When negotiating a lease agreement, one element that is usually brought up during negotiations is the lease option to renew. Essentially this is the Lessee’s (tenant’s) “option” to renew the lease after the expiration of the initial term. This is a benefit to the Lessee because they now have the flexibility to potentially test the market after the initial term, but still have a concrete fallback option should they decide to stay. Many times, investors feel as though it is a benefit to the tenant but a detriment to themselves, since they give up a perceived sense of control. However it can be a benefit to the investor as there is no downtime for vacancy and they hopefully have a long time tenant that pays their bills on time. Either way it’s important to understand the different ways a lease option can be negotiated.
Standard Increase. This means that an incremental increase that has occurred over the course of the initial lease term is extended into the option period. Say for example, there are 3% annual increases during the lease term. The first month of the new lease option will be 103% of the last month of the initial period. In this scenario, both the investor and the tenant understand in advance what the option term rent will be. The positive is that an investor knows what his approximate yield will be at some future date, and the tenant can budget for those increases ahead of time. Another benefit is that there are no further negotiations, so each party can continue along as before. The negative (especially in longer term leases), is that the rental increase at that time may be below market, meaning the investor left money on the table, or above market, meaning that the tenant may not exercise the option and look for a more competitive lease rate.
Negotiable Rate. Negotiable rate simply means that there is an option to renew, but both parties will negotiate a rate favorable to both sides at the time the option is exercised. The benefit is that it is hopeful both sides come to an agreement and they come up with a “fair market value” for the space. The biggest difference between this option and Fair Market Value is that neither party is obligated to come to an agreement on value. Therefore, if the proposed rental rate is not agreed to, both parties can walk away.
Fair Market Value. FMV is different in that it is a rate that is negotiated at the time the option is exercise, but both parties typically have an obligation to come to an agreement. Should the discussions not produce a rental rate favorable to both sides, then some type of mediator is usually employed to help negotiations along the way. Sometimes the parties will hire appraisers or brokers to come up with opinions of value and help mediate the transaction. The positive is that you will really get as close to a fair market value as you can in this scenario. The negative is that this type of increase can sometimes cause friction between the Lessee and the landlord.
In addition to these, there are a myriad of other ways to structure options depending on the scenario, lease term, and willingness of both parties to come to terms. If negotiations over the original lease were heated, chances are the negotiations over determining the FMV will be difficult as well. Just make sure to choose the option that is best suited for your scenario and ask advice from a professional.