6-Ways to Exit an Office or Warehouse Lease When the Space No Longer Works

Part 8 of CARMEN’s 10-Part Commercial Real Estate Pain Points Series

A commercial lease may have made perfect sense when it was signed 5, 7, or 10-years ago. Now, t3-years later, the business may look completely different.

The company may have grown and needs more space. Headcount may have declined and half the seats are empty. Or, a merger, acquisition, relocation, work-from-home strategy, or business closure may make the location unnecessary altogether.

Unfortunately, the lease does not automatically change when the business does. A company with three years remaining on a five-year lease may still be responsible for hundreds of thousands—or even millions—of dollars in future rent and operating expenses.

That does not necessarily mean the tenant has to remain in the office or warehouse space until the lease expires. There are several ways a business can potentially exit or restructure an existing commercial lease.

The key is understanding the options before simply approaching the landlord and asking to be released.

1. Negotiate an Early Lease Termination

The most straightforward solution is often a negotiated termination agreement.

Approach the landlord and proposes ending the lease before its scheduled expiration date. The landlord may have one or more reasons they would be open to an Early Termination.

Perhaps the market for space has increased since you negotiated the lease, leaving a short supply of space, which would likely drive rental rates upward.  The landlord may agree to terminate your lease so they can get the space back and then lease to another tenant at an increased rental rate. A landlord with a tenant willing to pay $30 per square foot may be more receptive to releasing an existing tenant paying $22 per square foot than a landlord facing a weak leasing market.

Another reason is the landlord may find your use of the space incompatible with the existing tenant mix. Perhaps an medical office located in a building of professional service firms, such as investment firms.  Your medical office may be preventing the landlord from leasing to more investment firms, or visa-versa.

Another possible scenario is the landlord may have plans to modify the existing building by increasing the size or converting it to retail from office space. Your business’ occupancy may be standing in the way of the landlord making those changes and vacating would allow them to move forward with their plans.

Although the landlord may be agreeable to your vacating the lease, it’s likely they’ll want some sort of payment to do so.  The amount may be based on several factors, including:

• Remaining rent obligation
• Current market rental rates
• Demand for the space
• Cost of preparing the premises for another tenant
• Unamortized tenant improvement allowances or leasing commissions
• The landlord’s expectations regarding how quickly the space can be re-leased

The tenant should understand the economics of the property and its negotiating position before proposing a termination.

A termination payment can initially appear expensive, but it should be compared with the total cost of continuing to occupy—or pay for—space the company no longer needs.

2. Sublease All or Part of the Space

Subleasing is one of the most common exit strategies.

The existing tenant finds another company to occupy some or all of the premises for the remaining lease term. Essentially, the tenant becomes the sublandlord and the new tenant becomes the subtenant.

However, office and warehouse leases almost always state the original tenant will continue to remain responsible for the lease. The subtenant is responsible to you, as the original tenant.  If the subtenant stops paying rent, the landlord can typically still look to the original tenant for payment. Therefore, if your business subleases to another business, you should do your homework in evaluating possible subtenants to make certain they’ll be able to fulfill their obligation to pay rent and any other obligations stated in the original lease and sublease.

There may also be a financial gap. For example, a tenant may be paying $30 per square foot under its existing office lease but may sublease the space for $22. That creates an $8-per-square-foot annual obligation that the original tenant must continue to absorb. And there may be other costs.  The tenant may also incur:

• Brokerage commissions
• Legal expenses
• Tenant improvement costs
• Furniture allowances
• Free rent or other concessions

A sublease does not necessarily eliminate the lease liability, but it can substantially reduce it.

3. Assign the Lease to Another Tenant

A lease assignment is different from a sublease.

Instead of becoming a subtenant, another company assumes the existing tenant’s rights and obligations under the lease.

Assignments are frequently used in connection with:

• Business sales
• Mergers and acquisitions
• Corporate restructuring
• Relocations
• Transfers between affiliated businesses

Most commercial leases require landlord approval before an assignment can occur.

And there is another important issue tenants sometimes overlook:

As with a sublease, an assignment does not always release the original tenant from liability. Unless the landlord specifically agrees to release the original tenant, that company may remain responsible if the replacement tenant later defaults.

Obtaining a complete release should therefore be an important part of the negotiation.

4. Restructure the Existing Lease

Sometimes the best solution is not leaving the property. It is changing the deal.

A company occupying 40,000 square feet may determine it only needs 25,000. Instead of relocating, the tenant and landlord may be able to restructure the lease.  The circumstances where a landlord may be willing to restructure the lease is when the tenant agrees to extending the term on the new downsized space. For example, instead of having a 40,000 sq. ft. lease for three more years, the landlord may agree to having a 25,000 sq. ft. lease for five or more years.

Other possible solutions to make this happen might include:

• Giving back a portion of the premises, so the landlord can lease to another tenant
• Moving into a smaller suite within the building
• Restructuring rental payments
• Relocating within the landlord’s portfolio

A landlord may prefer restructuring an existing tenant’s lease NOW, rather than losing the tenant entirely a few years from now.  This can create an opportunity for both sides—particularly when the landlord believes the surrendered space can be leased to another company.

5. Exercise a Contractual Termination Right

Some tenants already have an exit strategy built into their lease. Commercial leases may contain termination provisions triggered by certain circumstances.

These can include:

• Negotiated early termination options
• Kick-out provisions
• Co-tenancy requirements
• Casualty provisions
• Condemnation rights
• Landlord redevelopment rights
• Certain assignment or acquisition provisions

Large tenants with a lot of leverage sometimes negotiate a specific termination option allowing them to cancel the lease after a defined period in exchange with advance notice and other termination terms, such as a termination payment. Termination rights frequently require notice six, nine, or twelve months before a specific date. Missing the notice deadline can eliminate the option entirely

Unfortunately, most tenants do not have enough leverage to negotiate a Termination Right in the lease. Landlords hate Termination Rights, therefore, they must have a great reason to provide the tenant this right.

6. Help the Landlord Find a Replacement Tenant

There is another approach that can sometimes produce a cleaner solution than a traditional sublease. Instead of subleasing the premises, the existing tenant works with the landlord to locate a replacement tenant that will sign a completely new lease.

The landlord terminates the existing lease and simultaneously enters into a new agreement with the replacement tenant.

This approach can be particularly attractive when:

• Market rents have increased
• The space is highly desirable
• The existing lease has several years remaining
• The replacement tenant wants a longer lease term
• The landlord wants to restructure the economics of the space

In many circumstances, all three parties benefit. 1) The existing tenant eliminates its lease obligation. 2) The new tenant gets the space it wants. 3) and the landlord gains a new tenant with a new lease, potentially at a higher rental rate or for a longer term.

Finding a replacement tenant often goes hand-in-hand with subleasing.  Although you work with the landlord to identify a replacement tenant, you still may put the space on the market for sublease. In fact, offer the space for sublease can often motivate the landlord to find a replacement tenant so they can have more control over the new tenant than a sublease, where the existing tenant is in between subtenant and landlord.

The Worst Strategy: Waiting Until the Last Minute!

One of the most common mistakes tenants make is waiting until the decision has already been made.

The company announces it is relocating. Management signs a lease at another building. Employees are told the office is closing. Only then does someone ask:

“What are we going to do with the existing lease?”

At that point, the tenant’s negotiating leverage may already have diminished…..maybe to “0”.

The better approach is to analyze the existing lease and evaluate exit strategies and the associated costs before making the final real estate decision.

At CARMEN, we have seen companies successfully restructure, sublease, assign, or negotiate their way out of lease obligations—but the strongest outcomes generally begin with time, information, and a clear understanding of the landlord’s position.

Understand the Economics Before You Negotiate

Now I’ll tell you what I tell every one of our clients that want to exit from an existing lease: Leaving an existing space can be “bloody”…meaning it can be costly. If you expect a lease exit to be costly, you won’t be disappointed when you have to write a check for a termination payment or making-up the rental gap between what your paying in rent and what the subtenant is going to pay you.

Exiting a commercial lease is rarely as simple as turning over the keys. Each alternative has financial, legal, and operational consequences. Before approaching the landlord, tenants should understand:

• Their remaining lease liability
• Current market rental rates
• The landlord’s leasing activity
• Sublease competition
• Demand for their particular space
• Their contractual assignment and subletting rights
• Potential termination costs
• The cost of staying versus leaving

That analysis allows management to compare the alternatives and determine which strategy creates the best financial outcome.

A lease may be a contractual obligation—but it does not always have to become a business obstacle.

CARMEN helps companies evaluate their commercial real estate obligations, develop exit and restructuring strategies, and negotiate solutions designed around the company’s business objectives.

Up Next — Part 9 of 10: “The 11th-Hour Lease Trap: How To Handle Last-Minute Renewal Surprises”

Learn more at carmenrealestate.com