The terms of commercial leases vary significantly depending on the type of commercial property being leased and the specific business goals of both landlords and tenants. “Option clauses,” also known as “renewal terms,” are provisions in a commercial lease agreement that allow a tenant to extend the term of the lease for an additional term after the initial term has expired. Tenants prefer option clauses because they reduce the risk of having to relocate an established business after the expiration of the initial term.
While option clauses are prevalent in commercial leasing, most landlords would probably prefer not to have to deal with them. This is especially so where the rental rate during the option period is fixed. Option clauses prevent landlords from leasing the premises on the open market and ultimately obtaining the highest possible rent. Options give tenants a choice which necessarily reduces a landlord’s flexibility. Once a tenant exercises its right to the option term, the terms of the option clause govern regardless of how good the market is at the time. That is why most landlords prefer that the rental rate during the option period be determined by the actual market rate for the premises at the time the option is exercised. This is generally a fair approach for both landlords and tenants because each side is equally exposed to the vagaries of the market.
A market rate would benefit tenants if the leasing market is especially soft when it comes time to exercise the tenant’s option. Moreover, in soft markets, tenants may be tempted to explore better options leaving landlords with empty space. To hedge against this uncertainty and in exchange for including an option clause, landlords will usually require that there be a floor to the new rental rate during the option period (usually no less than a 3% increase over the rental rate immediately preceding the option period). This provides landlords with the best of both worlds – a minimum increase in rent even if the leasing market is dismal or an increase in rent equal to the higher market rate should the market be strong. In such circumstances, tenants are better off with predetermined fixed increases in rent usually consistent with the annual increases in rent during the initial term of the lease. Either way, option clauses are inherently valuable to tenants and how the rental rate is determined during any option period under the terms of the lease will depend on the tenant’s bargaining power during commercial lease negotiations.
There are four important elements to option clauses: the notice period (the time period in which the tenant is required to give notice of its intent to exercise the option); the term(s) of the renewal period(s); the rental rate during the renewal period; and, if the new rental rate is based on the fair market value, the mechanism that will be used to determine the fair market value. A well written option clause that addresses these elements and which is tailored to memorialize the intent of both the tenant and landlord is conducive to long and rewarding tenancies. Determining the rental rate is addressed above. The mechanisms for determining the market rate at the time an option is exercised are as varied as they are complex. There are numerous examples of these mechanisms available on the internet. Generally, the terms call for the parties to submit market rates established by their respective appraisers and if they cannot agree on a rental rate based on said appraisals to refer the decision to a neutral arbitrator.
Notice requirements are often overlooked by tenants especially where the tenancy has been relatively frictionless. Tenants who feel comfortable dealing with management after years of exceptional business history may overlook the technical requirements under the option clause. Doing so can and has in many cases resulted in tenants losing their option rights and eventually resulting in the loss of their business. Tenants with option clauses in their commercial leases need to be acutely aware of the notice provisions (the time in which they are required to give notice to the landlord that they are electing to exercise their option to continue the lease and the method of giving said notice). If a tenant misses this narrow window or fails to give notice in writing, the landlord may suddenly find itself with the flexibility it desired in the first place. Regardless of how well the business relationship has been, if the market is strong and the landlord can obtain a significantly higher rent than the rent called for under the option clause, it will invariably demand the higher rent. The only way to ensure that the option is exercised is to properly do so pursuant to the notice provision in the option clause – usually a written notice sent by certified mail to be provided during the period beginning 180 days prior to the lease expiration date and 90 days prior to the lease expiration date. In negotiating the option clause, astute tenants will try to negotiate for a longer notice period.
The term of the option period generally is comparable to the initial lease term. Most commercial leases with five year terms will also call for five year option periods. However, in some cases where the initial term is very short (usually designed to test the waters for both the landlord and tenant), the option period may be longer. It is also common for there to be two option periods sometimes with a fixed rental rate for the first option period and a market rate for the second option period. Whatever the case, it’s important for the parties to give serious consideration to the term of the option period and whether two option periods are desirable.
Consult an experienced San Diego commercial lease lawyer to ensure that your lease agreement has a well-drafted option clause.