Who Benefits from a Renewal Option?
Most commercial office leases are long-term in nature, typically 5, 7 or 10 years in length, but also typically contain provisions for extending the lease beyond the initial term. A renewal clause in a real estate lease allows a tenant to decide whether or not to extend the lease once the initial lease term expires. The key concept to remember is that the renewal option is a benefit to the Tenant.
Short-Term versus Long-Term Leases
Before I decided to write this article, I did a quick on-line search of articles written on the subject of the renewal option. In most cases, these articles emphasized the point that Landlords and commercial leasing agents typically want tenants to sign long-term leases and the better approach was to sign shorter term leases with renewal options. I won’t disagree that in some cases a shorter term lease may be a more prudent strategy for some companies; however there are disadvantages to signing short-term leases including:
- Short-term leases equate to less negotiation leverage and fewer concessions.
- Tenant improvement allowance: If you need significant improvements to renovate the space to your needs then expect to come out of pocket for the costs. The shorter the lease term, the less the Landlord is going to provide in funds for tenant improvements.
- The inability to fix rental costs for a longer period and exposure to higher rental rates in subsequent renewal terms.
Most of the authors of these articles recommended asking for renewal options with predetermined increases for a series of renewal options. This sounds great in theory, if you can get the Landlord to agree to what you consider reasonable predetermined rent increases. However, the reality is very few Landlords are willing to give you that flexibility without paying a premium, even in a soft market. In other words, expect those predetermined increases to be rather significant.
The whole short-term versus long-term lease decision comes to down to flexibility and what’s the cost associated with that flexibility. There are reasons businesses sign longer term leases and short-term leases are the exception rather than the rule. Generally speaking longer term leases result in lower costs. More flexibility is sometime necessary and the additional cost or limitations associated with short-term leases is worth the trade-off.
Negotiating a Favorable Renewal Option
Landlords reluctantly grant renewal options because it limits their flexibility to market the space to prospective tenants. However, they typically recognize it’s going to be required in order to complete a lease transaction with most tenants. The “Renewal Clause” spells out when the tenant is required exercise their renewal option, the term of the renewal period and the rental amount and/or the method for determining the financial terms for the renewal period.
Elements of the Renewal Option:
Notice Period: Most renewal clauses require the tenant to give written notice to the Landlord that they are exercising their right to the renewal option within a specified period of time, often 6 or 12 months prior to the expiration of the lease. From the Tenant’s perspective you want to make this notice period as long and as flexible as possible, giving you and your broker time to thoroughly evaluate the market, solicit proposals from competitive buildings and make a good business decision while your option period is in effect.
Term: The renewal clause will state the length of the lease renewal period. If possible when negotiating the renewal clause, ask for the option to renew the lease with different length terms (i.e. 3/5 years or 5/10 years).
Rental Rate: In some cases the renewal clause will have a predetermined renewal rental rate, but the more common approach is to have the renewal financial terms tied to a determination of “fair market value” (FMV).
Fair Market Value: It is important to define in detail the definition of “fair market value” because in essence, this is a negotiation that will take place at a later date. The objective is to leave as little as possible subject to the Landlord’s interpretation of FMV. Does the definition of FMV include accounting for tenant improvement allowances, free rent, and other concessions offered by competitive buildings? Is there a floor for the minimum rent? I have often seen language in the clause that states; “in no event shall the tenant pay less than the current rental amount” Can you get a ceiling on the maximum rent; 95% of FMV? What if the Landlord and Tenant cannot agree on FMV? The renewal clause should also contain a mechanism for engaging a third party arbitrator if the two parties cannot agree to terms.
The Renewal Option Protects the Tenant
In reality, the renewal option provides very little if any benefit to the Landlord. For the tenant it is important because it can protect their rights and negotiation leverage in market conditions or a situation that is tilted in the Landlord’s favor.
- Another tenant may be willing to pay a higher rental rate than you for your current space.
- A larger tenant in the building may want your space for expansion.
- You may have made a huge financial investment in improvements or infrastructure in your space and the Landlords knows it will be cost prohibitive to move.
If you have a well structured renewal option, it acts as the framework for putting a ceiling on the costs of renewing the lease for your office space. In a soft, tenant-oriented market the renewal option is not as critical. The Landlord wants to you to renew at the best terms they can achieve, but realizes competition for your tenancy and market conditions will prevent them from invoking any predetermined framework outlined in the renewal option.
When you are negotiating your lease it is difficult to predict what business and market conditions will look like 5 or 10 years down the road. If you do not have a renewal option in your lease or it is poorly structured, it could be very costly. However, a well structured renewal option can save you a significant amount of money, particularly in a tight market.
The renewal option may seem secondary to the primary lease terms that are important to your business today. However, down the road the renewal option can have a big impact on your business. It is important to assume that market conditions are going to be in the Landlord’s favor when it becomes time to exercise the renewal option.
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