How Much Should It Cost To Kick-Out Of A Lease? Not As Much As Is Being Asked.

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Today, we’ll start in the middle of our thoughts by opening with an example that we’re going to return to several times in this week’s posting. You can have a five year lease with an option (in favor of the tenant) to extend its term by five years, or you can have a ten year lease with the tenant having the option to end it at the five year point. In fact, you can do those numbers any way you want. So, what’s the difference?

Psychology aside, probably nothing if the math wizards are at work. Perhaps, one party or the other can play around with the tax treatment given to the lease. But, basically, the present value for each five year segment should be the same. If someone were to suggest that having the right to terminate the lease early protects a tenant against “forgetting” to renew, then why not make the renewal automatic unless the tenant sends a notice to the contrary. Wow, that sure sounds like the right to terminate early in different words. Oh, by the way, most in the real property leasing trade call the early termination option, the right to “kick-out” of the lease.

[Before our readers get too antsy, yes, no matter how one structures this kind of deal, our example can only be considered a five year lease. That’s how lenders will treat it. That’s how potential property purchasers will treat it. But, that’s not where Ruminations is going today.]

Now, there is a kind of “kick-out” right that isn’t the direct equivalent of a lease extension option. That’s the conditional “kick-out” right, one that isn’t available to a tenant unless a prior condition or set of conditions has been met. A very common example is where a tenant (OR A LANDLORD) has the right to end a lease early if an agreed-upon sales level has not been met by an agreed-upon time. [While most landlords don’t care about having such a right, some, especially outlet mall landlords do. But, we digress (as we commonly do)]. This also isn’t where Ruminations is going today.

So, where is Ruminations going? “(It’s) the economy, stupid.” [Attribution: James Carville.]

We like examples. So, we’ll use another one, and then we’ll drill down a little. To make our example simple, we’ll assume that regardless of the length of a particular lease’s term, two years – a hundred years – the parties are happy with a given rent for the first year and a 2% rent increase for every year thereafter. So, it doesn’t matter how you get to ten years – a straight ten year lease or one with five years to start followed by a five year extension term (a five+ five) or a one year term followed by nine successive one year extensions or a ten year lease with one kick-out at the five year point or a ten year lease and the right to kick-out at the end of each year. The rent stream is the same in each case.

So, what’s the difference? Think: transaction cost. It cost the same to negotiate a ten year lease or a “five + five.” In fact, it could cost a little more for the “five + five” if you want to fight over the details of the extension right. Regardless of the length of the lease, it costs as much to ready the premises for delivery. It costs as much to get an SNDA or a lease approval from a lender (in each case, if needed). Those, and other costs, are “transaction costs.” Those are costs each party has to build into the economics of the deal. Presumably, however, a tenant seeking a kick-out right fully accepts that not being able to spread those costs over a long period of time is an explicit cost for the kick-out right it is seeking.

What about a landlord?

To begin, we need to assume that the lease with a “kick-out” is the best deal on the table at the time, and is a better deal than leaving the space empty. Now, to another example.

Suppose the landlord has agreed to spend $100,000 to ready the space for a particular tenant. We’re not talking money spent to put it back in leasable condition to begin with; we’re talking “tenant improvements” for this particular tenant. That’s not “free” to the tenant. The rent is higher with the landlord’s $100,000 than without it. [We’ve written about this HERE.] To keep it simple, we’re going to ignore borrowing costs or “use of money” issues, and posit that the landlord (in this example) will be tacking on $10,000 more rent in each of the ten years of our hypothetical ten year lease. If that’s not satisfying, try to comfort yourself knowing that the 2% hypothetical annual rent increase is “like” interest when applied to this $10,000 annual increment.

[We can’t resist. If there were an extension right beyond the ten year point, why should any agreed-upon annual increase apply to that particular $10,000 annual increment? Shouldn’t the annual “base” rent, so to speak, fall back by $10,000 before setting a year 11 rent? That’s also something to think of when doing a 5+5+5+5. At what point should the landlord’s “loan” burn off? – probably at the five year point.]

Let’s return to the theme of today’s posting – the kick-out right.

Using our example, a landlord who spread its transaction costs (our example, the cost of tenant improvements and other “up front” costs) over a hoped-for ten year term will be pretty unhappy if its tenant does, in fact, kick-out at the five year point. How unhappy? Absorbing the cost unhappy, that’s how unhappy.

Typically, this is an easy mental state (“cost unhappiness”) to overcome. Leases with kick-out rights can condition the right on the tenant “repaying” those unamortized transaction costs to the landlord in the form of a “kick-out” payment. Take note that we wrote “on a tenant ‘repaying’… .” That’s because landlords who bargain for the right to end a lease “before its time,” don’t usually offer to cover the tenant’s up-front transaction costs. They should. Wise tenants know to ask (insist). Let’s drag out a favorite mantra – it’s all “bargaining power.”

You won’t find leases (of the tenant can “kick-out” variety) that simply say: “Tenant will reimburse Landlord for X% of Landlord’s transaction costs.” (Almost) invariably, this kind of lease says that the tenant will pay the landlord for a pro rata share of the cost of improvements made by the landlord (it’s best to be a known, fixed number or a number determinable by reviewing reliable, trustworthy accounting records) and for a pro rata share of the brokerage commission paid on account of the lease. If there are other concrete transaction costs, they are typically well-defined. If they aren’t well-defined, that’s just sloppy drafting. Sometimes, there might be a termination fee (knowingly or unknowingly) related to “soft” transaction costs to be recovered upon an early lease termination. That component of the transaction cost recovery might be separately stated or might be embedded in an overall termination fee, something we’re getting to.

Landlords shouldn’t automatically be entitled to recover all unamortized fit-up costs or tenant allowance amounts. For example, if a landlord installs a separate meter or replaces HVAC equipment, items that constitute general improvements to the space and not ones with limited appeal to tenants in general, there doesn’t seem to be a good reason for a kicking-out tenant to “pay” for such items.

To Ruminations, however, a brokerage fee recovery component should never be implicated. In the first place, the broker shouldn’t be receiving a fee for the “kicked-out” portion of the term. That fee shouldn’t be payable until and unless the kick-out right has expired without it having been exercised. In that way, the brokerage commission would be treated no differently than had the lease included a term extension right. Where a lease includes term extension rights, the broker gets paid when the extension period begins (or even over a period of time after that point). Where a lease has a kick-out right, the “rest” of the commission should not be payable any sooner than it would have been paid had the lease been structured with extension options. So, to us, it would be a rare situation where a landlord should ask to be made whole for the “rest” of the (unamortized) brokerage commission.

Readers can extend those concepts – unavoidable transaction costs, and avoidable transaction costs – to other items and negotiate the “recovery” or “make whole” component of the “kick-out” payment from a tenant (or, if applicable, from a landlord).

What about termination payments unrelated to recovery of up-front transaction costs? Those theoretically based on “the space will be vacant, you need to cover the lease-up period” are usually not justified if the notice period for a kick-out is the same as the notice period for a lease term extension would have been. After all, if nine-months’ notice is the “deal” for an extension option, a nine-months’ notice period for a kick-out should be all that is needed. Either way, the space will be availably vacant at the end of nine months. Of course, in a nine-months’ “notice for an extension” marketplace, if a tenant wants to wait on its kick-out decision until it has reached the three months-to-go point, a six month termination payment would be appropriate.

There is one other category of “termination” payment to be considered, and that is to compensate for favorable “rent.” What do we mean by that? Let’s revisit an earlier hypothesis, the one that said the annual rents would be the same regardless of how the lease was structured, in essence, regardless of the length of its term. Most often, that’s not “market.” What is “market,” for whatever reason, is: longer leases mean lower annual rents (on a present value basis). So, if a ten year lease with a kick-out right at the five year point is priced as if there were no kick-out, it would seem “fair” to include a kick-out fee component to “recapture” the implicit “longer lease” discount. How much? We don’t know, especially because no one ever thinks about this factor. But, it’s there.

Our admission as to not being able to figure out the “discount” described immediately above might be why some tenants prefer a kick-out right instead of no extension option. [We’re not thinking about the “sales threshold” kick-out kind of provision.] Basically, it seems that such tenants negotiate the “longer” term and the rental amounts for that longer term and then, once those are set, insist on a kick-out right. Basically, if the present value of rent for a ten year lease is less than that for a “five + five,” why not negotiate for the ten year rental figures? Again, there may be some accounting “tricks,” but those “tracks” don’t seem to be what drives the “kick-out” approach.

If any readers have other ideas as to why “go” the kick-out approach or about any other aspect of the kick-out approach, please tell the rest of us by adding your thoughts below where it looks like you have been given the space to do so.

[Last week’s posting lamenting about the difficulties encountered in defining what is “structural” and what is not, generated a lot of thoughtful comments, though not very consistent with one another. So, we’ll be revisiting that subject pretty soon, taking advantage of the contributions made by a number of loyal readers – co-Ruminators.]

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Comments

  1. How about considerations relative to a Landlord introduced kick out clause in a lengthy lease, offered during an economic down turn wherein the Landlord offers a kick out clause to retain the tenant and the current rent structure. Landlord’s hopeful escape is that the Tenant receives a significant rent reduction for agreeing to eliminate the clause.

  2. All very good points and worthy of consideration in any lease negotiations involving some type of early out clause.

    Another area for consideration … at some time during the lease term, the property or the tenant’s business gets sold to a third party who was not involved in the original lease discussions. Seen this happen many times. Usually the new LL or tenant business owner wonders what “happy pill” everyone was taking during the original discussions.

    And being in the real estate brokerage side of the business, I would tend to disagree that the broker should not be fully compensated up front for the fully anticipated lease term. If the tenant elects to exercise their kick out clause, the prorata brokerage fees should be a part of the tenant’s payment to get out of the originally anticipated lease term early. A broker having done their required work up front, should not be penalized for things in the future they have no control over.

    Best wishes.

  3. Sam Tucker says:

    I have sat on both the Landlord’s and Tenant’s side of the negotiation table and it is highly unlikely that the Landlord will agree to a kickout cost. If the Tenant believes that it might want to kickout of the Lease early, the Landlord will most likely not want that Tenant in its property. If the office or retail property is in an area that is not desireable or the property was vacant for an extended period, the Landlord may agree to a kickout. In any canse the Landlord should be reimbursed for the unamortized Tenant improvement costs Tenant allowance, leasing commissions, and an estimated period to release lthe property. In administering over 700 leases I have only seen two cases of a kickout clause.

  4. Henry Pharr III says:

    Sam –

    Good points. I have also sat on both sides of this discussion, but have seen more kick-outs added to LOIs and the final lease (although less in recent years as the economy has rebounded from 2008-2009). Where I see it discussed and included the final deal is usually driven by a number of factors on one or both sides, such as:

    1. The relative financial strength and experience of the tenant (established business = possibly; small shop start ups = generally no);
    2. The landlord’s plans for the asset – If there is a desire to flip or sell within term, a kick out clause may actually help the the process;
    3. Landlord lender/loan status may push this one way or the other depending on requirements for stable rental income;
    4. At what point during the term is tenant required to re-pay the residue of any amortized costs incurred by landlord; and
    5. How much security is received by landlord at the beginning of the lease. If tenant provides multiple personal guaranties, a letter of credit, large security deposit etc, I have seen landlords be willing to consider the kick out option more favorably than if tenant is just giving a Scout’s honor pledge to re-pay TI costs, brokerage fees and other up front costs incurred by ownership.

  5. How about the other side of this “kick out” coin? Many landlords will insist upon a reciprocal right to terminate early. The issue then is in calculating the lost opportunity cost for the tenant who is being asked to leave the property, having negotiated attractive rental terms which they are being asked to relinquish and which may not be available in a relocation.

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