Extension Options in a Commercial Lease
Extension options, sometimes called renewal options, are a provision in a commercial lease that grants the tenant the right, but not the obligation, to extend the lease term for an additional period. This right is typically exercised before the expiration of the original lease term, providing the tenant with a predetermined window to opt in for the extension.
Extension options are designed to offer tenants stability and predictability, allowing them to continue occupying the leased premises under agreed-upon terms. For landlords, these options can ensure continued tenancy, reducing the risk of vacancy and the associated costs of finding new tenants.
Important Considerations in Negotiating an Extension Option
When negotiating an extension option, several critical factors must be considered to ensure that the provision aligns with both the tenant’s and landlord’s interests. Two primary areas of focus include the time frame within which the option must be exercised and the basis for determining the rental rate during the extension period.
1. Time Frame for Exercising the Option
The time frame within which a tenant must exercise the extension option is a crucial element of the agreement. This period, often referred to as the “exercise window,” dictates when the tenant must notify the landlord of their intent to extend the lease.
Considerations:
– Advance Notice Requirement: The lease should clearly specify the amount of advance notice the tenant must provide to exercise the extension option. Commonly, this notice period ranges from six months to a year before the lease’s expiration. The purpose of this requirement is to give the landlord adequate time to plan for the future, whether that involves preparing for the tenant’s continued occupancy or marketing the space to new tenants.
– Failure to Timely Exercise: It is important for tenants to understand the consequences of failing to exercise the option within the designated time frame. Typically, missing the deadline results in the automatic forfeiture of the right to extend, potentially leaving the tenant without the opportunity to remain in the space.
2. Rental Rate for the Extension Term
Determining the rental rate for the extension term is a pivotal aspect of negotiating an extension option. The rent can either be a predetermined fixed amount or based on the fair market rental value (FMV) of the property at the time of the extension.
Fixed Rental Amount:
A fixed rental amount provides clarity and predictability for both parties. The lease specifies the rent for the extension term at the time the option is granted, often as a percentage increase over the existing rent or based on a specified formula. This approach offers simplicity but may not reflect changes in market conditions.
The inclusion of a fixed rental amount is an extremely tenant favorable condition. While at first glance, a fixed option may appear relatively neutral, in reality such an option exclusively favors the tenant. This is because, if market rent at the time the option must be exercised is lower than the rental rate provided in the option, the tenant can likely negotiate a lease extension with the landlord at this lower rate without exercising the option provided in the lease. However, if marker rent is higher than the rent provided in the option, the tenant has a favorable right to extend the lease at a below market rate. The significance of this right is only compounded if the tenant has multiple extension options.
The impact of a fixed rate extension option on a landlord is exacerbated when you consider that the value of a property is largely related to the income stream produced by the rents. If a tenant has a series of fixed rate options and market rates significantly exceed the rental rate provided for in those fixed options, the value of the property will be significantly less than if the lease had provided for fair market value extension options. Landlords should think vary carefully before agreeing to a fixed rate extension option.
Fair Market Rental Value (FMV):
In the case of an extension right in which the rent is based on fair market value, several factors need careful consideration.
Considerations for Determining FMV:
– Comparable Properties: The FMV is typically determined by comparing the subject property with similar properties in the same market. This comparable set should include properties with similar characteristics, such as size, location, amenities, and condition. The process may involve reviewing recent leases of comparable properties to establish a market rate. The lease should be specific as to what competitive set will be used for the purpose of calculating fair market value.
– Landlord’s Savings: The lease should specify whether or not the calculation of FMV may take into account the savings the landlord realizes by extending the lease with an existing tenant rather than securing a new one. These savings can include reduced downtime, leasing commissions, tenant improvement allowances, and marketing costs. Acknowledging these savings can result in a lower rental rate for the tenant. It is common for a negotiated extension provision to provide that this consideration will be excluded when calculating FMV.
– Benefit of Existing Improvements: The lease should also specify whether or not existing improvements made by the tenant may also be considered when determining the FMV. If the tenant has invested significantly in the space, the value of those improvements and their specific utility to the tenant may result in a higher rental rate for the tenant. It is common for a negotiated extension provision to provide that this consideration will be excluded when calculating FMV.
– Present Use vs. Highest and Best Use: Another important consideration is whether the FMV should be based on the present use of the property or its highest and best use. The present use reflects the tenant’s current operations and market positioning, while the highest and best use considers the most profitable legal use of the property. Determining the appropriate basis can impact the rent significantly, particularly in rapidly evolving markets or areas with diverse potential uses. In many cases, it makes sense to base FMV calculation on the current use of the property, but there are instances in which it is appropriate to base the FMV calculation on the highest and best use of the property.
– Dispute Resolution Mechanism: If the parties cannot agree on the FMV, the lease may include a mechanism for resolving disputes. One common approach is so-called “baseball arbitration,” where each party engages a broker to provide a calculation of FMV. If the brokers cannot agree on an appropriate FMV calculation, the two brokers each submit their proposed FMV to a third broker acting as a neutral arbitrator. The arbitrator then chooses one of the submitted values, without modification, based on which is deemed more reasonable. This method encourages both parties to propose realistic values and facilitates a fair resolution.
Tenant and Landlord Perspectives
Tenant Considerations:
Tenants should carefully assess the terms of an extension option to ensure that they align with their long-term business plans. Key considerations include understanding the timing requirements for exercising the option, the predictability of rental costs, and the flexibility to accommodate business growth or market changes. For tenants, it may be desirable to have a short initial lease term allowing them to close down the business if the location proves to be unsuccessful, but a series of extension rights allowing them to extend their tenancy if the location becomes successful, so that the tenant can continue to operate out of the same premises without interruption to their business.
Landlord Considerations:
For landlords, extension options provide a mechanism to retain desirable tenants and maintain stable occupancy rates. However, landlords must balance this stability with other potential uses for the property that they may wish to explore in the future. While extension options are FMV are generally desirable for a landlord, fixed rate extensions must be approached with caution.
Conclusion
Ultimately, the successful negotiation of an extension option requires clear communication, careful planning, and often the guidance of experienced legal and real estate professionals. By addressing these considerations thoughtfully, both tenants and landlords can secure terms that support their respective goals and foster a positive, long-term leasing relationship.
