RETAIL PERFORMANCE OPTIONS AND TERMINATION AGREEMENTS
This LARG looks at several clauses involving options to extend and rights to terminate in retail leases. Both pro-tenant and pro-landlord provisions are included. Many condition exercise of the particular right upon the tenant's sales performance or some other factor. The first article in this LARG covers general drafting considerations for such clauses. The second article looks in particular at options to extend based upon retail sales or payments of percentage rent. Finally, the Lease Clause Critique focuses upon pro-landlord and pro-tenant convenience cancellation clauses.
Tying Retail Option And Termination Rights To Performance
Increasingly, retail landlords and tenants are bargaining for option and termination rights based upon the retail sales performance of the tenant. Options to extend and rights to terminate the lease early (i.e., prior to the normal expiration of the original term) sometimes just don't make business sense without looking at the tenant's sales performance.
The regional shopping center landlord is dependent upon percentage rental payments for its real return on its investment in the center. The landlord reasons, "If the tenant is not paying percentage rental, why should I let him extend the lease? In fact, why shouldn't I be able to terminate his lease after he has a reasonable time to get the business going, if he can't hit percentage rent? Without percentage rent, I have no return."
Likewise, tenants, especially chain store tenants, are not content to suffer through a ten year term in a location that is not making money. The tenant reasons, "If the sales aren't there, I want out. If I have to pay a termination payment to get the right to walk, fine, at least I'll have a way out of a bad location. If I have the leverage to get the right to walk without tying the cancellation to sales results, so much the better."
In many cases, a deal would simply not happen if both the tenant and the landlord insisted upon unconditional termination rights (i.e., without reference to the tenant's sales). Performance standards for such rights frequently pave the way for compromise and for getting the deal done.
The Basic Clauses
The most common cancellation and option devices include:
- A pro-tenant right to terminate the lease early if certain sales results are not reached over a negotiated period. Normally, the right to terminate does not arise until the tenant's retail operation has matured in the particular location (e.g., after the first three or four years of operation). Often, the tenant must pay the landlord a termination payment if the right is exercised to compensate the landlord for unamortized leasehold improvements made or paid for by the landlord (i.e., improvement costs that would have been spread over the portion of the initial term that was cancelled by the tenant). These termination rights are often referred to as convenience cancellation or convenience termination clauses, and are covered in more detail in the Lease Clause Critique in this LARG. Sometimes they are merely called "early outs."
- A pro-landlord right to terminate the lease early if certain sales levels are not attained by the tenant; in some cases, performance termination rights are mutual (i.e., can be exercised by either the landlord or the tenant).
- Options to extend the term in favor of the tenant, but conditioned upon a minimum level of sales over a negotiated period during the initial term of the lease. These are often referred to as performance clauses or performance options.
- Market erosion protections negotiated by supermarket tenants that give them a right to terminate the lease if the demographics in their primary trade area (e.g., the number of households within a certain radius of the store with incomes above a certain dollar amount) decline by a certain percentage over the term.
- Both the landlord and the tenant might want to consider the following issues when drafting and negotiating early outs and performance options:
- Are the termination rights unilateral or mutual in the event the stipulated gross sales are not achieved by the tenant?
- What is the duration of the period during which the stipulated gross sales must be made?
- If the performance period is a lengthy one, must the tenant meet a specified level of gross sales for every year during the period, or merely average a certain level of gross sales over several years?
- If the tenant fails to make the required level of sales during any year of the period, does the landlord then have the right to terminate?
- Are the performance tests reasonable in view of the particular type of tenant (e.g., how much must the market demographics decline for the primary trade area for the location before a supermarket tenant can walk)?
- If the performance standard for termination or exercise of renewal options is based upon gross sales, is the calculation of gross sales specifically tied to the computation mechanics contained in the lease (to prevent the tenant from inflating its reports of gross sales during the applicable period) to avoid the termination or secure the option?
- How will the landlord's lender react to the termination provision? Lenders are not famous for giving warm receptions to pro-tenant termination clauses. For a pro-tenant termination provision, the lender's concern will no doubt increase in proportion to the probability that the event triggering the right to terminate by the tenant will actually occur during the term. The more restrictions placed upon the tenant's right to walk, the more likely the lender will ultimately agree to the provision.
- What is the time period associated with the notices for termination? For pro-tenant early outs, both the landlord and the lender will want lengthy advance notice before the tenant actually vacates the space to give the landlord adequate time to find a replacement tenant.
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