Planning for Tenant's Changing Needs: Options To Renew, Expand, Cancel, or Reduce

by Ballard Spahr LLP

Editor's Note: Mortgage banking companies are often tenants leasing or subleasing office space, usually in multiple locations. This is the fourth in a series of articles by attorneys in Ballard Spahr's Leasing Group that explain the commercial leasing process and explore issues such as how a lease affects ongoing operations, how to plan for changing needs, the impact of foreclosure and bankruptcy, and how to get out of a lease. In this article, A. Eric Levine, an attorney in the firm's Philadelphia office, and Alicia B. Clark, an attorney in the firm's Denver office, discuss how certain rights and options of a tenant in a commercial lease can help the tenant satisfy its changing needs during the term.

As a tenant's business changes, its needs and space requirements also change. If possible, a commercial tenant should anticipate the possibility of changing needs by negotiating certain beneficial options and rights into the lease up front, when the landlord is usually the most interested in attracting a new tenant.

The options and rights a tenant might consider include renewal options to extend the lease term, rights of first refusal or rights of first offer to lease additional space or purchase the leased property, early termination rights, and contraction rights. If these rights are important to the tenant, they should be included in the initial lease negotiations so that the term sheet or letter of intent expressly provides for them. After the landlord agrees to the concepts, the details can be worked out in the lease document.

Renewal Options

Renewal options are commonly included in commercial leases, although there are varying exercise requirements and methods to compute the option rent. Key elements of renewal options to consider are as follows:

  • Condition of no default: Almost every renewal option will require, as a condition preceding the tenant's ability to exercise the option, that the tenant is not in default (or has not done anything that with the giving of notice or the passage of time would be a default) under the lease, at the time the tenant exercises the option or at the time the renewal term is to commence. Such condition is fairly reasonable and customary.
  • Notice period: Most renewal provisions require the tenant to give written notice to the landlord that the tenant is exercising its renewal right within a specified period of time, most often at least six, nine, or 12 months before the expiration of the lease (either the initial term or a renewal term, to the extent the tenant has multiple renewal options). Often a shorter notice period will benefit the tenant, as it gives the tenant additional time to survey the market and determine overall leasing needs before deciding whether to exercise the option.
  • Number and length of options: The lease will set forth how many renewal options the tenant will have and the length of each renewal term. Ordinarily, the terms and provisions concerning each option (i.e., notice period, term, and conditions) will be identical, except for the rental rate. The renewal term, however, does not need to be the same duration as the initial lease term.
  • Rental rate: This is often the most heavily negotiated element of the renewal option. It is generally calculated as either a fixed rate or "fair market value" (FMV). The benefit of agreeing to a fixed rate is that it provides certainty to the parties and eliminates the potentially onerous process of establishing and agreeing to a rate based on FMV. If the leasing market falls during the term, however, the tenant faces the prospect of having to pay an above-market rent under the option; conversely, if the market strengthens for landlords, the tenant could get a below-market fixed rate.

The more common approach is to base the renewal rate on a determination of FMV. It is critical to define how FMV will be calculated since it will not be determined until near the end of the lease term. A tenant will want FMV to include tenant improvement allowances, free rent, and other concessions offered by competitive buildings in the particular market.

A landlord may want a floor on the minimum rent during the renewal term to protect itself from downturns in the market. Such language, if included, would diminish one of the greatest benefits to the tenant of having a renewal option based on FMV, that being the possibility of having lower rent during the renewal term if the market supports it. Conversely, a tenant may negotiate a ceiling on the maximum rental rate (e.g., setting the renewal rate at 95 percent of FMV), since the landlord benefits by not having to market and re-lease the space and risk having an empty space.

One additional consideration is the mechanics of determining FMV. The landlord may want the unilateral right to determine FMV based on the defined factors in the lease and tell the tenant to essentially take it or leave it. If the tenant has an opportunity to counter with its own determination and the landlord disagrees, the tenant may want the right to rescind the exercise of the option. Often, the parties are bound to come to come to an agreement. The renewal section should contain a mechanism by which the parties can settle on FMV and, consequently, the renewal rental rate. Often this mechanism is some form of arbitration.

It is important to remember that a tenant does not have to exercise the renewal option to renew its lease. Rather, a tenant is free to negotiate a renewal or extension of the lease on terms that may be vastly different. The decision to negotiate or exercise a renewal option depends on the leverage of the parties at the time.

Just having a renewal option in the lease may enable the tenant to negotiate more favorable renewal terms, even if the tenant does not exercise the option. The landlord may place value in having a tenant with a proven track record of performing under its lease as opposed to having to deal with a new, unknown prospect. The tenant also may want to use the renewal negotiation as an opportunity to negotiate other provisions of the lease.

Right of First Refusal and Right of First Offer

Other rights a tenant may consider negotiating into its lease in an effort to anticipate changing needs is a right of first refusal (ROFR) or a right of first offer (ROFO) to lease additional space or, in some cases, buy the leased premises. Often the ROFR or ROFO will apply to space that may not be available at the beginning of the initial lease term but becomes available during the term. In a multitenant building, the ROFR or ROFO may be restricted to the floor where the tenant currently leases space or other contiguous space in the building. A tenant may be most successful in negotiating a ROFR or a ROFO to purchase the premises if it occupies the premises as a single-tenant building.

  • Right of First Refusal: Unlike an option, where a tenant is granted the right, but not the obligation, to lease or buy a specified asset in the future, a ROFR does not enable the tenant to force the landlord to sell or lease the asset. Rather, a ROFR provides the tenant with the right to require the landlord to lease or sell the asset to the tenant on the same price and terms that the landlord is willing to accept from a third party.

    Since a ROFR is triggered by a bona fide offer from a third party to the landlord (or in some cases by an offer from the landlord to a third party), the ROFR provision should specify what qualifies as an offer. For a right to lease, the offer might be in the form of a fully negotiated letter of intent or even a fully negotiated lease. If an existing tenant has a ROFR and agrees to all of the terms of the third-party offer, that tenant has the superior right to lease the space on those terms, and the landlord is bound to lease the space to that tenant.

    If the existing tenant agrees to only some, but not all, of the terms offered by the third party, however, the landlord may decide not to lease the space to that tenant and close the deal with the third party. While a tenant may want a ROFR in its lease to help address changing needs, the tenant should be prepared for resistance from the landlord. After all, a ROFR has a chilling effect on the marketability of the owner's property.

  • Right of First Offer: A ROFO gives a tenant the first right to make an offer to the landlord to lease additional space or buy the premises before the landlord can offer the space or premises to a third party. The lease should give the landlord a specific time period to either accept or reject the tenant's offer. If the landlord rejects the offer, the landlord is free to lease the subject space to one or more third parties, with the only restriction usually being that the landlord cannot accept a rental rate or purchase price that is less than that offered by the tenant under the ROFO.

    Since the tenant is making a new offer to the landlord and not agreeing to the terms of an existing third-party offer as in the case of a ROFR, the tenant should ensure that the lease adequately describes how the tenant's offer will be compared to other offers. For a ROFO to lease, this is usually handled by reference to the net effective rent after all free rent, tenant improvement allowances, and other concessions are deducted from the stated rental rate.

Because of the importance and value of these expansion rights, tenants may want to pay particular attention to expansion rights that the landlord has granted to other tenants, as well as the relative priority of its rights versus the rights of existing and future tenants. To that end, particularly at larger buildings with many tenants, the tenant should require the landlord to include in the lease a list of all preexisting expansion rights of tenants at the building, together with basic facts about each such preexisting right.

Termination and Contraction Rights

Commercial tenants may want the flexibility to downsize or terminate their leases. For various business reasons, a tenant may want the right to terminate the entire lease on one or more fixed early termination dates, or even on a rolling basis (perhaps after some minimum number of months or years), in each case with advance written notice to the landlord. Similarly, tenants may also want to negotiate contraction rights, which allow the tenant to give back space to the landlord to reduce the square footage of its leased premises at certain times or on a rolling basis.

Early termination and contraction rights often require the tenant to pay a fee to the landlord. This fee may factor in a penalty of a certain number of months' rent, together with repayment of landlord's unamortized leasing costs (i.e., broker commissions, rent abatement and other concessions, costs of tenant improvements, and/or legal fees) for the space being terminated. The feasibility of obtaining these rights often depends on current market conditions.

A tenant, however, should expect resistance from the landlord because of the uncertainty these rights create in the leasing prospects of the property and their potential to negatively affect the value of the landlord's property in a sale or financing. A landlord may be more willing to give early termination or contraction rights when the premises is being delivered "as is" or with only generic tenant improvements. In such cases, the landlord is less invested in a particular tenant with unique tenant improvements and may be less concerned about finding a new tenant for the space after early termination or contraction.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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