There is no doubt that the last few years have marked some of the most dismal of economic times. Nevertheless, leases are still being executed all the time. With the help of new ideas and consistent small business financing, businesses continue to sprout in the San Francisco Bay Area and the rest of the country. However, the liberal spending tactics that existed with new businesses just a few years ago are long gone, and have been replaced by conservative company policies focused on efficiency, longevity, and maintaining a tight belt. As a result, today’s entrepreneur tends to lease just enough space to support their current business, with possibly some additional space – albeit a small percentage – designated to sustaining growth.
But what happens if/when the economy turns a corner and the space that was once acceptable now becomes too small? Was there language in the lease that the tenant could have implemented that addresses this situation? Simply put – yes. I think that including language today in a lease agreement that that provides a tenant with (i) right of first refusal, (ii) a right of first offer, or (iii) terminations rights, will allow the tenant to lease additional or new space as the company grows, and also prevent the tenant from over-committing to unnecessary space while the business is in its developmental stage.
Interestingly enough, these clauses also provide incentives to landlords.
Under a Right of First Refusal, the landlord must first bring to the tenant any offer for an adjacent (or other space) space from a third party that the landlord would otherwise find acceptable, and the tenant is provided with a short time in which to meet the terms of the offer. There is not much wiggle room here – the tenant either matches the terms exactly or loses their right to lease the space. However, if the tenant does, in fact, match the terms, then the landlord is obligated to lease the space to the tenant, setting aside the offer made by the third party. In today’s market, with buildings experiencing ten to twenty percent (or more) vacancy rates, a right of first refusal clause could be a clever way to provide expansion space for a tenant without tying the tenant down to a larger rent.
Another alternative is the Right of First Offer, in which the landlord notifies the tenant that a certain space will be coming available, and also provides the tenant with terms in which landlord would be willing to execute a lease with the tenant for the new space. The tenant is again provided with a small window of time to decide whether or not they wish to move forward, and during that time, Landlord agrees not to offer the space to any outside third parties. The right of first offer tends to be more neutral than the right of first refusal because it provides the tenant with the ability to lease a space, but only on terms set by landlord. In this economy, however, the right of first offer may result in the landlord offering a similar rent as that of the previous tenant, or what could be a rent amount above the fair market rental rate.
In this economy, Termination Rights are also becoming more and more practical. Termination rights allow a tenant or landlord to terminate the lease under certain circumstances or for no reason at all by providing the other party with a prior notice and possibly, a termination or relocation payment. For a tenant, a termination option may prove to be beneficial as it provides them with the ability to terminate the lease and find new space altogether should they outgrow their space or wish to downsize. A tenant’s termination right is most likely coupled with a lease termination or cancellation fee, which may be related to the anticipated losses incurred by the landlord as a result of having to re-lease the space, or may just be an arbitrary number negotiated by the tenant and landlord at the outset of the lease. Regardless, although a termination fee may be expensive, it will usually be far less so than the remaining total rent due under the lease. And landlords take note – if a tenant exercises their termination rights, keep in mind that recovering possession of the space provides you with the opportunity to recapture fair market rent and ultimately, come out ahead.
When negotiating a lease with a landlord or tenant, consider your long term goals with your company and/or your property – and include language in the lease that facilitates these goals. It could be a win/win situation for the tenant and the landlord.