Cancellation rights and alternative means of achieving flexibility in leases.

The confluence of a long, deep recession, the precipitous decline in rents, and advances in technology has created a new reality for commercial tenants and landlords. Tenants have relearned a tough lesson that leases should be flexible to match the needs of a contracting, consolidating or expanding business. To achieve this flexibility, tenants increasingly ask for the right of early cancellation of a lease.

Whether the parties will agree on a cancellation clause depends on a host of factors, such as the type of property involved, the tenant's credit, the length of lease, rent increase methods and frequency, the cancellation compensation, and -above all- the relative bargaining strength of the parties. If the parties cannot come to terms on a cancellation provision, the parties may satisfy a tenant's need for flexibility by creatively structuring the lease, using expansion and contraction options and crafting appropriate assignment or subleasing rights.

1. Cancellation Right.

By cancelling a lease, a tenant may completely eliminate the cash drain caused by excess, obsolete or overpriced space, or if the tenant desires, move to cheaper, larger, smaller or newer space, or if market rents have declined, renegotiate and reduce its rent. Due to the impact on the landlord, landlords are reluctant to grant cancellation rights. For example, with a cancellation clause, a landlord will bear the financial risks of a decline in rents and consequent added turn-over and associated expenses. Also, a cancellation provision adversely affects the property's financeability and value, especially in a single- tenant property, such as an industrial facility.

If a mom and pop tenant suffers in business and defaults or abandons the premises, the landlord is not likely to recover its full contract rent or damages for default. Therefore, granting the cancellation option to a poor credit tenant may be less prejudicial. With a good credit tenant, however, the cancellation right is a more meaningful concession on the landlord's part.

To make a cancellation provision more acceptable, the landlord may seek to limit its exposure by imposing certain conditions on the tenant's right to cancel. For example, to assure a minimum period of occupancy by and rent from tenant, the landlord may provide that the tenant may not exercise the cancellation option prior to a set date. In a retail lease, the landlord may require poor sales as a condition to tenant's ability to cancel, or require a reciprocal cancellation right if the tenant fails to meet a minimum sales threshold. The landlord may also make the cancellation option personal to the original tenant, so that if the tenant assigns or subleases, the cancellation option terminates.

Most landlords will require the tenant to compensate the landlord for some or all of the following categories of costs associated with a cancellation option: potential decrease in market rents; unamortized lease expenses; and rent during the reletting period.

The compensation to landlord for a potential decline in rents may be a predetermined amount or based on a formula. A lump sum payment that does not change regardless of when the tenant actually cancels the lease deters tenant's cancellation of the lease in the latter portion of the term. The parties may agree that for every month of the lease term that is eventually cancelled, the tenant pays a certain amount, e.g., a percentage of the monthly rent. Such a formula may be more equitable to a tenant, while assuring a landlord that tenant may not have the incentive to cancel unless the market rents decline more than the cancellation consideration.

In addition, the landlord may demand to be made whole for its out-of-pocket lease expenses. A landlord usually incurs expenses for tenant improvements, free rent, relocation or moving allowances, lease take-over payments and brokerage commissions expecting that tenant will pay rent for the entire lease term. A fair compromise is to amortize such costs over the original term of the lease and for the tenant to pay for the unamortized portion of such lease costs, perhaps with interest.

The landlord may require a minimum period, for example six months, to market and relet the space. The landlord will expect the tenant to pay the rent for such absorption period. Instead, the tenant may offer the landlord a very advance notice of tenant's exercise of the cancellation option, and provide landlord's needed head start on the reletting process. The tradeoff between the length of the cancellation notice and length of the absorption period depends on how much flexibility the tenant desires in giving the notice.

2. Lease Structure.

If the parties cannot agree on a cancellation right, an alternative is to structure a short term lease, such as three to five years, with one or more extension options. Whether this solution will satisfy the tenant's needed flexibility will largely depend on the amount of rent during the original term and option periods. With short term leases, the rent may be higher, and landlord may provide less tenant concessions, such as improvement allowances or free rent.

Few landlords are willing to give extension options with fixed rents, unless the rent is set high enough so the landlord feels comfortable that the option rent will be at or above the then market rates. This option, however, is of little or limited value to a tenant. Tenants are also reluctant to have option period rent increased or determined by CPI, since in the past few years, the CPI has been increasing while market rents were decreasing. Landlord and tenant may avoid imposing the risk of rent fluctuations on one of the parties by providing that option period rent will be the then fair market rent.

3. Expansion and Contraction Options.

In some instances, a tenant's need for flexibility may be satisfied by an option to expand or a right of first refusal for leasing other space. One other option is to provide a tenant right to reduce its premises. A tenant may be required to pay a consideration for a contraction option, similar to a cancellation option, but apportioned for the cancelled space.

From a landlord's view, such options may be preferable to an outright cancellation of the lease, since the tenant continues to pay some rent. The practicality of such options depends on tenant's space needs and landlord's space inventory. For example, such options may be more workable in leases in large office buildings, where space is more fungible, and the landlord has a relatively large amount of space.

4. Liberal Transferability.

As another solution for disposing of a tenant's excess space, the parties may provide the tenant wide latitude in assigning the lease or subletting the premises. This approach has at least two major disadvantages for the tenant. First, the tenant has the duty to market the unwanted space and mitigate any rent deficiency, as opposed to simply cancelling the lease. Second, after exercising a cancellation option, the tenant is released from further liability under the lease, while the tenant remains liable under a lease after an assignment or subletting, unless the lease provides otherwise.

Here, the allocation of profits from increase in market rent can be a bargaining chip. The tenant may argue that if the landlord is not willing to give a cancellation option, then since the tenant takes the risk of rent decreases, correspondingly the tenant should receive the profits from increase in rents. Conversely, if the landlord gives the tenant a cancellation option, then the landlord may maintain that the landlord should receive all profits from increases in rents. In other words, the party that takes the risk of decrease in rents also receives the benefit of increase in rents.

Whether a cancellation option is preferable to prospects of "rent profits" depends on the likelihood of market rents rising above or falling below the lease rent. The longer the length of the lease term, the more likely that rents may increase during the lease. Also, if lease rent is contractually-increased frequently, then the likelihood of profits decreases.

If the tenant agrees for the landlord to receive the rent profits, then the landlord may realize such profits by one of the following methods. First, upon the tenant assigning the lease or subleasing the premises, the landlord may increase the rent to then market rates. Under this approach, the landlord receives 100% of the rent profits without paying any of the associated costs, and the original tenant remains liable on the lease. Second alternative involves using a recapture provision, where landlord may terminate the lease if the tenant assigns or subleases. If the landlord elects to recapture, the tenant is released from liability under lease, and the landlord receives all the rent profits but pay the associated expenses. A third option is for the landlord and tenant to share such rent profits, either equally or on some other basis.

Even though unpalatable to a landlord, in today's tenant market a landlord must seriously consider a tenant's request for a cancellation option. Alternatively, to satisfy a tenant's need for flexibility, savvy landlords and tenants can structure short term leases, employ expansion and contraction options or negotiate appropriate assignment or subleasing rights.

Mr. Mashian is an attorney and shareholder at the law Firm of Buchalter, Nemer, Fields & Younger. He specializes is real estate law and is based in Los Angeles.