A renewal option in a lease are clauses which allow tenants to extend a lease after the initial term has matured and give tenants a much easier way to re-negotiate when the time for renewal approaches. Understanding the best ways to negotiate a renewal option and the different lease types that can pair with a renewal opinion can greatly benefit an office tenant.
The Short-Term Lease Question
In some cases, companies may feel that effective risk management can come from signing a series of short-term leases with renewal options. While this can work well for some, there are some significant reasons for avoiding this type of scenario:
- If your company needs tenant improvement allowance to retrofit a new space exactly to your specifications, a shorter term lease is much less likely to deliver sizable funds from the landlord during negotiations, leaving you to pay out of pocket for space changes.
- Leases with short terms leave you with less leverage in negotiations and can deliver fewer concessions from the landlord in the end.
- A short lease opens you up to the possibility of rate hikes at each negotiation and eliminates the option of locking in a rate over a long period of time.
Some believe that asking for renewal options with set rate increases can ameliorate that last problem. The truth is, however, that landlords do not want to lose this option and if they do accept a predetermined rate hike, it is likely to be pretty significant.
When deciding between a long term lease and a short term lease with a renewal option, understand that you are balancing flexibility against cost savings. Determine which will benefit your company best in the long run and then work to negotiate the best deal within that framework.
Finessing the Renewal Option
Renewal options are a necessary evil to many landlords. While they may wish to avoid them and retain the ability to market a space to a newer, higher-paying tenant, they often understand that they are needed at times to cement a deal with a tenant. A renewal clause works against the landlord because:
- He or she might find a tenant willing to pay a higher rate.
- A high-priority, large tenant in the building may want your space.
If you have a well structured renewal option, it acts as the framework for putting a ceiling on the costs of renewing the lease for your office space.It is important when negotiating a renewal clause that a tenant understand a landlord’s natural reticence, as well as the specifics involved in a renewal option.
The notice period of a renewal lease demarcates how far ahead of time you need to inform a landlord that you want to negotiate a renewal. These periods typically run at anywhere from 6 to 12 months. Try to negotiate a longer period so that you have plenty of time to review other options and so that your landlord is aware that there is a healthy amount of competition in the mix.
Negotiating the renewal clause will also involve specifying the length term of the renewal period. Try to introduce different term lengths, such as 3/5 years, into a renewal clause to give you some options.
The new rental rate for a renewal period can sometimes work on a predetermined basis, as mentioned above. It is more likely however that a renewal clause will state that a fair market value be used to determine a new rate.
Fair Market Value
The fair market value itself should be carefully discussed and defined. Your main goal should be to not leave the FMV up to the landlord’s interpretation. Make sure that the FMV is defined as including items such as the tenant improvement allowances or concessions you might find from the landlord’s competition. It is also a good idea to make sure that third-party arbitration is included if you and the landlord cannot agree on an FMV.
Senior Vice President at Colliers International, based in Houston, Texas.