A lease renewal option is a clause within the initial agreement that allows the tenant to extend their lease at specified terms in the future.
Renewal options, or extensions, are often for a specified period of time and there can be multiple option periods (e.g. two, 36-month options). Renewals are a great way for tenants to ensure they can remain in the space beyond their initial lease term if desired, while reducing liability and maintaining the flexible to vacate if needed.
There’s typically a set number of renewal options for defined periods of time, where the tenant simply provides notice that they intend to exercise their renewal a certain number of days prior to expiration of their existing term; however, renewals can also be automatically contingent on external factors like receiving a government contract, for example.
Also, it’s not unusual for tenants to renegotiate renewal terms as their existing lease nears completion particularly if the terms are clearly not in line with market. For example, if the initial agreement was signed seven years ago and market rent is now 50% of the rate specified in the renewal option, the terms can likely be renegotiated assuming the landlord wants to retain the tenant’s occupancy.
Sometimes, tenants will extend their leases early (e.g. exercise their future five-year option halfway through their initial seven-year term) as part of a negotiation with the landlord, in exchange for the landlord providing something like an expansion to the premises or a TI allowance.
Pat’s Pizza Pies (PPP) is leasing a 3,000 sq. ft. space for a pizza restaurant. PPP ideally wants to be able to occupy the space for nine years, but wants the flexibility to be able to vacate after five years.
Given their situation, PPP decides to sign a five-year lease with two, 24-month options to extend, guaranteeing that they’ll have the ability to occupy the space for nine years but limiting their liability to five years.
Things to Consider
Besides the obvious, there are a few intricacies that PPP should consider when negotiating the renewal options, including the potential impact of terms like rent escalations and concessions.
PPP’s base rental rate for the initial lease term is $40.00 per square foot, and the rate escalates 3% annually. The landlord’s proposal implies this escalation will continue into the renewal options. The proposed rent schedule looks like this:
While it’s certainly possible that market recent increases at rate equivalent to the contractual 3% compounded escalations, there’s also a strong possibility that it does not. Particularly when options occur far out into the future, you may not want to commit to continued future escalations determined in the present.
To avoid this, it’s not uncommon to reset to “fair market rent” upon renewal, though that usually involves engaging outside experts to determine market rent rate which can get messy. There’s also the possibility that market rent inflates beyond your expectations, in which case you’re obviously at an advantage if you’ve locked in the rental rate in advance.
Another factor to consider when negotiating renewal options is the impact of any concessions provided for the initial lease term.
During the initial term, let’s say the landlord applied a $4.00 per sq. ft. upward adjustment to PPP’s rental rate in order to amortize the $20.00 tenant improvement allowance over the five-year term. They also adjusted the rent upward to account for a three-month rent abatement provided upon commencement of the lease.
Since the landlord theoretically recouped these concessions within the initial five-year term, there’s a clear argument that rent during the renewal options should be adjusted back down to market, assuming no additional concessions are provided.