The Cancellation Clause In A Commercial Lease

Whether a rental market is weak or strong, lease negotiations can be difficult when the landlord wants concessions that are different from the norm.
One situation that happens is when the owner of an office building or other commercial property intends to sell when market conditions improve, whether that occurs next year or five years from now. Another is the holder of vacant or underimproved property who plans to develop it whenever market conditions justify. In the meantime, these properties must be leased to generate sufficient cash flow to pay operating costs and debt service. Such an owner will be amenable to giving significant concessions, including a low rental, provided the landlord can cancel the lease during the term.
An alternative to a long-term lease subject to cancellation is a series of short-term leases. However, a long term lease subject to cancellation under specific conditions may be much more preferable to a tenant than a short-term lease that the landlord can refuse to renew for any reason. Here are some guidelines for drafting a fair cancellation clause.
The Guidelines
The option to cancel the lease by the landlord could easily lead to misunderstandings and lawsuits unless it is carefully drafted. Here are some important things to consider:
• Definite Reason. A landlord asking for the option to cancel in order to sell the property or demolish the improvements nevertheless may want the option clause in the lease to be unconditional. The need to specify a reason in the notice exercising the option could raise questions of good faith or improper exercise if, for example, a subsequent sale or demolition is delayed or postponed for a period. On the other hand, the tenant may insist that a reason be given; oral representation during negotiations will not themselves limit a cancellation option that is unconditional in the lease.
• How the option is exercised. One solution to the problem of an unconditional option is to make it exercisable only on actual sale of the premises. This would mean that possession could not be given at the closing of title and so be unacceptable to the buyer. The landlord will want the option exercisable at the time the contract is signed (perhaps with the tenant to be entitled to remain until title is closed).
• Notice to tenant. The tenant will need a reasonable time to terminate its business and remove its property. The landlord will not want the notice period to be so long as to discourage a prospective buyer.
• Reimbursement to tenant. If the tenant will incur substantial costs to prepare or improve the premises for use, it may insist on reimbursement if the lease is canceled. A common formula is to amortize the up-front costs over the lease term, with reimbursement to equal the unamortized cost at the time of cancellation. (An alternative method is for the rent to be set initially at a low level, stepping up after periodic intervals.)
The lease should make clear when any such payment is to be made–at the time the notice of cancellation is given, at the time the tenant vacates, or at a subsequent time. Use of an escrow may be a solution to this issue.
• The new landlord. Suppose the original landlord sells the property to a buyer willing to take the property subject to the existing lease so no cancellation occurs. Does the new owner have the right of cancellation, or does it terminate on the sale? This should be made clear; if the option extends to the new landlord, it should also be clear as to whether the original or successor landlord is responsible for any payment due the tenant.
• Right of first refusal. The tenant may seek a right of first refusal in the event of a proposed sale accompanied by a cancellation of the lease. This would give the tenant the right to match the offer of a third party to buy the property. Landlords do not like rights of first refusal because they complicate efforts to sell; in this situation, it is unlikely that the tenant will insist on the right since the value of the property to a third party intending to develop it is likely to be substantially above the market value of the property under its current use.
• Tenant’s right to cancel. The tenant may ask for a similar right to cancel the lease under certain conditions. While the landlord’s cancellation option is fully valid without a corresponding right for the tenant, the landlord may be willing to make this concession in order to gain agreement.