Major Lease Terminations: Don’t Sweep them Under the Rug
A major tenant terminating its lease is more than an occupancy issue. Depending on the loan documents, it may require lender consent, trigger cash management or reserve requirements, determine how termination proceeds are held and used, or create an event of default if notice or other requirements are not satisfied.
The specifics vary significantly by lender and loan. That’s why borrowers should understand not only what their loan documents require when entering into a lease, but also what happens when a significant lease is modified, surrendered or terminated, or approaches expiration.
It starts with the definition
Loan documents do not define a “Major Lease” or “Material Lease” consistently. Thresholds may be based on net rentable area, square footage, percentage of rental income, lease term or a combination of factors.
That distinction can be easy to miss. In one loan we service, a tenant did not meet the square-footage threshold for a material lease but qualified under a separate test based on the length of the lease. When the tenant later exercised an early termination right, the loan’s material lease provisions still governed how the termination fee was handled.
The lesson is that square footage alone does not determine whether a lease is material. Borrowers and servicers need to review each element of the applicable definition before concluding that lender consent or other loan requirements do not apply.
A termination can affect more than occupancy
Lease termination proceeds are another item that is easy to overlook. Depending on the loan documents, proceeds received in connection with a lease termination may have to be delivered to the lender for deposit into a reserve and later made available for approved re-leasing costs, such as tenant improvements or leasing commissions.
In one situation, a significant lease termination payment came to light during a routine financial review, months after the termination occurred. The delayed disclosure raised unnecessary concerns about transparency, even though there was no indication that the borrower intended to withhold the information. Under the loan documents, the termination proceeds were subject to provisions requiring the funds to be delivered to the lender and held for re-leasing the space.
Once the borrower presented a thoughtful plan for re-leasing the space and using the termination proceeds, the lender ultimately agreed to allow the borrower to retain the funds for those purposes.
The lesson? Early communication matters. Had the borrower brought the termination to the servicer when it occurred, together with its plan for the space and use of the proceeds, the conversation could have started from a position of transparency and focused on the path forward rather than first having to address why the termination had not been disclosed.
Watch the calendar, not just the rent roll
Termination is not the only lease event that can affect a loan.
In another example, we had a timing conflict between the loan documents and the lease. The loan documents required cash management to begin 12 months before a major lease expires unless the tenant has renewed on terms acceptable to the lender. Yet the lease requires the tenant to give only six months’ notice of renewal.
The property can be performing as expected and still trigger cash management. The lesson is that the loan documents and leases may operate on different timelines. Reviewing those timelines together at origination can help identify potential trigger dates well before they occur, rather than discovering the mismatch when a lease is already approaching expiration.
Other tenant-related events can have similar consequences. Depending on the loan documents, a major tenant default, bankruptcy, “go dark” event, cancellation notice or credit-rating downgrade may also activate loan provisions.
Bring the servicer in early
When a significant tenant gives notice of termination or non-renewal, borrowers should involve their servicer promptly. Early communication allows the borrower to explain the circumstances, present its plan for the space and address any loan requirements before the issue surfaces later through a rent roll, operating statement or other financial reporting.
This can be particularly important when asking the lender to deviate from the loan documents, such as by allowing the borrower to retain termination proceeds that would otherwise be held for re-leasing.
Before agreeing to a termination, surrender, amendment or other significant lease action, borrowers should understand the applicable major lease definition, lender consent requirements, trigger events, reporting deadlines, treatment of termination proceeds, and any related cash management or reserve provisions.
Bottom line
Major lease terminations should never be treated as ordinary leasing events. Knowing what the loan documents require and coming to the lender and servicer early with a thoughtful plan can provide a clearer and more transparent path for addressing both the termination and what comes next. It’s also a good example of how relationship-based servicing at origination can pay big dividends, helping both the borrower and lender navigate the unexpected issues that can arise over the life of the loan.