Know Your Lease Options
Learning and understanding your lease options that can help you control your costs up front and build in room for the dynamic space needs for your business. However, they can be tricky to negotiate and often Landlord’s are resistant to offering them. First, let’s do a rundown on what the most common types of options are.
Expansion Option: This one is first because it’s my favorite. It’s a simple one as well. This is a written-out, agreed-to and executed plan for growth attached to your lease. It is typically attached as a rider or an amendment to your core lease document and allows for you as a Tenant to exercise your option based on certain timing or triggers that may occur during your term. The key is that these are negotiated on the front end, so once you choose to exercise your option the space is yours, just a matter of buildout and occupancy (if any is required.) This provides you with budgeting value (prediction of increased space costs) and savings up front since you do not occupy or pay rent on the space now. Here is an example. Let’s say you sign a lease for 2,500 S.F. on the 3rd floor of an office building and it is a five-year term. There may be a space directly adjacent (attached) to yours that is coming available in two years. Often times, if that current Tenant chooses to vacate or is known to want to leave, a Landlord will be willing to give you an option to expand into that space. The rate and business points usually mirror the tenets of your current lease and provide for an extension of term, some tenant allowance, and rate adjustments where necessary.. Neat huh? Now let’s get a little more granular.
Rights of First Offer/Refusal: These go hand in hand with expansion options, but are often a little more vacuous in nature. While they can be tied to your current lease terms, sometimes they are left open since a specific space is not necessarily identified (unlike in an expansion option). The idea here is you have a right (one-time or ongoing) to match other potential lease offers on the space (s) around you within the center or building. In a Right of First Offer (ROFO), you will be presented with a bonafide letter of intent from an interested party of the space(s) adjacent or identified within your ROFO lease amendment. Typically, you have a short period of time (3-10 business days) to match this offer and sign a lease extension/amendment for the space. Yes, the Tenant who made the bona fide offer is left in the cold, but a good Landlord has let them know about your right far in advance so as to avoid getting any hopes up. If you choose not to exercise your option, that Tenant receives the space and the right goes away. Landlord’s are then free to lease it without asking you for any matching, offer or rights. One caveat: if you negotiate an ongoing ROFO, the Landlord has to ask you EVERY time they want to lease adjacent or identified spaces in your lease amendment. An ongoing ROFO is usually only reserved for the biggest tenants, but hey, no harm in asking. Next you are wondering about Right of First Refusal (ROFR)? It is basically the same as ROFO, wherein you have the right to match the offer or “refuse” the other party leasing the space. The same principles above apply, but taxonomy be damned.
Termination Options: Just a heads up - Landlord’s HATE termination options. Asking for this is like bringing uranium to the party, which makes the entire negotiation radioactive. A termination option is a lease amendment/rider that allows a Tenant to notice the Landlord of their intent to terminate their lease and then vacate the space with no further obligations. You can see why this is problematic. Landlord’s do something we call “capitalization” of your lease in order to figure out what the long-term value of your rent obligations are. Income is the way the vast majority of commercial real estate is assessed and purchased. Assets are purchased on what we usually refer to as “Cap Rates” which are indicative of what an investor (or group of investors) believe their return will be on an asset, assuming an all-cash purchase and consistency from a property’s tenancy. Not to dive super deep on property valuation but here is a quick example:
Let’s say you and I want to purchase a small retail center with two tenants. The purchase price is $1,000,000.00 and the NET income per annum is $100,000. In this example we are purchasing the asset on a 10% CAP. Meaning we expect to return 10% on our investment of $1,000,000.00 per annum. CAP Rates are a sliding scale of risk and return. Investors will accept much lower yields in return for much lower risk. In the example above that small retail center would likely have local credit tenants and be in an average market condition. Whereas if we wanted to purchase a long-term leased AAA center, think Starbucks, Chipotle, Verizon, we can reasonably assume the risks are much lower of receiving that rent. They are massive, established businesses and have proven rent payments in the billions of dollars. Leasing to those level of national-credit tenants on long leases the same center may be priced at a 5% CAP. If we were willing to accept a 5% return, we would pay $2,000,000.00 for the VERY SAME CENTER. So know that we know credit, risk and yield are all very closely related you are getting a peek at how a Landlord looks at your lease. They are balancing those very same factors. Credit/Term/Rent play the biggest roles in capitalization for a lease.
Very frankly, Landlords ASSUME you will pay rent on time and throughout the term so they tell other investors and lenders that they can expect to make a return on that EXPECTED rent to collect. Now back to termination. If they are capitalizing a five year that is pretty standard stuff, it is the market for being able to start capitalizing leases. Anything less than that and investors or lenders (in refinance or finance situation) do not give owners and Landlord’s full credit for the lease on the books. This is because when the Tenant leaves a Landlord may very well incur costs, commissions, new tenant allowances, etc… so they actually DISCOUNT the value of said lease and now the income is lower, and if the income is lower the building is worth less. SO, if you negotiate a termination option you're stepping on the biggest toes a Landlord needs, income and capitalization which directly affects their value.
For example, let’s say you negotiate a year 3 (Month 36) termination option on a five year, the Landlord will only get credit for 3 years of that deal come time to sell or refinance. You can see how this is not their favorite cup of tea. That all being said (and we said a lot there) you should know a termination option is a super powerful tool for a Tenant. Allowing yourself out of a lease you know you will outgrow is amazing, it’s also going to cost you a lot in both upfront negotiations, notice periods and eventual termination fees...yes they will charge you a big few (months and months of rent) for the right to get out, along with ANY unamortized lease costs. Yes, that’s the unamortized lease commissions and tenant allowances they haven’t fully realized. You will see these up front if you shoot for a termination option and look carefully, oftentimes a termination option will cost you almost as much as just paying out the lease...like I said, Landlord’s hate them.
Good Guy Clauses: Good guy clauses allow a Tenant and Landlord to cooperate if a Tenant’s business fails. In these scenarios typically a Tenant (personal guarantor usually or Letter of credit) agrees upon a fixed period of short rent to pay while the Landlord is given adequate notice to release the space. It can reduce security deposits and guarantees in some cases as well. The idea is to create a structure for the two parties to work together, no one wants a bankruptcy and the Landlord does not want a non-paying tenant, this helps set the stage for amicable solutions.
Optional Letter of Credit/Security Deposits: If your credit isn’t up to snuff, or is so good you can dictate terms, you may consider alternative security deposit structures like the one above. I personally hate the personal guarantee because of its difficulty to enforce. Security deposits and letters of credit (bank enforceable security deposits) are best and give both parties budgetary consideration up front and recourse paths. The less confusion the better if things go wrong. Attorneys and certified financial professionals can help here.
Contraction Option: The same as expansion but in reverse. Plus, these will usually COST you money to exercise since the Landlord is losing value they counted on. While somewhat useful the preferred route is almost always sublease or assignment. Funny how that works huh?
Learn more about options, leases, buildings and find out what you should really be paying for your commercial space at Tenavox.com