Last updated on May 13th, 2019 at 02:35 pm
When one of the largest proposed commercial developments in Milwaukee history bit the dust recently, termination rights for tenant leases were cited as one reason for the bust. The long-awaited, $317 million PabstCity project, a high-profile retail and entertainment complex to rise in Phoenix-like fashion from downtown Milwaukee’s old Pabst Brewery, would have meant thousands of jobs during both construction and operation. It would also have meant $39 million in city support generated through tax incremental financing, a common approach used by cities to borrow money to help finance development, then repay the loan with new property taxes generated by the new development.
Politics and organized opposition were the well-reported factors in PabstCity’s demise, but in its final throes, "kick-out rights," as they are often called, picked up 15 minutes of fame as part of the problem. It needn’t have been. At least, not unless you consider commonly used lease provisions to be deal killers. In business, it is common for tenants and landlords to negotiate up front the conditions under which a lease may be terminated.
Because commercial and retail leases are usually long-term, landlords and tenants must agree in advance on many events that affect their relationship. A good lease will contain provisions allowing the landlord to terminate the lease if the tenant defaults and that allow either party to terminate the lease for unexpected events. These can include destruction of the premises (or the building in which the premises are located) by fire, hurricane, tornado, a terrorist attack or in the event of condemnation of all or a substantial portion of the premises, its parking area or entrance.
Tenants entering into retail leases of proposed developments, such as PabstCity, may also want termination rights in the absence of absolute assurance that the necessary permits, licenses and government approvals will be granted to get the premises up and running. Tenants often insist on making the lease contingent on their obtaining such approvals with the right to terminate the lease in its early stages before significant expenditures are made if the approvals are not forthcoming. Variations on these contingencies and termination rights are also used to cover financing, the granting of a franchise or, increasingly, receipt of proof that the site is free of contamination.
Many other circumstances may prompt a request for termination rights, from the concern over how new laws or regulations may impact a business to worry that a key person may unexpectedly die or become disabled. Since few landlords are willing to give an open-ended termination right, lease negotiations often result in the parties agreeing that the tenant may terminate the lease if the gross sales from that store do not reach a predetermined level. Early termination provisions are not restricted to tenants. Landlords may want to remove retail tenants who are not performing at adequate levels, measured by their annual gross sales. Landlords may want the right to terminate leases of office or industrial tenants, should the landlord decide to occupy the building for its own purposes, substantially remodel or demolish the structure, or lease it to a third party.
Retail tenants dependent upon a steady flow of customers in a development project, such as a shopping center or entertainment complex like PabstCity, frequently insist on the right to stop paying rent and/or terminate the lease if customer traffic is adversely affected. These include the failure of an anchor or other tenants to open or remain open for business, or a substantial change in the nature of the anchor tenant’s business (such as a first-class operation evolving into a value operation).
Landlords often must give this right to tenants with strong bargaining power to attract critical tenants to new and uncertain development projects. While such early termination rights appear to favor the tenant, landlords can protect themselves by delaying the actual lease termination for a period of time, say a year, from the triggering event and the landlord’s receipt of the tenant’s notice of intent to terminate. Lenders rarely like termination rights, or for that matter, anything else that may jeopardize the flow of income that can be used to retire debt. Since loan documents often provide that the lenders can look only to the equity in the project and the income stream that comes from the project leases to repay the indebtedness, they are highly sensitive to the possibility of an interruption in the income stream and a cancellation of a lease by a tenant or a reduction in the tenant’s rent.
In PabstCity’s case, early termination rights were viewed as potentially dangerous to repayment of the city’s $39 million dollar financial input. If termination rights were given to major tenants such as The House of Blues, the possibility existed that, should the tenants cease operating, the city would be on the hook for the $39 million plus interest. While the termination provisions reportedly negotiated by PabstCity tenants may have been appropriate and necessary under the circumstances, the City of Milwaukee was responding in a manner similar to a lender when it objected to the provisions.
The question is, should it have been a deal killer? While that question may remain forever unanswered, what is clear is that in most lease negotiations, the parties move forward, granting each other sufficient assurances and provisions to close the deal.
Early termination rights are not unreasonable requests. No contract is ever air-tight. and the future is never completely predictable. PabstCity was no different. Early termination rights may have been part of the problem, but certainly not all of it. Left in the hands of competent legal counsel and professional real estate developers and advisors, continued discussion and negotiation could have improved the chances of a win-win outcome for everyone, including taxpayers.