§ 24.01 Options to Renew or Extend

• Jurisdiction: United States
• Publication year: 2022

§ 24.01 Options to Renew or Extend

One rule governs a tenant's strategy with options: "If you can get them, take them."² Options take many forms and are exercisable at different times. Among the options are renewal, holdover, expansion, contraction and cancellation. The tenant may also rent with an option to buy.³ The most common ones are renewal, holdover, expansion, cancellation and purchase options. Each of these options gives the tenant a benefit that will be useful during the lease term usually at no or low cost until it is exercised. A tenant should negotiate for these options at the beginning of the deal. Otherwise, as time goes by and the possibility of exercise becomes more likely or imminent, the cost will go up substantially or the option may no longer be obtainable.

Options are triggered by the tenant's timely notice to the landlord stating that the option is being exercised.⁴ Often leases will contain a "time is of the essence" requirement with respect to such notice. Renewal options allow the tenant to: (1) extend its lease term for (2) a "stated number of years (might be fixed or optional)," (3) for "part or all of the space," (4) "at a rental rate (and concession package) that is fixed or a function of market."⁵ Expansion options allow the tenant to add a fixed or variable amount of space to the leased premises. The option generally permits the expansion for the balance of the lease term and the rental rate (and concession package) can be "fixed, or fixed based on the prorated shorter lease term, or a function of market."⁶ In a down economy or if a tenant is a start up or simply concerned about its future success, the contraction and cancellation options are especially important. These types of options generally require the payment of a fee by the tenant either to reflect a market loss amount (for time to re-lease the premises) or a reimbursement amount to cover the "landlord expenses (e.g., unamortized leasehold allowances and brokerage commissions)."⁷

Some of the issues to consider when negotiating an option include:

(1) Will this right be a one-time right or will it be a right continuing throughout the term of the lease?

(2) What is the time frame for tenant's exercise of his option?

(3) What if the tenant does not exercise a right or option the first time it is offered, will that preclude exercise in the future?

Clearly such rights or options limit the landlord's ability to lease space and he or she will want to place restrictions of the time within which the tenant must act.

Additionally, it is not easy to keep track of the leases, rights and interests in a building, especially a large building with many tenants. Landlord and his counsel can keep track of the building information by developing a "stacking plan" for the property. Basically, this is a chart listing the leased premises by floor, indicating the lease commencement and expiration dates for each and any other rights the tenants have to expand or change their interests.⁸ This type of plan allows the landlord and tenant to review interests at a glance. Lease abstracts or summaries, rent rolls and computer-database driven leasing files are also very helpful in seeing the information necessary to plan for the future.⁹

[1]—Why Obtain an Option?

There are many reasons that a tenant may want option rights. Flexibility if certainly an importance one, allowing the tenant to adapt to changing corporate needs. According to an industry survey,¹⁰ corporate managers gave the following reasons for obtaining lease options:

• Renewal,

• Sublease,

• Options to leave early with a pre-established buyout price,

• Space Expansion, and

• Space Reduction.

The interesting finding of this survey was the emphasis given to early buyout and space reduction rights, areas not usually a chief concern of corporate real estate executives. Perhaps this reflects the fact that corporations are downsizing. Even in a good economy, managers and real estate professionals had to deal with this phenomenon.

With any type of option, parties should seek the same flexibility they desire in an assignment or subletting clause. Depending on economic conditions, parties may want to have either liberal contraction or expansion rights. Options can be structured to give the tenant the ability to expand or, in this age of downsizing, to contract its operation within the premises without incurring penalties or the liability for default.

A shorter term with renewal options may be great for a small company unable to forecast how successful it will be. It also assures the tenant that he or she can renew at a specified rate (or in accordance with a set formula). If the market takes a downturn, the tenant can opt not to renew and do better in the general market. However, if prices go up, the tenant can stay on at the agreed upon rate. Renewal options can also benefit the landlord. Making the right to renew contingent upon the tenant's compliance with the lease terms—the tenant's good standing—serves as an incentive for the tenant to comply with its obligations under the lease. It is also something the landlord can offer in return for a tenant concession.

The tenant's desire with all options is to increase its flexibility in handling its lease interests and capitalizing on its stay at the premises. In general, options are unilateral to the tenant. They may not necessarily be exercised, but they give the tenant leeway and flexibility when negotiating with its current landlord or with other potential landlords.

[2]—Definitions

An option clause is a provision that gives a party, usually the tenant, a right within the specified time of carrying out a transaction upon stipulated terms. The instances for which options are typically given are: (1) renewal; (2) first refusal; (3) expansion or contraction; (4) cancellation; and (5) purchase rights.

A renewal option is a provision that gives the tenant the right, upon notice, to extend the lease after the expiration of the term or previous renewal period either at the set rent or rent to be determined either by appraisal or agreement.

An expansion right is the tenant's ability under contract to extend the term, usually at specifically designated points, or to acquire additional space in the building. This can be contrasted with a right of first offer in which the landlord must come to the tenant before it can market the space. In addition, the lease may be structured with a first refusal right. In such a situation, the landlord obtains a bona fide lessee and deal in order to test the market, then offers the space to the tenant. If the tenant refuses the offer, only then is the landlord free to make the deal with the next lessee.

A cancellation or early buyout right is a lease provision that gives the tenant a right to terminate the lease at a certain point during the term usually for a pre-determined fee. These are rarely given. The lease may also provide for the parties to have cancellation rights in certain instances, such as destruction of the building or premises or breakdown of services.

A holdover clause is a stated provision in the lease that addresses the status of the tenant who remains in the premises after the term's expiration. With the landlord's permission, a tenant in a holdover situation usually is in a month-to-month tenancy or other short term tenancy. The tenant remains liable for its contractual and lease obligation during the holdover tenancy and there is usually a premium attached to the holdover rent. Holdover rights are not automatically granted and in some instances the tenant may end up being a tenant at sufferance, or a legal trespasser if it stays in the premises after the lease term expires. Holdover provisions typically are structured to permit the tenant to remain in the premises after the term, usually to accommodate its need for additional time while it is fitting out its new space. These provisions usually set a high fee typically 150 to 200% of the last year's base rent or current base, with the tenant remaining liable to the landlord for the landlord's potential loss of a succeeding tenant in this space should be holdover result in a termination or reformation of a successor lease interest at the premises. Care must be taken with a holdover subtenant since a subtenant's illegal holdover at the premises may trigger additional penalties for the master tenant under its lease that may not be covered in a lease clause with the subtenant.

Purchase rights are rarely given to a tenant, but if given, may permit the tenant considerable leeway in capitalizing upon a profitable leasing transaction. A fair buyout price requires the tenant to reimburse the owner for the unamortized costs of the improvements in the premises to pay the owner some monies to compensate for its loss of profits on the lease and the costs in renewing the space. This price is customarily established at the time the lease is negotiated. Purchase options prices, on the other hand, would be set either during the contract negotiations or by appraisal at the time of that the option is exercised.

[3]—Essential Option Terms

As might be expected, the issue of what an option contract must contain to be enforceable has been subject to litigation. The court must assure itself that there was a definite "meeting of the minds" between the option parties and that essential terms of the option were not left to future negotiations.¹¹

Generally speaking, specific performance of an option requires a higher standard of proof than that for legal damages. There must be clear and convincing evidence that leaves no doubt as to the option terms.¹² All the material and central terms must be stated in the option contract before a court may grant an order for specific performance. One court outlined the following material terms: (1) time and manner for transferring title; (2) a procedure for declaring forfeiture; (3) allocation of the risk with respect to damages or...