Negotiating A Contraction Option in Your Office Lease Agreement

Obermayer Rebmann Maxwell & Hippel LLP

Obermayer Rebmann Maxwell & Hippel LLP

With COVID-19 not yet contained, many commercial tenants are uncertain of how much office space they will need in the future.  Adding a contraction option to a lease agreement allows the parties to adjust the amount of space leased to adapt to changing conditions.  Put more simply, a contraction option is the fixed right to return space to the landlord in the future should the tenant no longer require all of the space that it originally contracted for.

Prior to March of 2020, landlords and their lenders were resistant to granting this concession.  However, due to the current challenges now facing office landlords, the tides have turned and so have the way parties are conducting business. Tenants with strong finances are enjoying increased leverage and negotiating power. 

Before adding a contraction option to a lease agreement, landlords and tenants need to consider the following:  

  • Will the tenant be able to exercise its right to contract only during a certain period of time (for example between the 5th and 7th years of the lease term) or only on a certain date or dates?
  • Once exercised, what is the date of the give-back?
  • What is the size or percentage of space that can be given back? The landlord has to make sure that both the space kept and the space returned are code compliant and that the space returned will be marketable to third parties.
  • Can the give back space be identified at the time that the option is exercised or will it be determined at the outset?
  • What is the landlord’s contraction fee? A contraction fee is generally derived by multiplying the unamortized costs of the leasing transaction (such as any tenant allowance/landlord construction costs, leasing commissions, and landlord’s legal costs) by the percentage of the premises to be returned. Also commonly included in the contraction fee are the costs to demise the contracted space into a separate leasable area after the space is given back to the landlord. These costs may include the separation of HVAC distribution ductwork, utility lines and other equipment, and the construction of a multi-tenant corridor if necessary or required by any applicable laws. 
  • When must the contraction fee be paid?
  • Are other rights of the tenant impacted as a result of the exercise of the tenant’s contraction right (for example, will the tenant no longer have a renewal right or an expansion option)?
  • Is the contraction right personal to the original tenant (meaning that it cannot be exercised by a subtenant or an assignee)?
  • Should the tenant default under the lease, will the contraction option be lost?
  • In addition to the contraction fee, what other consideration will the landlord require to grant the contraction option to the tenant (for example, higher rent or a long term lease)?

As a result of the Covid-19 pandemic, office landlords are now more willing to offer concessions to new tenants and to those whose leases are up for renewal. A contraction option in a lease agreement offers flexibility and peace of mind to tenants who require office space but remain uncertain of their long-term needs. 

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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