The Leader Magazine

SEP 2016

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3) The last category of tenant options is contrac- tion/termination options. These options allow a tenant to permanently reduce the size of its leased premises or terminate its lease altogether. Subleases and lease assignments are well- established ways to reduce or eliminate the economic costs of unused leased premises. Consequently, the provisions of a lease describing a tenant's sublease and assignment rights should be given careful consideration to maximize their value. However, with a sublease or lease assignment, the tenant as sublandlord or assignor will continue to be liable to the master landlord under the primary lease. In addition to the continuing economic costs and risks inherent in assignments and subleases, there is an administrative burden. Subleases and assignments essentially put the tenant in the business of being a landlord, a business it might prefer not to be in. Despite the administrative and other costs, there may be good business reasons to sublease. For example, subleasing can be a way to reserve space that is not needed now for an expected need a few years out. The term of a sublease can be structured to provide temporary reduction in the cost of unneeded space while keeping the space for the sublandlord's use when the sublease term ends. On the other hand, contractions and termi- nations offer the ability to completely eliminate all or part of an unneeded lease obligation permanently. For flexibility, both good sublease and assignment rights and contraction/termina- tion options should be obtained. A tenant must typically pay a fee to exercise a contraction or a termination right. This fee is usually equal to the unamortized amount (as of the effective date of contraction or termination) of the portion of the total of the follow- ing costs paid by the landlord that is allocable to the part of the leased space being eliminated: (i) tenant im- provements, (ii) leasing commissions and (iii) any abated rent. The amor- tization is calculated on a straight-line basis with imputed interest over the term of the lease. The appropriate imputed interest rate is always subject to debate. Obviously, the lower the interest rate, the better from the tenant's perspective. It is also important to make it clear that the amortization takes place only over the course of the original lease term; that it does not extend through any extension term. Finally, it is a good idea to attach an amortization schedule to the lease. Not only does this memorialize the totals of all costs subject to recapture, but it also sets out, at a time when heads are cool, exactly what the contraction or termination fee should be, month by month, of the lease. In addition to this amount, sometimes a landlord is able to get a tenant to agree to include a couple of months of extra base rent in the termination fee. s ome universal issues In addition to the issues discussed above, which are specific to each kind of option, there are several issues to be negotiated that typically will be applicable to all forms of option rights. These include the following: (i) will the tenant lose the option right if it has ever been in default, subject to notice and cure protections, or will the tenant's default status only cause forfeiture if existent at the time tenant would otherwise be eligible to exercise an option right (or at the time an exercised right would become effective); (ii) are the tenant's option rights personal to the tenant or are they rights that the tenant can pass on to an assignee or sublessee; (iii) must a tenant have a certain percent occupancy of its leased premises or have subleased no more than a certain percent of its leased premises in order to be eligible to exercise an option right; and, finally, (iv) for any required determination of current fair market rent, what components are included in the analysis and what is the process for making the calculation and final determina- tion? Some of these issues arise from legitimate landlord concerns, but beware of compiling a list of technical hoops to jump through that can inadvertently, and for little good reason, cause the loss of important option rights. As this article suggests, option rights can be complicated and can add to the time needed for negotiating and preparing a lease. Increasingly, however, tenants seem to find they are worth the required investment because of the flexibility they provide in dealing with the inevitable changes a company will have in its space needs. 18 SEPTEMBER 2016 Paula S. Crow is a partner in the Real Estate and Finance Practice Group in the San Francisco office of Sedgwick LLP, with more than 30 years of experience dealing in complex real estate transactions. F E A T U R E A R T I C L E

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