Welcome to the fourth post in our series on the ABCs of commercial real estate leases. In this post, we’re going to begin a discussion on Lease Options, another fundamental component of commercial real estate leases. We’ll start by explaining what a commercial real estate lease Option is, then delve into two different types of Options, Contraction Options—also referred to a Reduction Options– and Expansion Options.
What Is A Commercial Real Estate Lease Option?
In commercial real estate terms, an Option is a right granted to either the tenant or the landlord. Options are typically granted via lease documentation and include renewal, expansion, contraction, termination, rights of first offer, rights of first refusal and purchase options.
Contraction/Reduction Options, Explained
A Contraction or Reduction Option grants a tenant or landlord the right to reduce the amount of space leased by such tenant. A contraction option often defines (a) the premises subject to reduction; (b) the notification and effective dates of contraction; (c) the impact on Rent and (d) any contraction fee paid by the party exercising the option. An Auto‐Contraction option is a form of Contraction Option whereby the size of the premises reduces automatically on the effective date without any notification requirement.
An Example of A Contraction/Reduction Option
1.02: Premises and Option to Reduce Space. Landlord leases to Tenant Suite #500 (Premises) as shown cross‐hatched on the attached floor plan (Exhibit A). The Premises contain approximately 7,666 Useable Square Feet of office space and the fixtures, improvements and other property now installed. Tenant acknowledges that it accepts the Premises in their current AS IS condition, subject to Landlord’s obligation to maintain, repair and replace the Premises as set forth herein. The foregoing sentence shall not be deemed to imply that Landlord, as part of its obligations hereunder, does not have the obligation to repair, maintain or replace existing conditions and defects which require maintenance, repair or replacement. Landlord has made no representation or warranty with respect to the condition of the Premises as of the date hereof except as set forth herein. Notwithstanding anything contained herein to the contrary, Tenant, in its sole and absolute discretion, shall have the right (the “Reduction Right”) at any time during the Term of this lease to reduce the size of the Premises from 7,666 Useable Square Feet to an amount not less than 2,500 Useable Square Feet in any configuration. In order for Tenant to exercise the Reduction Right, Tenant shall provide written notice to Landlord of its intention to exercise the Reduction Right and such written notice shall include (i) the date which such reduction notice shall be effective, (ii) the amount of Useable Square Feet Tenant elects to retain (the “Retained Space”), provided the Retained Space is no less than 2,500 Useable Square Feet, and (iii) a drawing or other description of the Retained Space. Landlord agrees to reasonably cooperate with Tenant in order to re‐configure or alter the Premises in connection with exercise of the Reduction Right. Upon the date which Tenant indicates the reduction shall be effective, the Premises as defined herein shall consist of the Retained Space and Base Rent shall automatically be reduced to an amount equal to the then current annual Base Rent the square footage of the Useable Square Feet in the Retained Space. Something to note about this example: The Option to Reduce is imbedded in the paragraph describing the Premises. The title of the Paragraph leads the reader to understand that the option is in there but, be aware that not all leases provide such clues. This example illustrates how important lease provisions can be buried in mundane sections and why it is important to read the lease in its entirety.
Making Sense of A Contraction or Reduction Option
Referring to the lease clause above, here are some important items to look for in a Contraction/Reduction Option:
- Definition of Contraction Space: In the example above, a portion of Suite 500, in any configuration, in an amount not to exceed 5,166 Useable Square Feet so that the Retained Space is not less than 2,500 Useable Square Feet.
- The Notice Date: At any time during the Term
- The Effective Date: As stated in the written notice
- Contraction Payment: None
- Other: Written notice to include a drawing or description of the Retained Space
Expansion Options, Explained
An Expansion Option is an option granted to a tenant which allows it to increase the amount of leased premises at a future date. In an Expansion Option, the expansion premises, notification date, effective date and rent are typically clearly defined. In addition, the right of the tenant to expand via such an option is not contingent upon the occurrence of any event related to the expansion premises (i.e., availability for lease, offer from third party). An Auto‐Expansion option is a form of Expansion Option whereby the premises expand automatically on the effective date without any notification requirement. This is sometimes referred to in leases as “Must Take Space”.
An Example of An Expansion Option
This example of an Expansion Option was taken from a real lease. As you can see, Expansion Options can be lengthy and consist of multiple clauses, which is the case with this one.
43.1: Subject to the terms and conditions hereinafter set forth, Tenant shall have an option (an “Expansion Option”) to lease an additional 2,000 to 3,000 rentable square feet, as determined by Landlord, of additional space on the eighteenth (18th) floor of the Building (or such lesser remaining rentable square feet of the 18th floor of the Building after any exercise by Tenant of the First Offer right set forth in Article 42 above) that is contiguous to the Premises then being leased by Tenant following the timely and proper exercise of the expansion option by Tenant (“Expansion Premises”), for a lease term commencing as set forth below.
43.2: Tenant must exercise its Expansion Option, if at all, by notice to Landlord given no later than August 1, 2023, time being of the essence. If not timely and properly exercised, the applicable Expansion Option shall terminate pursuant to this Article.
43.3: The term of the lease of the Expansion Premises shall commence (the “Expansion Premises Commencement Date”) upon the date Landlord delivers the Expansion Premises to Tenant, which delivery shall be during calendar year 2024. If Tenant timely exercises its Expansion Option pursuant to this Article, then, subject to the limitations in the Article, Landlord shall designate the size and location of the Expansion Premises and the scheduled Expansion Premises Commencement Date in a notice given at least ninety (90) days prior to the scheduled Expansion Premises Commencement Date.
43.4: If Tenant validly exercises its options to lease the Expansion Premises, then effective as of the Expansion Premises Commencement Date, the Expansion Premises shall be included in the Premises, subject to all the terms, conditions and provisions of the Lease, except as follows:
43.4.1 the rentable area in the Premises shall be increased by the rentable area of the Expansion Premises and Tenant’s Proportionate Share shall likewise be increased.
43.4.2 the term of the demise covering the Expansion Premises shall commence on the Expansion Premises Commencement Date and shall expire simultaneously with the expiration or earlier termination of the Term, including any extension or renewal thereof.
43.4.3 the Expansion Premises shall be rented in “as is” condition as of the Expansion Premises Commencement Date. It is the intention hereof that if Landlord leases the Expansion Premises to a third party prior to leasing the same to Tenant pursuant to this Article, Landlord shall have no obligation to demolish or remove any leasehold improvements made by or on behalf of such third party tenant (i.e., Tenant shall rent such Expansion Premises in “as is” condition as of the Expansion Premises Commencement Date).
43.4.4 the rate of Annual Rent per square foot of net rentable area for the Expansion Premises shall be equal to the Market Rent (as defined or determined in Section 41.2.1 above) and shall be payable at the same times and in the same manner as Annual Rent is paid with respect to the balance of the Premises.
43.5 Tenant may only exercise its Expansion Option, and an exercise thereof shall only be effective, if at the time of Tenant’s exercise and on the Expansion Premises Commencement Date, the Lease is in full force and effect and Tenant is not in default beyond applicable notice and cure periods set forth herein and Tenant has not assigned the Lease or sublet all or any part of the Premises.
A Note About The Above Example
Notice that in two places, the Expansion Option sends the reader back to other sections of the lease. Section 43.1 refers back to Article 42 and Section 43.4.4 refers back to Article 41.2.1. This is not unusual and when a lease references other sections, it is important to go to those sections and read them in order to understand the terms of the current section.
Making Sense of An Expansion Option
Referring to the example above, here a few critical items to look for in Expansion Options:
- Definition of Expansion Space: An additional 2,000 to 3,000 rentable square feet of contiguous space on the 18th floor (or such lesser rentable sq. ft. remaining after any exercise by Tenant of its First Offer Right granted in Article 42).
- Date when Tenant must exercise: No later than 8/1/23.
- Date when Expansion is effective: Upon Landlord delivery, which shall be during calendar year 2024.
- Rent for Expansion Space: Market Rent (as defined in Lease, Section 41.2.1)
- Other: No Construction Allowances granted ° Landlord will provide notice to Tenant designating the size, location and scheduled Expansion Premises Commencement Date in a notice to Tenant given at least 90 days prior to the scheduled Expansion Premises Commencement Date.
More Information On Lease Options
In our next few posts, we’ll continue our discussion on commercial real estate lease options, until we cover all of the most common ones. Meanwhile, if you’d like more information on lease options and commercial real estate leases in general, there’s a comprehensive primer on leases called “The ABCs of Commercial Real Estate Leases” in the Library section of our web site, as well as a glossary of commercial real estate lease terms with definitions to over 140 terms. Feel free to download a copy of either or both.
By Terry Banike, Marketing Manager, Realogic