Why exercising an option in your commercial lease may not be the best option for your business…

24 Feb 2021 09:13 PM

[5-minute read]

Summary: Options for further terms in your commercial lease provide an excellent safety net for your business, however you will lose leverage if you rely on those options to secure your next lease term, likely costing your business significantly more than necessary.  To ensure you achieve the best possible financial result for your business, you should approach any potential new lease term (regardless of whether there is an option for a further term) as an opportunity to renegotiate.  You hold all the cards as a tenant – you just have to know how to play them.

As you are most likely aware when negotiating your commercial lease, multiple option periods are an excellent way of securing your property for a long-term, while giving your business the flexibility to relocate or exit the property at regular future intervals. 

In other words, option periods in your commercial lease provide your business with an excellent safety net.  If your business is performing well, you have the security of knowing you can stay in your property for at least as long as the option periods last.

The problem, however, is that options in commercial leases are mostly not treated as just a safety net for the business and that is a lost opportunity to save money or access capital.

Most businesses typically begin to think about whether they want to commit to their property for another lease term around six to twelve months before the date their lease is due to expire or the last date to exercise their option.  Then, having made the decision to stay, they serve notice to the landlord exercising the option to lease for a further term in accordance with their lease.  If there is a market review provision in the lease, they may have already agreed with the landlord what the new rent will be before exercising the option, or they may be happy to rely on the market rent review provision in the lease to ensure the rent remains at a “fair” rate.  

But here is why that approach costs businesses money they don’t even know they could save, particularly in today’s environment where a tenant holds even more cards than usual.  

A market rent review at the start of your new term lease term will never fully reflect the best deals being completed in your local real estate market.  First, they will rarely reflect incentives of new leases being entered into (the “effective rent” rate), but rather reflect the inflated, pre-incentive rent rate (or “face rent” rate).  You can read more about “effective rent” versus “face rent” here.  Second, even in declining markets where asking rental rates are reducing, there can be a lag between the best deals being completed by tenants and a market rate being determined at that reduced level.  A determining valuer will never set a new low benchmark for market rent – this can only be achieved through negotiation between a landlord and tenant.

Therefore, if you intend to stay at your property beyond your lease expiry, you should always seek to renegotiate the lease, even if you have an option to renew for a further term.  This should be done well in advance of your last date to exercise the option, when you have maximum leverage in any negotiations with your landlord (and a safety net to fall back on in case your negotiations are not fruitful).

When renegotiating your lease, the landlord should be considering your offer in the right context of what they would have to offer another tenant in the event you left the property at lease expiry (plus the costs they would have to incur to secure that new tenant).  In today’s environment, this might include an extended period of the property being vacant and not generating revenue for the landlord, advertising costs and leasing fees, plus large incentives to the new tenant by way of contributing to fit-out or extended rent-free periods.

To create this right context for the renegotiation of your lease with your landlord, your timing is absolutely critical as is the way your future intentions are portrayed to your landlord.  If your landlord believes you are seriously contemplating relocating or exiting at lease expiry, and there is sufficient time remaining on your current lease for you to relocate, then you are much more likely to create the right context for renegotiation.  (Remember, you do not have to be seriously contemplating a relocation of your business, your landlord just has to believe it is possible that you are.)

By renegotiating with your landlord in the right context, you can create a win-win scenario.  

Your landlord can avoid all of the uncertainty and cost associated with losing one tenant and sourcing another.  You can access the benefits a new tenant would such as contribution to upgrading your fit-out or a rent-free period that you cannot access by exercising your option or by relying on the market rent review provisions to set your new rent.   

By simply exercising your option, you can easily end up paying 20% more than you should for your next lease term, after taking into account a lost opportunity to receive landlord incentives such as rent-free, rent abatement or capital contributions.

How can Lpc Cresa help?

At Lpc Cresa, we help tenants across Australia and New Zealand with their commercial real estate needs, including transaction advisoryportfolio management and project management.  In summary, we make sure tenant interests are protected and that our clients enter into tenant friendly lease agreements.

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