The option to extend a lease term or assign a lease are key provisions for most commercial tenants – especially those who invest large sums to build out their premises. For instance, in San Francisco, upscale restaurants are known to spend millions on build-outs, not to mention the amount of energy and time dealing with planning and building department restrictions and delays. A 5-year term can easily turn into a 4-year term if construction is considerable and lengthy, so it’s important to plan ahead.

Tenants need to be particularly vigilant with respect to options to extend for several reasons, including (1) if the premises are located in a prime location that is crucial to their business (e.g., a high-volume pizza place that caters to nearby businesses), (2) if selling the business at a high price is the tenant’s end game, or (3) as noted above, if the tenant has spent substantial amounts (and time) on the improvements to the premises. Essentially, for businesses that would be very expensive to re-locate and/or duplicate, negotiating a solid option to extend is critical, especially if the initial lease term is not very long. Adding to this is the fact that market conditions inevitably change, which can make things very tricky. Having a well-drafted option to extend a lease enables tenants to weather both their own projections and future market conditions with fewer surprises. As such, it’s important to be prepared.

When it comes to options to extend, most commercial tenants shift their focus to (a) ensuring that the lease contains an option (or multiple consecutive options) to extend the lease, and (b) the rent to be paid if and when the lease term is extended. That’s a great step in the right direction, and all very important, but it’s equally as important that the language be carefully crafted to ensure that the tenant doesn’t inadvertently lose the option. Here are a few points to consider.

Assignment Issues

Many commercial leases state that options are personal to the tenant. In essence, this cancels the tenant’s right to exercise the option if the tenant assigns the lease – something that is especially common in cities with a high turnover and high rents. Buyers of established businesses almost always will look for a solid remaining lease term (including an option to extend) and this will be factored into the sale price. Take a look at the example below:

Seller invested a large amount (over $250k) in the build-out of a restaurant. Seller signed a 5-year lease, has a monthly below-market rent of $2,500 for another 2 years plus a 5-year option to extend with a market rate cap. Seller’s business does well, especially because the rent is low. Seller wants to sell the restaurant for $300k. Buyer likes the space, thinks the price is right, and is ready to buy Seller’s restaurant in order to have the lease (and the favorable lease term) assigned to Buyer. Meanwhile, aware that the rent is below market, L wants increase the rent to $5,000 if S sells the business. As a result, B will most likely offer a purchase price significantly below $300k. Moral of the story: Seller loses money because the purchase price is much lower than expected as a result of the discount, Buyer gets a well built-out space at a higher rent, and the one reaping the most benefits is the landlord, who now owns a well-built out space AND gets to raise the rent.

Selling your business is probably not on your radar when you are just getting ready to launch, but circumstances can change, and you really must think ahead. Whether you plan to sell your business or not, a poorly drafted option to extend your lease can make or break the sale of your business and the price that you receive. Likewise, if you are a tenant planning to take over premises from an existing tenant under an existing lease, you must carefully review the language of said lease to determine whether the assignment will cancel the option to extend: this can affect the price that you pay to purchase the business.

Notice

Another key issue is the notice period to exercise the option to extend the lease. You must ensure that the period is reasonable and sufficiently flexible. Often, a lease will mandate that the tenant provide 12 -18 months prior written notice in order to exercise the option. Landlords usually want sufficient time to market the space to prospective tenants if the existing tenant does not exercise the option to extend. A tenant may not be able to project as far in advance, or the economy may be shifting, in other words too much can happen over the course of 12 months. At the same time, tenants should allow themselves a reasonably long timeframe in order to really evaluate whether they want to continue operating in the same premises. A more reasonable time period would be 6-12 months, which gives the tenant the time to project and the landlord the time to market the premises if the tenant does not exercise the option. In my experience, in markets like San Francisco where the economy shifts quickly, it’s very difficult to decide too early in advance whether to exercise or not. Also, notice periods should be carefully spelled out, preferably with a timeframe by which the tenant must exercise the option, a set time for the landlord to respond with a rate for the extension term, and a notice period during which tenant can accept or reject the proposed option term rent. You don’t want to miss the notice periods, or you will lose the option.

Default

Finally, most landlords will want to ensure that the option to extend cannot be exercised if the tenant is in default under the lease (at the time of exercise and at the extension term commencement date). While it’s often difficult to avoid this caveat, it’s important, if at all possible, to make sure that it’s limited to a material default. This should be sufficiently defined: for instance, failure to timely cure a small default like a minor plumbing issue for reasons that have nothing to do with the tenant’s overall financial health should not render the option null and void.

Drafting an option to extend a lease is tricky, especially with respect to the extension rent, but there are certain hidden dangers that can eviscerate the entire option long before you start discussing numbers with the landlord. Make sure that you identify them before you sign the lease.

As a final issue, while this article does not discuss the option term rent, this is obviously a key point when you negotiate your initial lease. A poorly drafted provision really isn’t an option. For instance, language that provides that “rent during the renewal period shall be negotiated at the time of renewal,” really isn’t a much of an option. It’s best to base the option term rent on the then-current “fair market rent” or set an increase of the tenant’s current rent by a specific percentage (i.e., a 2-3% increase per year). Much will depend on how the market is faring at the time the option is exercised, but in any event, with respect to extension rent, a dispute resolution mechanism should be included in the language. Otherwise, if the two parties cannot agree, the landlord will be able to pull the plug on the option.

As an attorney with a litigation background and a former business owner, I have a unique perspective on balancing legal and financial risks, having experienced firsthand the joys (and pitfalls) of starting, running and selling small businesses. One of the first opportunities I had to leverage my legal experience came when I negotiated a commercial lease for one of my former restaurants. As is typical, we were handed a hefty, 20-page, fairly “standard” commercial lease (plus personal guaranty) – the kind that generally leaves the tenant holding the bag if anything goes wrong. As a seasoned attorney, I knew well enough to imagine all of the “what-ifs” and doomsday scenarios I could possibly conjure up, but really learned to navigate the murky waters of commercial leases, this time as a small business owner. Although “standard” commercial leases can actually differ significantly, I’ve identified a few hidden dangers that come up repeatedly, and will explore and share some practical ramifications here in a multi-part series.

-CG

DISCLAIMER. None of the materials contained in this Website is offered, nor should be construed, as legal advice. The material on our Website has been prepared and published for informational purposes only and may not reflect the most current legal developments. You should not act or rely upon information contained in these materials without specifically seeking professional legal advice.