There’s gold in that contract – how to find hidden value in your office lease

In the time that I’ve been in commercial real estate, I’m always amazed when I talk with a space user who mistakenly believes that a lease is a rigid obligation until the negotiated expiration date, with absolutely no flexibility.  A savvy real estate executive understands that everything is up for negotiation.  In this article, we will discuss key lease terms that can provide significant value to your business, often with a measurable dollar value.

Contraction Option – In short, this term in a lease provides the leaseholder with the option to reduce their space use and, therefore, their ongoing rent obligation.  This is typically declared in the lease for a specific portion of your space.  This can be useful for a tenant to exercise when

  • Your space needs have changed and you use less space
  • Occupancy costs have risen and you can’t afford to spend as much on space
  • You have a phased relocation in place and don’t have a termination option that you can execute

Termination Option – Unlike a contraction option, which is for a specific portion of your office space, a termination option allows the tenant to completely end a lease and move out of the building.  Although I have seen leases with “floating” termination options, most will be negotiated to take place on or before a specific date, with a period of notice preceding the termination.  These options can be costly to exercise if poorly negotiated, as unamortized tenant improvements and rent abatements are often due to the landlord at the time of termination, along with a termination fee of either a fixed amount or a sum representing the rent cost over a defined period (i.e. 6 months at the then defined base rent + tenant’s share of real estate tax and operating expenses).  This can be useful for a tenant to exercise when

  • The size, cost or location of your existing space no longer meets your business needs

Expansion Option – Also known as a “Right of First Refusal” or a “Right of First Offer”, an expansion option entitles the leaseholder to expand into additional space in a building.  There are many ways this can be defined, including

  • adjacent space on the floor
  • contiguous space within the building (adjacent, above or below)
  • larger space within a defined range

Regardless of the specifics, this term will give the tenant the right to grow.  This can be useful for a tenant to exercise when

  • You need more space and prefer to remain in your current building

Renewal Option – Very simply, a right to continue to occupy space beyond the original lease expiration.  Often defined as one or more “renewal periods”, renewal options will typically state the duration of the period as well as the process used to decide the rental rate for the future periods.  This can be useful for a tenant to exercise when

  • The size, cost and location continue to meet your business need

Assignment and Subletting Clause – The freedom to sublet your space to another business or organization can be invaluable.  Ongoing business demands may require that you relocate to another building, submarket, city or country, even while you still have a substantial remaining term on your lease.  If you don’t have a contraction option or termination option, this lease term can be your best means of “bowing out” of a situation.  Note that subletting doesn’t remove obligation to the landlord, but finding a reliable sublet tenant can provide your firm with more flexibility in location and space needs.  This can be useful for a tenant to exercise when

  • Business needs require that you change your space use and the landlord cannot accommodate within the building
  • Your current lease is at below-market rents, affording you the ability to provide a good deal to a sublet tenant

Beyond the initial guidance above, there are more complex strategies and “gotchas” when negotiating or executing each of these lease clauses.  Since each tenant’s business needs and lease terms differ, one blog post would not be sufficient to delve into each unique scenario.My goal is to keep this brief, so let me know what you think about these options.  I’m personally working on deals for three clients with termination and contraction options in their leases, so this comes up fairly often.  What have been your experiences working through exercising one of these options for your firm or client?

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