Having an option to renew is a terrific benefit to any tenant and represents a substantial landlord concession. Let me count some of the ways.
Most significant-especially for tenants to whom location is very important, like retailers and medical offices-it gives continuity of service to customers. The lease/location becomes an important part of the company’s good will, especially when large sums of money in custom TI work have been invested. Further advantages include lengthened depreciation on improvements and avoiding the downtime and loss of business that can result from a move.
Bottom line: Every tenant negotiation should have a renewal option as one of its main goals. Without an option to renew, you can be forced out at the end of your lease, resulting in costly (and serious) disruptions to your business. Planning for business continuity is an insurance policy that can save the tenant (and counsel) untold cost and frustration in the long run.
The option language often reflects the parties’ goal of some cost certainty; for example, negotiation of a fixed increase during the renewal term (say the 3 percent per annum that the tenant has been paying annually during the initial term). More typically on a larger deal, the renewal rent is keyed to Fair Market Value (FMV), and as the renewal notice date nears, the tenant can then get an idea of the market and make a more educated decision as to whether or not to renew.
While they rarely outweigh the pluses, some downsides for the tenant include not being able to precisely know the rent, or missing the notice date (very telling in those business areas where automatic renewal clauses are common and the tenant must give a certain amount of notice if it does not wish to renew).
Also, changes in lease accounting as proposed by the FASB (Financial Accounting Standards Board) will make a drastic difference in the way lease obligations are featured on tenants’ books. Now leases are carried as an expense; the new rules will require that lease obligations be shown as a liability. What this means for the tenant is that the renewal option will now be factored in on the liability side of its balance sheet. Many believe that will make having an option less attractive.
Let’s not forget the landlord’s perspective, which views the option as potentially troublesome and costly-a sometimes necessary evil. It is generally regarded as a significant concession. This is stated as a corollary to the “rule” that landlords are at risk when tenants are granted lease rights that may reduce the landlord’s control over the premises.
That degree of risk can be mitigated by pre-exercise criteria (e.g., tenant not in default), and a long notice period (typically six months to a year). The longer notice period gives the opportunity to seek a replacement tenant should that be necessary, and the pre-conditions are typically designed to make sure that the landlord is not stuck with a chronically defaulting tenant for any longer than the (now regretted) initial term.
What then are the hallmarks of the option clause?
1. Conditions precedent: Tenant not in default. But as of when? The date of the notice of exercise of option? The date the option term begins? Both? Anytime during the term? Also, what of a default that occurred during the term but has been long-cured? Must the default be material? Have required notice and opportunity to cure periods run?
2. Option notice: Where to be sent? When? Form (language)? Signed by? May attorneys give notices?
3. Method of delivery: Certified mail? Overnight courier?
4. Date deemed delivered: On mailing? Three days after mailing? Deemed next-day delivery?
5. Renewal rent: Fixed or formula? If formula, mechanism to implement. Note that a lease that says “the rent for the renewal term will be set per the parties’ agreement”-i.e., one without a fixed rent or a formula and mechanism for determining rent will be unenforceable as an “agreement to agree.” Today, the most common is FMV, as determined by baseball arbitration (to be discussed in detail in Part 2 of this article).
So the exercise of the renewal option is in the tenant’s court. What are some of the relevant criteria? They include an analysis of the current market; available alternative space; determination of the real cost of moving; and, significantly, whether the current space is still adequate for the tenant’s business needs-and the same goes for the length of the renewal term.
Of course, here’s where the tenant’s savvy real estate adviser will earn his or her keep.
Exercising the Option
Many cases hold that to be effective, the option must be exercised “clearly and unequivocally” in strict accordance with the lease. The tenant must be in compliance with conditions precedent-i.e., no rent default-and the notice of exercise of option given exactly as prescribed: address, addressee and method of delivery. (By the way, this is not the time to add qualifying matters like “I’m exercising this option provided landlord gets the elevator to work” or the like, as that may be deemed to negate the notice-dilute the message-meaning that a court may rule the renewal option has not been properly exercised.)