Most commercial tenants believe that securing an option to extend their lease term upon expiration is important. They realize how inconvenient, perhaps even devastating, being forced to relocate their business can be if they need to remain in place. While a tenant may ensure that an extension option is included in their lease, they may not pay sufficient attention to the details of the actual provision because the “event” does not occur for five or 10 years and there are so many other controversial issues in the lease that must be negotiated.
“Extension options are typically the type of lease provisions that initially appear straightforward. They may ramble on for many paragraphs and can be quite tedious to review and understand,” says Robert Chavez, founder and CEO of Guardian Commercial Realty. “It can be very easy to gloss over important details or restrictions. It is even more difficult to identify missing provisions that are essential to a meaningful extension option. Accordingly, extension options can lead to big surprises when the tenant least expects them. Surprisingly, however, the majority of commercial tenants seldom formally exercise their extension options.”
Smart Business learned more from Chavez about why an extension option must be properly drafted when they are essential on the one hand, and why so many tenants elect not to exercise them on the other.
What are the essential elements of a meaningful extension option?
At a minimum, tenants should make certain the following issues are addressed in their extension option:
ν Ensuring the notice period required is reasonable. A landlord may propose 12 -18 months prior written notice from a tenant to exercise its option. This is too long, as the tenant may not be able to project its needs so far in advance. A more reasonable time period is six to nine months.
ν Formulating the new rental rate. The exact option rent is seldom specifically set forth in the lease provision. Along with other material business points, the landlord and tenant must agree upon the new rental rate. This is often the most controversial issue between the landlord and tenant when negotiating Extension Options. Some leases initially offer what appears to be a reasonable fair market value (FMV) compromise, only to also state that the option rent shall in no event be lower than the last month’s rent of the primary lease term. This is not reasonable, as it could force the tenant into an above-market rent rate.
ν Defining fair market value. FMV should be a reasonable standard for both landlord and tenant to consider as a benchmark when determining rent and other material business points of the extension option. Moreover, FMV should be carefully defined in the option to minimize discrepancies between the parties. At a minimum, it is essential that tenants define FMV to include all concessions being offered in the market for similarly situated tenants. Why should a landlord not concede items such as rental abatement, tenant improvement allowances, moving allowances, parking concessions and the like if it is routinely given to a new tenant. A tenant should not be penalized for exercising its option. After all, the landlord also benefits from the tenant’s continued occupancy and cash flow as opposed to losing the tenant and then having to absorb the added expense and downtime to secure a new tenant. It is not unreasonable for a tenant to request 95 percent of FMV given that the landlord’s occupancy is secured and risk mitigated. This is all part of the negotiation.
ν Arbitration terms. There may be instances where the tenant has exercised its option to extend and simply cannot come to acceptable terms regarding the new rent or other material business points with the landlord. In such instances, the parties must use one or more third parties to arbitrate these terms. It is essential that the tenant have a memorialized set of rules and guidelines that the arbitrators must abide by. While there are many forms of arbitration, baseball arbitration is popular. Each party agrees upon one neutral arbitrator. The landlord and tenant submit their respective terms to the arbitrator who must select either the landlords or tenants terms — period. The arbitrator cannot make any adjustments. They select whichever position they believe is most reflective of the market, or as otherwise defined under the structure of the extension option language in the lease. This process often brings the parties so close (since neither is inclined to overstate their position and lose) that they agree on terms before the arbitrator has to make a final determination.
When are options most important?
Tenants must exercise tremendous caution with Extension Options when they have: i) a ‘special use’ facility that would be expensive to duplicate, ii) a prime location essential to their business, iii) premises with substantial over-standard improvements, or iv) an industrial facility with heavy equipment that is prohibitively expensive to relocate. Landlords are well aware that they have tremendous leverage in these circumstances. Under these circumstances, tenants can be reluctantly forced into exercising an unsatisfactory option because it is simply too risky not to secure the space. This is one area where planning ahead is so vital. Failure to properly draft the extension option when the lease is being negotiated, long before the option is needed, can have massive economic consequences to a tenant.
On the other hand, traditional office tenants may not be so sensitive to a particular building, location or product type. For accountants, lawyers and other general office uses a building is a building provided it is substantially similar in quality and properly managed. Traditional office tenants seldom exercise extension options. They simply negotiate new terms separate and apart from the option. Note however, that there have been periods such as the dot-com era where the landlord market is so white-hot that office space is in short supply. While rare, the competition for space is so intense that landlords have had the luxury of selecting from a pool of tenants at exorbitant rates, and have even negotiated to participate in the profitability of the tenant’s business. In such a market it can be very comforting to know that your space can be protected by exercising your extension option.
Robert Chavez is founder and CEO of Guardian Commercial Realty. Reach him at [email protected] or (310) 882-2060.