Where's the Exit
The office lease is a complicated contract. Once executed, but for its expiration, there’s no easy way out. In our experience, companies often give too little consideration to the exit. It’s understandable amidst the excitement of signing a new lease. Thinking about how to unwind the lease before signing it is a bit like sliding a prenup across the table to your future bride a few days before the wedding. But things happen. And things especially happen over a period of years.
So how should companies think about the exit? Firstly, they should contemplate business scenarios that might result in circumstances which would render the lease problematic. These would include positive growth scenarios in which the space would be too small; and, downsize scenarios in which the space is too big. How likely is either to occur? What remedies can be negotiated into the transaction to alleviate these scenarios? For example, if there is a high expectation of growth, such growth should be modeled and during the negotiations efforts should be made to secure future contiguous space in the building - - - not necessarily as commitments, but as opportunities or options, such that if the space is needed there will be a solution. Alternatively, consideration should be given to downsize mechanisms which might include everything from termination of the lease to contraction of the leased premises. Of course, most leases have sublease and assignment rights that allow the tenant varying degrees of flexibility. But these are heavily negotiated rights that can be either beneficial or not so helpful, depending upon the quality of the negotiated outcome.
There are many ways to address expansion. The most common concepts include:
Must Take
Right of First Refusal (ROFR)
Right of First Offer (ROFO)
Option for specific amount of space during specific period of time
The Must Take is exactly what it sounds like, a forward commitment to take a certain amount of space at a specific time. The ROFR is a scenario in which the tenant has the right to “refuse” a deal that has otherwise been negotiated with a 3rd party tenant. Landlords don’t like this structure because it is an encumbrance on their leasing effort, one they typically feel compelled to disclose and which can thus impact their ability to lease the space. The most common and least taxing approach is the ROFO. We often see tenants make the mistake of having a “one time” ROFO on existing vacancy. This is a problem because the landlord will offer the space immediately upon execution of the lease (when, of course, the tenant does not need it), forcing the tenant to decline the space and freeing the landlord to lease it without restriction. Hence in certain circumstances, the one time ROFO is of zero value. Better is an ongoing ROFO. Still better is an ongoing ROFO that has a second bite at the apple in the event the subject space is not leased within a certain period of time subsequent to tenant’s rejection. Lastly, there is the option. Options obligate the landlord to provide a certain amount of space within a certain window of time. These are also more difficult to negotiate because they, too, serve to encumber the landlord.
On the subject of downside flexibility, there are essentially 2 scenarios:
Termination Option
Contraction Option
The termination option will be exercisable at a point in time and have a set termination date. It will nearly always call for the tenant to pay a termination penalty which is often calculated as the unamortized cost of tenant improvements and leasing fees (amortized with interest), plus some number of months of rent. Depending upon market conditions, a tenant may find that subleasing yields a better outcome than exercising the termination. As to contraction rights, these are similarly structured, but relate to only a portion of the space.
Finally, there is the most common mechanism for exiting unwanted space, the sublease. Subleasing is a highly market-sensitive outcome. In markets like current day San Francisco, it is extremely difficult. Subleases are often discounted because the subtenant does not enjoy the same rights as a direct tenant, the term is usually shorter than normal and there is typically not much money available for tenant improvements. Subleasing is, at best, an imperfect solution.
Leasing is about more than negotiating a market favorable rent. There’s a lot to consider, including what happens if you no longer need all or a portion of the space. We’re always available to take a deeper dive on any of our TenantSee Weekly topics, just ask.