First, let’s look at the common framework of the termination option, which is generally comprised of the following characteristics:

• Enables the tenant to terminate all or a portion of the remaining lease term - typically with 25%-50% of term remaining.

• Requires advance notice to the landlord - typically 9-15 months.

• Mandates a payment to the landlord (typically the sum of landlord’s unamortized initial transaction costs/concessions, and in some cases an additional penalty of several months of then-escalated rent).

Taking this a step further, we can illustrate how the value of a termination option increases in a market environment where rents have fallen below the tenant’s contract level. In this case, even with a substantial termination payment, tenants may have the ability to take advantage of the newly "corrected" market in a restructured lease commitment that results in meaningful financial savings through its lease expiration. In the simplistic hypothetical example below, let’s assume a law firm may contractually terminate its lease after the 10th year of a 15-year lease in a market that has seen a 25% correction (likely akin to many markets in 2021…).

Here, the high-level math suggests savings to the tenant by exercising the option, paying the penalty and resetting to market. However, while this example represents the first line of thinking when evaluating a right to terminate, there is more to consider with respect to the overall savings potential.

Remember that the underlying impetus for this analysis is that market conditions have worsened in a significant manner for landlords. Rents have dropped because availability rates have increased, and leasing volumes have fallen (a market dynamic that is imminent in today’s climate). In these markets, landlords are vulnerable to increasing vacancies in their properties and typically maximize incentives (i.e., free rent and construction allowances) to secure their rent roll. In fact, the value of the termination fee is typically dwarfed by the vacancy risk/replacement cost inherited by the landlord, post-exercise. Furthermore, as many law firms are gravitating towards smaller space requirements as efficiencies increase and work-from-home strategies provide another lever towards reducing space, additional savings may be achieved by terminating and downsizing. It should be pointed out that if deftly navigated, the effect of this leverage and the risk exposure to the landlord can result in a full or partial waiver of the termination penalty in exchange for a new commitment to the existing landlord (and with law space that has been right-sized and re-purposed for the firm).

In evaluating a tenant’s right to terminate all or a portion of its lease, one must exercise a thorough review of all the applicable steps and variables in order to establish a strategy that will maximize the benefit to the tenant. Such factors will include but not be limited to:

• The overall goal of the tenant including the due diligence required to establish the appetite to downsize, extend the term and/or relocate;
• Identification of alternatives in the market that would most effectively increase the leverage required to engage the existing landlord;
• Access to the capital required to exercise the termination right, if necessary;
• The likely direction that overall market will take over the period of time in which the exercise date falls;
• The specific market position and exposure of the tenant’s building and landlord; and
• The most effective time period to commence the process, in order to maximize leverage before and after engaging the existing landlord.

In summary, the tenant’s possession of a termination option may provide the catalyst for compelling its landlord to engage in a market negotiation, years in advance of a lease expiration. If handled diligently, a landlord may be incentivized to reward its tenant with a lower rent, money for capital improvements and perhaps some free rent in exchange for NOT exercising its termination option and/or extending the lease. In addition to many other factors, the threat of vacancy, downtime and replacement cost should motivate the landlord to evaluate a proactive lease restructure, simultaneously creating the opportunity to increase space efficiencies, lower cost and increase the firm’s per-partner profitability.

As this industry-wide discussion unfolds and firms learn more through trial and error, Savills Legal Tenant Practice Group will continue to monitor and report on best practices. For more insights, please visit The Legal Tenant.

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