Mitigating Leasing Risk: Negotiating Break Clauses and Capped Occupancy Costs

Economic uncertainty before and after the pandemic has led tenants to seek risk mitigation measures in their commercial leases. Specifically, redevelopments and extensions in shopping centres have become more unpredictable due to factors like insufficient trade areas, increased competition from other centres, and poor design.

To manage this risk, tenants are increasingly negotiating break clauses and capped occupancy clauses.

What is a Break Clause?

A break clause allows tenants to terminate the lease early, under specific conditions, often with a penalty. It provides flexibility to exit the lease if the venture isn’t as successful as anticipated. Break clauses usually require notice at a specific point in the lease, often in the second year or around the midpoint. Penalties can range from 3 to 12 months’ rent, depending on the terms.

However, in some cases, break clauses may not include a penalty. These are typically rarer and usually triggered by a failure to achieve a specific sales threshold within a certain time period. In the USA, such penalty-free break clauses are more common, especially in the retail sector, providing more flexibility for tenants.

Typical break clause conditions include not meeting audited sales targets or a new shopping centre not reaching its target occupancy level.

What is a Capped Occupancy Clause?

A capped occupancy clause protects tenants by limiting rent when sales fall below expectations. There are two types of capped occupancy clauses:

1. Downward-Only Capped Occupancy Clause: The maximum rent cannot exceed a certain percentage of the tenant’s sales. If sales fall short, rent is reduced, and rebates are typically issued quarterly.
2. Upward-and-Downward Capped Occupancy Clause: Rent is adjusted based on sales fluctuations within a defined range. For example, if sales fall between $X and $Y, the rent will fluctuate between a minimum and maximum percentage of sales.

Landlords often prefer that these clauses be placed in a deed rather than directly in the lease, especially with upward-and-downward caps, to avoid disclosing these arrangements in the formal lease.

These clauses are more challenging to negotiate for small specialty retailers in major shopping centres but may be more achievable in smaller centres where landlords are typically more flexible, especially on downward-only caps.

When Are These Provisions Useful?

Break clauses and capped occupancy clauses are particularly valuable in new shopping centre developments or redevelopments, where the market may be uncertain during the first few years. They are also increasingly common in corporate and international lease agreements, where business performance can be impacted by a wide range of unpredictable factors.

These provisions offer added security, allowing tenants to mitigate potential risks if their business underperforms.

Important Considerations

Although break clauses and capped occupancy clauses can be beneficial, they are not common in most leases. Even when negotiated, they may not always be triggered. However, their presence offers tenants added protection against unforeseen economic circumstances.

How to Negotiate for These Clauses

Preparation is essential to successfully negotiating these clauses. Present research and fact-based evidence, including examples of similar clauses in comparable properties. Landlords are generally reluctant to offer these provisions, particularly in stable, established shopping centres, as they increase the landlord’s risk. However, there may be more room for flexibility for new developments or smaller centres as both parties face a degree of risk in an untested market.

Tenants can effectively manage their risks during periods of economic volatility by negotiating break clauses or capped occupancy clauses. While these provisions may be difficult to secure, they play a crucial role in providing risk management solutions that can help safeguard tenants in uncertain times.