Potentially beneficial to both tenant and landlord, option clauses are standard inclusions in most commercial leases. But knowing what to include in that clause can be difficult. In this post we break down how an option operates, and how to draft yours to maximise your future security.
What is an optional term?
An option is a clause in a lease agreement allowing a tenant to renew their tenancy for an additional term.
Does every commercial lease have to include an option to renew?
No. As a landlord you’re under no obligation to include an option term in your commercial lease. However, including one may benefit both parties.
As the landlord, you’ll receive greater potential income security, as well as enhancing your property’s value. This is particularly so if you have a long term tenant, as the risks associated with long term leases are lower. Meanwhile, your tenant will benefit from continued security of location.
What happens if I don’t include an option term in my commercial lease?
Your tenant will have no right to renew the lease at the end of the term. If you both wish to continue the tenancy, you’ll have to re-negotiate the lease, including lease term and rent.
How is an option exercised?
How your option is exercised depends on the terms of your option clause. Most commercial leases require a tenant to give written notice of their intention to exercise the option. For the ease of both parties, the method of exercise should be as clear and unequivocal as possible.
This means being specific about the form and delivery of that notice, setting it out clearly in your option clause. For example, the notice must be made in writing, delivered to the landlord’s place of business, and must include the tenant’s full name, business name, address and signature. This reduces confusion and ensures the formalities of the lease are carried out.
If the tenant fails to properly follow the terms of the option, they lose their right to exercise it. It’s your responsibility as a landlord to ensure they’ve followed the terms as set out in the lease.
Do time limits apply?
Yes. Most commercial leases specify a time limit in which an option must be exercised. This may be done by specifying a date by which the tenant must have exercised the option, or by specifying a period during which the tenant may exercise the option. This is normally during the last year of the current term, most commonly within the last 3 to 6 months of the lease.
If a tenant fails to exercise the option during the specified time period, they subsequently lose the option. In these circumstances, you may still agree to enter a new lease agreement, but you’re not bound to offer it on the same terms as set out in the option clause. That is, the lease may be re-negotiated.
The legal effect of exercise of option
Although we refer to the continuing tenancy as a ‘further term’, ‘option period’ or ‘renewal of lease’, the valid exercise of an option creates an enforceable and binding agreement. That is, a new lease is created and both parties are legally bound to that agreement.
However, the new lease only comes into effect once the new lease or deed of renewal has been prepared and signed by both parties. Until this is done, there is only an ‘agreement to lease’. So it’s essential you have the new lease or deed of renewal executed immediately after the exercise of the option.
Conditions on exercise of option – tenant default
Option clauses commonly state a tenant cannot exercise their option if they are in breach, or have consistently been in breach of the lease throughout the term. This protects you, the landlord, from having to continue a tenancy with an undesirable lessee. To secure your position and avoid confusion, state your terms as clearly as possible. For example: by stating that a tenant cannot exercise their option:-
- if they are in breach as at the date of exercise of the option, and/or on the last day of the initial term; or
- if they have consistently breached the lease throughout the current term (even if the tenant is not technically in breach of the lease as at the date of exercise of the option). You may specify, for example, that 3 or more breaches of the lease during the current term by the tenant, will be sufficient grounds for the landlord to refuse to grant the further term.
Terms of the new lease
A well drafted option clause clearly specifies the terms and conditions which will apply to the new lease. This includes the new lease term and rent, as well as rent review mechanisms.
These new terms and conditions must also be clearly set out in the deed of renewal. Any new clauses included in the deed of renewal (that is, ones not set out in the original option clause) must be agreed to by both parties. If not, the original lease terms will continue unaltered.
Rent reviews
When drafting your option terms, it’s important to include a clause clearly stating how the rent will be determined upon the commencement of the new lease term.
Most leases state that a ‘market review’ will occur at the commencement of any further term. A market review is a rent review of similar properties in the surrounding area to determine the current market rate (you can read more about how they operate here). The rent is then adjusted upwards or downwards to reflect that review. It may be a rate agreed to between you and your tenant, or a rate determined by an independent valuer.
If your lease does not specify how the rent is to be reviewed at the commencement of a further term, you may not be entitled to an increase in rent for the first year of the new lease. That’s why it’s imperative you include clear and unambiguous rent review information in the option clause.
Retail leases
If you’re the landlord of a retail premises, there are some important considerations to note.
Under all Retail Leases legislation , the tenant has the right to request a market rent review . If that determination is not made before the option date, the law may extend the option period until the tenant has been notified of that determination.
(Note that each state’s requirements concerning the procedure for “retail” market rent reviews will vary slightly from state to state.)
This provision provides certainty to tenants who wish to exercise their option, but have concerns about their ability to meet new rent payments if the market review is higher than they’d budged for. If an agreement about future rent can’t be made, the tenant is able to avoid the risk of exercising their option to renew, and look for new premises instead.
Determining the new lease term
For properties in a high demand area, short term leases may be a better option – after all, supply and demand is in your favour. For properties attracting less interest – for example, those in rural areas – a longer term lease will provide greater income security. But whichever option you choose, negotiating a term that’s in yours and your tenant’s best interests should be your primary goal.
Need more information? You can read more about short versus long term leases here .
The big picture
Offering you greater income security and your tenant security of tenure, an options clause represents a win-win for both parties. By considering the options outlined above, you should be able to negotiate a clause that ultimately benefits both parties.
By Ian MacLeod