The Lease Break – Future Rent Debate

THE LEASE BREAK – FUTURE RENT DEBATE

Your lease should cover how much money residents will owe when residents break their leases and move out early.  Most leases require residents to pay rent for the remaining term or until the unit is re-rented (future rent clause) or a fixed sum for moving out prior to the end of the term (lease break clause).  Lease break lease clauses are commonly referred to as lease break fees, breakers, lease termination fees, or liquidated damages.  Recently, some clients have been reevaluating the advantages and disadvantages of lease break fees.  In particular, clients are re-visiting the issue of whether lease break fees are enforceable.  Because no Colorado Appellate Court has ever ruled on the enforceability of lease break fees, lease break fees are not without legal risk, and you should only adopt lease break fees in your lease after carefully evaluating the associated advantages, disadvantages, and risks.

Over the last ten years, the clear trend has been away from future rent clauses towards lease break fees.  A majority of owners and management companies now have some form of “liquidated damage” or “lease break” clause in their lease rather than a future rent clause.  Lease break fees take many forms.  However, the essence of any lease break fee is that the resident has to pay a sum of money if the resident breaks their lease prior to the end of the term.  Unlike the concept of future rent, residents are liable for the lease break fee regardless of whether the unit is re-rented.

Both lease break fees and future rent clauses have various pros and cons.  Accounting simplicity is often touted as a major advantage of lease break clauses.  Once the resident is out, the amount due can be determined immediately.  Unlike when you use a future rent clause, you don’t need to document or maintain records about re-leasing the unit, and then later recalculate amounts based on when the unit was re-leased.  In contrast, clients have told us that future rent clauses are problematic from an accounting perspective.  Because the resident remains liable for rent from the date of move-out until the unit is re-rented, the resident’s liability is not fixed until sometime in the future.  All the while, you have to track all aspects of the accounting.

Financially, the camps are split.  The lease break camp contends that lease break fees generate more revenue because the breaking resident is much more likely to pay a lease break fee as opposed to future rent.  In direct contrast, the future rent camp argues that future rent clauses generate more revenue in the long run.  Future rent proponents reason that lease break fees provide incentives for residents to break their leases.  Under a future rent clause, a resident who wants to or does break his lease is liable for the rent for the remainder of the term, or until the unit is re-rented.  If you have a lease break fee, the resident knows that the most they can be liable for is the lease break fee.  In the resident’s mind, the lease break fee isn’t that bad, so they break their lease and pay it.

Residents may view lease break fees as especially attractive if the resident is on a twelve month lease, and wants to break a two months into the term.  If the rent is $800 per month and your breaker is two month’s rent, the worst case is $1,600.  The resident can live with this.  On the other hand, a resident faced with the same facts under a future rent clause won’t want to risk being on the hook for $8,000 (10 months at $800).  Thus, arguably, residents who are liable for future rent are less likely to break their leases.  The rent you get paid by non-breakers exceeds the amount you receive in lease break fees.  The counter to this argument is the property gets the lease break fee and the revenue from a new resident.  This of course assumes you can re-rent promptly, and if challenged, that your lease break fee holds up in court.  Neither of these propositions are a given.

Residents who don’t pay end up in collections, which often means in court.  Regardless of whether you have to file suit to collect, lease break fees are the first to go as part of the collection (settlement) negotiating process.  Residents won’t settle or pay if you don’t reduce or waive the lease break fees. Future rent is also subject to reduction as a bargaining chip to induce settlement and payment. Since future rent is generally much higher, the corresponding reduction still generates more revenue than a lease break fee.  By way of example, assume a 12-month lease at $800 per month, and the resident breaks after two months.  If your breaker is set at two months, the resident owes $1600.  This gets reduced in the collection process to $800 to settle the case.  If you have a future rent clause and you don’t re-rent for 4 months, the resident owes $3,200.  Even if you cut by 50% to get the case settled, you get twice as much as you would have with a lease break fees clause.

Obviously, financial outcomes are dependent on property type, location, and resident composition.  Regardless of whether you use future rent or a lease break fee, collections are heavily scenario driven.  For example, under a future rent scenario, residents who break their leases late in the term, generally owe smaller balances, and thus are probably more likely to pay.  Because there are countless lease break scenarios that could affect a financial outcome, only you can determine the financial advantages and disadvantages of using a lease break fees clause as opposed to a future rent clause.

If lease break fees have the advantage from an accounting or collection standpoint, the exact opposite is true from an enforceability perspective.  Future rent has a decisive advantage over lease break fees when it comes to enforcement in court.  Future rent clauses are enforceable as supported by years of Colorado case law.  Under Colorado law if a resident breaks their lease, as damages, the resident owes you the rent for the remainder of the term subject to your duty to mitigate damages by re-renting the unit.

The courts will enforce future rent clauses one hundred percent of the time.  However, residents may still try to reduce damages by challenging your mitigation efforts or other aspects of your damages.  When sued for future rent, some residents claim that you didn’t make efforts to re-rent their particular unit, i.e. you rented all your other available inventory first.  This argument is almost always overcome if you maintain regular procedures for showing units, i.e. all prospects are made aware of all units of the type that the prospect is interested in (example 2 bedrooms), and prospect is informed of the availability of all units in inventory including the breaching resident’s empty unit. Usually such procedures, coupled with a lack of any evidence that the onsite management steered prospects away from the breaching resident’s unit are sufficient to prevail in court.  You should be aware that some breaching residents have actually gone as far as to send a prospect in to see if they are steered away from the breaching resident’s unit.

Concerns about the ultimate enforceability of lease break fees are a primary reason why landlords choose to go with a future rent clause.  With lease break fees, you always face the prospect that some judge will say that such fees are an unenforceable penalty provision.  Sometimes courts enforce lease break fees and sometimes they don’t.  Whether the collection courts (Colorado County Courts) will enforce lease break fees cannot be predicted with any consistency.  Our affiliated collection law firm states that at best lease break fees will be enforced 50% of the time in collection lawsuits.  From a legal perspective, the main problem with enforcement of lease break fees is lack of any legal precedent.  No Colorado Appellate Court has ever ruled on the enforceability of lease break fees.  Whether such clauses will ultimately be enforced on a consistent basis remains to be determined by a Colorado Appellate Court.  Given the number of landlords that are using such clauses, we envision seeing a reported opinion on such clauses within the next 3 to 5 years.

Some courts have not enforced lease break fees on the grounds that they either do not meet the requirements for a liquidated damages provision or are a penalty.  While no Colorado Court has ever ruled on lease break fees, plenty of Colorado legal authority exists for residents to make strong analogous arguments that Colorado legal precedent on liquidated damages clauses should apply to lease break fees.  However, under liquidated damages legal precedent courts could readily conclude that lease break fees are a penalty, and thus not enforceable.  Residents are becoming more aware of these arguments, and they are asserting them more often.  Resident awareness of potential valid legal challenges to lease break fees is a main reason that the industry has recently begun to re-evaluate this issue.

If you use a lease break fee, you have to be reasonable.  The higher the break fee, the less likely it will be enforced because the court is much more likely to view it as a penalty.  We have seen lease break fees set as high as three months rent.  We estimate the chances of this being enforced at nearly zero.  If you set your break fee at two month’s rent, the chances of it being enforced are less than 50%.  By far a lease break fee set at one month’s rent has the greatest chance of being enforced in court.  Courts don’t split or reduce lease break fees.  Thus, if you go to court on a lease break fee, the court will either award you the lease break fee, or award you nothing.

Your lease break fee can’t result in a windfall.  Assuming that a resident honors his lease and pays all amounts due, you will receive a certain amount.  If under a lease break scenario involving this same resident you would receive more than you would have if the resident had paid all amounts due under the lease, the lease break fee is not very likely to be enforced.  Enforceability of lease break fees can also greatly depend on how the lease break fee is written.  We have reviewed many leases where the lease break language could be substantially improved.

If you have a lease break fee, you should consider adopting a “play the percentages strategy”.  Collect it when you can; however, be open to compromising on the fee or reducing it as a bargaining chip to settle resident balances when residents challenge the break fee.  You should consider this because if you go to court your chances of collecting it are at best 50/50.  However, some argue that a playing the percentages strategy has its own disadvantages.  Mainly, word will get out that all you do to is challenge the lease break fee, and the property will waive it.

One potential solution to the problem is to have both a future rent clause and a lease break fee in your lease.  If the lease break fee is knocked out by the court (ruled an unenforceable penalty), you could fall back on the future rent clause.  However, no client has opted for this solution.  Clients who have lease break fee lease provisions want the resident to pay the lease break fee, and feel that the presence of a future rent clause is just a red flag to the breaching resident not to pay the lease break fee.  They reason that the resident will see the future rent clause and then opt not to pay it because the resident will just take their chances that either 1) the clause will not be enforced (you would have to have language saying that if it is not enforceable then future rent clause kicks in), or 2) you will re-rent the unit and thus they will come out ahead.  While it is permissible to have both clauses, you can’t collect double rent.

Within the last couple of years, we have seen a hybrid policy emerge. The policy is simple and incorporates both future rent and lease break fee concepts.  If a resident breaks, the resident owes future rent until the unit is re-rented.  However, if the resident wants to break his lease and wants to resolve potential future liability, the resident is given the option of paying an early termination fee (equivalent of a lease break fee).  The early termination fee can be a fixed amount, or can be set on a sliding scale by factoring lease term and the remaining unexpired term.

This hybrid solution is not a perfect solution.  Many, if not all, future rent disadvantages still apply.  However, it does eliminate all lease break disadvantages while preserving all lease break advantages if the resident elects to pay the early termination fee.  The fee is impervious to legal challenge because it is nothing more than an agreed upon settlement of a debt owed by the resident.  In short, the policy eliminates the resident’s ability to argue that the lease break fee (early termination fee) is a penalty.  “Your honor, they didn’t have to pay the fee, we gave them the option, they could have taken their chances as to when their unit was re-rented, and they elected not to take that chance, they chose to pay the early termination fee”.

While there is no decisive trend at the moment, the trend over time has been slowly and consistently moving away from enforceability of lease break fees, especially lease break fees set at more than one month’s rent.  Currently, no more than half of the courts are enforcing lease break fees.  Due to the legal uncertainty that lease break fees will be enforced, you must decide if you are willing to take the risk that they will be enforced.  If you’re interested in a more detailed discussion of applicable case law and the legal factors courts consider when determining the enforceability of lease break fees, our full lease break memo is available to clients on our website (htspc.com).  Client login is required.

View Resource »