How to negotiate a commercial lease: Tactics and strategies
Due to the economic turmoil caused by the COVID-19 pandemic, businesses interested in leasing commercial space in 2021 are entering a market roiled by uncertainties that barely existed a year ago. In this fractious new business environment, current tenants can find themselves renegotiating a lease. As for prospective tenants, they should take extra care to ensure that the lease they are signing contains enough flexibility to protect them against uncertain economic times and to preserve the integrity of their enterprise.
This article discusses some important leasing provisions that tenants should ask for in future negotiations and suggests some commercial lease negotiating tactics and strategies.
Exit strategies: Subleasing and assignment
Prior to the COVID-19 pandemic, commercial landlords were reluctant to allow tenants to sublease their space or transfer (assign) the lease to a third party. If it was allowed, most leases tightly restricted subleasing and assignment rights. But because so many businesses during the pandemic have either downsized, experienced extreme revenue losses, or gone bankrupt, tenants are seeing the wisdom of building in viable exit strategies in case they cannot fulfill their lease obligations. These provisions are now being more heavily negotiated than ever.
Subleasing some or all of the space to another business is one way to recoup some of the costs of rent. Under a sublease arrangement, the primary tenant essentially takes over many of the responsibilities of the landlord with respect to the subleased space — such as collecting rent and fielding complaints — and is responsible for ensuring that the subtenant meets their lease obligations.
Another option is “assignment” of the lease to a new tenant. Under an assignment arrangement, the new tenant essentially replaces the original tenant and assumes all the rights and obligations of the lease.
From a contractual standpoint, the difference between subleasing and assignment is that under a sublease, the original tenant retains a contractual relationship with both the subtenant and the landlord, while there is no contractual relationship (privity) between the subtenant and the landlord. Under an assignment, the replacement tenant's only contractual relationship is with the landlord (for example, the replacement tenant pays rent directly to the landlord) and the original tenant has no further property rights or obligations. The original tenant isn’t completely off the hook, however, as they can still be sued by the landlord if the replacement tenant breaches any terms of the lease.
Both subleasing and assignment allow the original tenant to reduce their rent burden and give landlords what they want, which is consistent payment of the rent. However, assignment only makes sense for the original tenant if the space is no longer useful to them and they do not plan to return.
A tenant should also consider negotiating for early termination rights in case its business is affected by future downturns or health crises. An early termination right allows the tenant to end the lease before the agreed lease term expires. In office leases, a termination right is usually structured so that the tenant may terminate the lease at a set date (for example, the tenant can end a five-year lease term after the third year). In retail leases, tenants may have termination rights — often called "kick-outs" — if agreed gross sales targets are not met.
Landlords will usually ask the tenant to pay a fee to exercise an early termination option. This termination fee may be several months' rent. Also, in many cases, landlords spend money to prepare the space for the tenant and spread these costs over the agreed lease term. This means that, if a tenant exercises an early termination right, the tenant often must reimburse the landlord for the unamortized portion of these costs. Tenants should be sure to negotiate these costs up front.
If the landlord refuses to allow early termination options, the tenant can achieve a similar result by getting creative with the lease term. Instead of agreeing to a five-year term, the tenant can ask for a two-year initial term with three renewal options for one year each. This essentially gives the tenant three opportunities to decide whether continuing with the lease makes sense.
During the COVID pandemic, many commercial tenants found themselves suddenly requiring dramatically different commercial accommodations. Some workforces went largely remote, leaving a great deal of unused space; others needed extra space to accommodate social distancing guidelines.
The ability to expand or contract space as needed can be negotiated through contraction or expansion clauses that allow the tenant to give unused space back to the landlord, or, if necessary, rent more space in the same building. Landlords are not fond of such clauses, so will typically insist on certain limitations. In a contraction clause, for example, landlords might want assurances that the space the tenant is returning will be rentable to another tenant, or that the tenant will give the landlord enough advance notice to find a new tenant.
For an expansion clause, the landlord has to be sure that the space will be available and usually cannot guarantee that the tenant will be able to expand into space that is adjacent to the current premises. In either case, such clauses give tenants some flexibility to adapt their space to the changing needs of the business.
Negotiating force majeure
For lawyers, the COVID-19 pandemic drew a great deal of attention to a normally "boilerplate" section of the typical commercial lease: the force majeure clause. This provision relieves business tenants of their contractual obligations if circumstances beyond their control make running the business at the leased premises impractical or impossible.
Typical force majeure events — also called “acts of God” — are hurricanes, earthquakes, floods, or other natural disasters, but can also include war, terrorism, riots, and labor strikes. Unfortunately, what many businesses are now discovering is that the force majeure clause in their current lease does not apply to acts of government, such as mandated business closures or pandemics. Few people foresaw the devastation of COVID-19 and very few leases expressly included pandemics as a force majeure event. Courts enforce contracts as they are written and have generally refused to excuse tenants from performing under a lease without clear language that the force majeure provisions were intended to apply to these COVID-19 circumstances.
In cases where the wording of the force majeure clause is vague, many attorneys are leaning on arguments based on the related common-law concepts of “frustration of purpose” and “impossibility,” but these arguments alone rarely get much traction because courts tend to interpret commercial lease language very narrowly.
Looking beyond COVID-19, the tenant should seek protections against any future government actions, pandemics, or public health crises that prevent the business from operating — it is imperative that tenants include this specific language in the force majeure clause of any new lease.
Businesses that lease space during and after COVID-19 need to keep the health and well-being of their employees in mind and make sure the space they are renting is also a safe place to work. At the very least, prospective tenants need to make sure the property’s management provides adequate sanitation, which includes daily cleaning of all surface areas in workspaces, kitchens, bathrooms, conference rooms, and common areas, using CDC-approved cleaning protocols.
Other safety measures that should be taken into consideration should include:
- HVAC systems: Does the building have state-of-the-art air filtration?
- Entrance protocols: Are people entering the building screened for COVID?
- Traffic patterns: Can the space accommodate social-distancing protocols?
- Workspaces: Can work areas be designed or retrofitted to limit close personal contact?
The lease should obligate the landlord to perform appropriate cleaning throughout the building and the tenant must ask for a clear explanation of how these cleaning costs are to be shared. No business can run if its space isn’t safe for workers and clients and any reputable property manager should be willing to make written safety commitments in the lease.
Final thoughts on how to negotiate a commercial lease
The guidelines above are general in nature; actual negotiations involving commercial leases should always take the needs of the renting entity into consideration. Office buildings, hospitals, malls, retail stores, manufacturing facilities, restaurants, and gyms all have different space requirements and all have different leasing priorities. Furthermore, commercial leases are complex legal documents, so enlisting the help of a real estate attorney familiar with the local laws and customs and the regional real estate market is a wise investment.