Tenants and landlords alike want predictability in their lease structure. The landlord wants the steady cash flow payments from the tenant, and the tenant wants a safe place to operate its business and predictability in its costs and operations. The world of business isn’t always predictable, though, and so commercial tenants often try to control for potentially-changing business needs by negotiating flexibility into commercial real estate leases, usually to either increase or decrease the size of the leased space. Landlords can sometimes accommodate this flexibility, for a variety of reasons. A landlord, when creating more certainty for a tenant, creates less certainty for itself (and its lenders!). The tenant-requested termination right has to be balanced against the landlord obligation to its lenders, other tenants in the building, and its investors. These factors are often outside of the control of the landlord, which in turn affects the landlord’s ability to offer these rights to tenants.

Sometimes, tenants discover that that they need to expand their current space square footage, or they at least want the ability to do so in the future. In that case, they’re going to negotiate for a right of first refusal (ROFR) or right of first offer (ROFO) on space adjacent or contiguous to the current location in the building.

In essence, a right of first offer (ROFO) gives the tenant the first opportunity to make an offer to lease the additional space before it is listed as available for rent on the open market. A right of first refusal (ROFR) allows the tenant to match an offer made by a third party to lease such space, and then the existing tenant will get to lease the space at the rent price that would have been paid by the offering third party. If the current tenant is a good one, landlords are usually content to offer a ROFO or ROFR, subject to that right already being exercised by another tenant in the building.

If a commercial tenant is paying its rent timely, operating as it’s supposed to and needs to expand beyond the space it currently occupies, the ROFO or ROFR is attractive to both parties. If the existing tenant wants the additional space, it saves the landlord the time and cost of marketing the space and obtaining and vetting a new tenant.

If the tenant is in default, however, the landlord will not usually be required to honor the ROFO or ROFR. The tenant will sometimes have to exercise an option or agree to add additional term to the then-current term, because the landlord will want a longer-term commitment in exchange.

Additionally, the rental cost might already be negotiated (or the parameters determining the price already set out), so there’s a lot of certainty and not a lot of additional work for the parties.

Often referred to as a lease contract buyout or early termination option, sometimes a tenant will want to vacate a space early if it doesn’t need to continue to operate there, such as the end of a contract or the completion of a project. A lot of tenants are looking to downsize when there are employees that work remotely or hybrid, either because the space is too big or because it no longer accommodates the new business operations needs of the tenant.

The landlord will usually require some sort of repayment of its unamortized expenses (leasing commissions, remodel or construction costs, etc.) and often tacks on a payment penalty as well I the tenant exercises this right. The landlord will require the tenant to give advance notice (often 180 days or longer), and to pay rent through the termination date, in order to give the landlord time to start looking for a new tenant for the space. The termination fee/penalty will also give the landlord some cash flow to meet its required payments while looking for a new tenant, which reduces the burden on its finances.

Many landlords have mortgages or other loans on their properties. Banks and other lenders have strict requirements for loans on commercial property assets, and often have approval rights over any “material modifications” to the lease. Investors also sometimes impose conditions regarding changes to leases. When the landlord is negotiating the ability of the tenant to make changes and decrease the term of the lease, this flexibility impacts the mortgage conditions. A non-compliant loan can reduce the resale value for the property, due uncertainty of cash flow, which is the whole point of commercial real estate investment.

A landlord must work within its loan structure, and comply with its terms, or it can be in default of its loan. For example, a loan may require a that certain percentage of the building must be leased up during the loan term. Additionally, the loan may require that the landlord sign longer-term leases (to preserve cash flow and the ability to pay back the loan!), or even require lender approval of any lease modification or negotiated early termination option.

Many, but by no means all, loans for commercial office space require lease terms of at least 3 years (or more) for a certain proportion of the space in the building. This means that if other tenants have an early termination right, or if a tenant is the only occupant of the building, the landlord might not get approval from the lender for a tenant termination right, because of the negative effect on the cash flow, and loan payback potential.

When a tenant exits a space early, either through a negotiated termination option or other contraction right, not only is the landlord’s income affected, but also the debt service coverage ratio. If the vacancy rate for the building is too high, and too many tenants leave, the landlord could be in default of its debt covenant. Institutional investors would realize a reduced revenue stream and the reduction in value means a higher buyout amount. All of this creates headaches for everyone except the tenant.

As at the beginning of a lease negotiation, it’s important to ask the landlord if there is a lender, and if there is a requirement for the lender to approve modifications to leases. By definition, that includes early terminations or exercise of lease options, which might be important in securing additional space under a ROFO or ROFR. Sometimes a landlord can stay in compliance with a loan with a short-term lease extension or other lease amendment, instead of a new (short-term) lease.

If the landlord provided a tenant allowance or advanced money to fit out the space or otherwise perform tenant improvements or construction as a condition of occupancy, the landlord will, at a minimum, want to recoup its investment. Tenants and landlords can model various rent structures, allowing the landlord to recapture these advanced costs, either before the tenant termination right comes into effect, or as part of the price of the termination. Conversely, if a landlord is performing construction in an expanded space for the tenant, the landlord will want reassurance that the tenant will stay long enough for landlord to recapture those costs.

It’s important to understand the financial implications of expanding and contracting leased space and to consider those implications when negotiating commercial real estate leases.

Visit lawbyjz.com for more information and to learn how to consider all the different factors when negotiating for commercial real estate leases. to learn how to structure ROFO, ROFR, and termination clauses that protect your investment and support long-term stability.

#commercialrealestate #commerciallease #commercialleasenegotiations