored by landlords because of the chilling effect on a landlord’s ability to lease to third party tenants.  The existing tenant can swoop in and take the third party deal simply by exercising its ROFR.  If a landlord is willing to grant a ROFR, the tenant will generally have a short period of time to exercise it after the landlord gives the tenant notice of the landlord’s receipt of an acceptable offer from a third party.  Landlords are generally more willing to grant a tenant a right of first offer or a right of first negotiation, either of which would give the tenant the opportunity to lease space prior to the landlord taking it to the market.  A tenant’s right of first offer will typically require a landlord to notify the tenant that it has space available for rent, and if required by the terms of the ROFO, the rental rate and other terms that the landlord would be willing to accept.  The tenant then has a specified period of time to notify the landlord that it desires to lease the space on the ROFO terms or such other terms that the landlord and the tenant are able to negotiate.  If the tenant declines to exercise the ROFO or the landlord and the tenant are unable to arrive at terms for a lease amendment, the landlord is free to bring the space to the market.  A right of first negotiation (or right of notice) is the least burdensome of all these rights, and merely requires the landlord to notify the tenant that space is available and gives the tenant the opportunity to negotiate with the landlord for a specified period of time before the landlord brings the space to the market.

Contraction (or termination) rights give the tenant the right to give back all or a portion of the leased premises, in the event the tenant does not need all the space it originally leased.  Landlords and their lenders disfavor tenant termination rights, so in situations where they are granted, they are not without an economic cost to the tenant.  It is customary for these rights to be conditioned upon the payment of a termination fee, normally consisting of the unamortized cost of brokerage commissions, tenant improvement allowances and other concessions granted by the landlord at lease inception plus an amount that is generally tied to several months’ rent.  The lease may require the termination fee to be paid upon delivery of the tenant’s termination notice to the landlord, or if negotiated by a prudent tenant, the fee may be paid upon the early termination date, or half upon delivery of the tenant’s termination notice with the remainder payable upon on the early termination date. In cases where the tenant has only the right to contract the space (i.e., a partial termination), special consideration must be given to how the contraction space is defined, which party bears the cost of constructing demising walls, and whether the tenant’s exercise of a contraction right will void any other rights that were specifically negotiated under the lease (i.e., extension rights, expansion rights, signage rights and exclusive use rights).

Extension Rights.  Rights to extend the term of the lease also should be considered, particularly where the tenant may desire the peace of mind of knowing that it will not have to relocate for a significant period of time (other than by its own choice) or where the tenant may desire to lock-up a desirable location for an extended period of time.  Rent during the extended term can follow a predetermined rent schedule with the same rate of increase as in the initial term of the lease, or rent can be reset to the market rent.  If the latter, care should be taken to define the market rental rate and provide a mechanism to determine the market rental rate if the tenant disagrees with the landlord’s determination of the rate.  A standard extension option will not permit the base rent to decrease during the extended lease term, often referred to as a “floor”.  However, tenants are free to negotiate the removal of the “floor”, and notwithstanding the mechanism in the lease for determining rent during an extended lease term, willing parties are always free to negotiate something else, closer to the end of the initial lease term.

Assignment and Subletting.  Most standard commercial leases will prohibit or restrict a tenant’s ability to assign the lease or sublet the premises.  The rationale for these clauses is to give the landlord control over the identity of the tenants in the landlord’s building, the tenant mix and the creditworthiness of tenants, all in an effort to maximize profitability.  From a tenant’s point of view, more flexibility in terms of an exit strategy is desired, and a tenant should consider negotiating for certain permitted transfers that do not require landlord’s consent, such as an assignment or sublet to any parent or subsidiary of the tenant, or any entity under common control with, controlling or controlled by the tenant or to any entity acquiring substantially all of the tenant’s assets, or if the tenant is a franchisee, transfers to the franchisor or to other franchisees.  If an assignment of the lease or subletting of the premises would require the landlord’s consent, the tenant should require that the landlord’s consent will not be unreasonably withheld, conditioned or delayed.  In the professional office context (i.e., law firms and accounting firms), make sure that the addition or withdrawal of partners or shareholders will not trigger a requirement for the landlord’s consent.  Tenants with some bargaining power may seek deemed consent by the landlord if the landlord fails to respond within a certain period of time and a release from liability under the lease following an assignment.

Leases may also give the landlord the right to recapture space in the event the tenant desires to assign the lease or sublease the premises.  Recapture rights are a useful tool in the landlord’s toolbox, as a decision to recapture space may be made by the landlord in its discretion and is typically not subject to any reasonableness standard.  In order to avoid the potentially adverse consequences of a landlord’s recapture right, tenants should negotiate for the right to rescind a request to assign or sublease, if maintaining the status quo would be preferable to losing the affected space (or the lease) altogether.  Leases also frequently require the tenant to share with the landlord any profit realized by the tenant upon entering into a sublease with a subtenant.  Tenants should negotiate to recover the costs of entering into the sublease (i.e., commissions, tenant improvement costs and other costs of subletting the space) prior to sharing any sublease profit with the landlord.

Tenants should also be mindful of the effect that assignment and subletting can have on other provisions of the lease.  For example, renewal options, expansion options, contraction options, exclusive use rights and signage rights may be personal to the tenant originally named on the lease, and these rights may be lost upon assignment or subletting.

Surrender of Premises.  Often times, leases can impose significant costs upon the tenant at the end of the lease, including, for example, the cost of returning the premises to the condition in which the tenant received it, which may require the removal of improvements and alterations made by the tenant (i.e., internal staircases between floors), as well as data cabling and other wiring installed by the tenant.  Tenants should attempt to limit their lease-end obligations as much as possible, including by exempting the initial buildout of the space from tenant’s removal obligations, and by providing that if the landlord will require subsequent alterations to be removed at lease-end, it must so notify the tenant at the time the tenant requests the landlord’s approval of the alterations.  While it is now common for tenants to be required to remove their data cabling and other wiring at lease-end, if that is not acceptable to a tenant, care should be taken at the letter of intent stage to address that issue.

Relocation Rights.  Many standard commercial leases give the landlord the right to relocate the tenant to other premises within the building or the complex owned by the landlord.  In order to avoid the disruption to the tenant’s business associated with a mid-term relocation, tenants should seek to eliminate or significantly limit the landlord’s right to relocate (or substitute) the leased premises.  If the landlord is not willing to forego the relocation right altogether, the right can be limited by allowing the landlord to exercise the right only during certain time periods, with plenty of advance notice given to the tenant.  For example, an accounting firm would not want to be forced to relocate during “busy season”.   While a typical relocation clause may require the substitute space to be “comparable” to the initial space, the tenant may desire to further limit the pool of potential substitute space (i.e., substitute premises having a certain exposure or view, or located upon certain floors of a particular building, or utilizing a particular elevator bank).  The costs of a relocation should be borne by the landlord, including the costs of moving, wiring and reprinting business cards and other stationery.  If a relocation would be particularly detrimental to the tenant’s business, consider negotiating an abatement of rent for the period of time around the move.

Conclusion.  COVID-19 has changed the way we work, and whether the “new normal” of social distancing and working from home will be a long-term or short-term phenomenon remains to be seen.  In times of uncertainty, savvy tenants will negotiate for lease provisions that help them maintain flexibility with regard to both space and term.  As mentioned above, these provisions should be addressed at the letter of intent stage, together with the principal business terms of the lease.  Failure to do so may significantly reduce a landlord’s willingness to include these provisions in the lease.

Special thanks to Tamerah Mayer for her assistance with this article.