Demystifying the ancient art of Options for commercial and retail property leases
In our experience in working with Tenants to negotiate renewal terms, we often come across situations where a Tenant has an option. Unfortunately, rarely do we see the Tenant fully understanding their rights under the option or knowing that their option expires on a date prior to their lease expiry date. Also, not knowing if they can still negotiate the rent and not understanding what they need to do to formally exercise their option.
In this article we demystify the ancient art of Options for commercial and retail property leases and help you understand your rights as a Tenant.
1. What is a Renewal Option in a Lease?
An option in a commercial or retail lease provides the Tenant, at their sole discretion, with the right to extend the lease for a further term. If the Tenant elects to exercise or trigger the Option, the Landlord must accept the new lease period and the terms agreed in the option, so long as…
a) The Option has been exercised or triggered within the strict time frame defined in the paperwork.
b) The Option has been properly exercised in the way set out in the Option paperwork, and
c) The Tenant is not in breach of the Lease up until the expiry of the existing Lease.
2. When Should a Renewal Option be used?
An option to renew is valuable to a Tenant who has a sustainable business and wants to be in control of the longevity for their future use of the tenancy. Being in the same location for a period of time will continue to grow the good will of the business.
From a different perspective, an option might be attractive for a newer business who may require the flexibility of a shorter lease to assess business viability and reduce long term financial liability, while retaining the ability to extend the lease term if desired.
Established and fast growing businesses can also utilise a lease option to have the protection of tenure at the existing tenancy and also have the flexibility to not sign the option to renew if they have outgrown the existing premises.
3. What will the Rent be if I Execute the Renewal Option?
There are two key elements to consider when it comes to the rent for a renewal option.
a) A Ratchet Clause or an Automatic Annual Rental Increase Percentage. This is where the rent automatically increases by a set percentage on an agreed date throughout the term of the lease. Typically, this is at the anniversary date on each year of the lease. If the renewal option sets out that the annual increase is to continue at the exercise of the option period and annually thereafter, these increases will be implemented automatically and there will be no opportunity to negotiate.
The issue with this is that after one retail renewal cycle, 10 years at 5% annual increases, the rent will increase by 63% and by 108% after two renewal cycles at year 15. If the market rent hasn’t kept pace with the annual increases, the Tenant will be paying above market rent. The other thing to consider, has the growth in sales kept up with the annual compound increase in rent?
If the annually increased rent reached a point where it was too far away from the market rent, the Tenant could decide not to execute the option and negotiate a new lease at the current market rent.
b) A Market or Independent Rent Review. This is where the Landlord and the Tenant make an assessment of the current market rent and work towards reaching an agreement of an acceptable rent to be paid. If they aren’t able to reach an agreement, then an independent valuer is appointed and the final decision must be accepted by both parties and they must share the cost of the valuer. What is critical here, is to try to aim to agree on the market rent with the Landlord, prior to the date you need to exercise the additional option term. If you exercise the option first, prior to agreeing on the market rent, then you are at the mercy of the Landlord and whether they want to negotiate. They may choose to not engage in a negotiation or be very unco-operative in negotiating, forcing the process of an independent valuer to be appointed, which means you lose control of the negotiations completely and then have to accept the result determined by the valuer, without objection.
4. Does my Option Expire?
YES! It does. Our experience in working with Tenants and their renewal options is that the option expiry date is rarely recorded and this date comes and goes without the necessary action being taken. Options typically need to be exercised between 3 to 6 months prior to the end of the Lease. This means that the work required to undertake the market rental assessment should be completed 4 to 7 months prior to the Lease expiring.
If a renewal option expires, the Tenant has lost control of the future tenure of the tenancy and given control back to the Landlord.
What this means is, if you are paying rent at below the current market value, which would have been protected under the option arrangement, the Landlord is now in a position to request that you pay the higher market rent and enter into a new lease that may not have been as favourable as the previous one.
5. How do you Execute a Renewal Option?
The form and any specific information required to execute an option will be set out in the Lease. Typically, the key steps include:
· Notifying the Landlord or the managing agent in writing that the option is to be exercised. It should be signed by the Tenant and set out the address, full name , business name, date of correspondence and noting the date the option is to be exercised by.
· Complying with any conditions set out under the option such as, work that may need to be done. This would include improvements to the fitout or shop front, ensuring that all rent and outgoings are paid in full.
· Not being in breach of the lease.
Conclusion
A renewal option is a powerful tool for business owners to develop goodwill, secure long term tenure, lock in preferable rent and provide a position of certainty if negotiated correctly. They also provide the flexibility for new businesses and fast growing organisations that may be operating in a somewhat uncertain business environment.
Over the past 25 years, Your Leasing Co. has negotiated over 1,000 leasing transactions, including new lease negotiation, renewal and option negotiations.
If you would like to get some peace of mind around how much rent you should be paying at renewal time, compared to the market, you can call us on our FREE phone hotline on 1300 356 702.