Set Limits on Tenant's Expansion Option

Don't be surprised if a prospective tenant—especially one with a growing business—asks for an expansion option in its lease. This clause reserves space owned by you, typically contiguous to the tenant's, when it becomes available. An expansion option is valuable to a tenant because if it needs to expand its operations, it'll have the opportunity to do so, but won't be obligated to take the space if it determines that it doesn't need it.

Giving a tenant an expansion option can help you fill available space as soon as possible, without having to go to the trouble of finding an outside tenant. But options can be a nightmare for owners that don't limit a tenant's rights. Failing to properly notify the tenant about available space—or failing to offer it in the correct priority to multiple tenants that hold this right—can lead to lawsuits. Negotiate expansion option provisions carefully, giving the tenant a way to conveniently secure extra available space rather than looking elsewhere for it, while protecting yourself from costly litigation.

Give Short Window to Exercise Right

An expansion option is typically given to a tenant by a “right of first refusal” (ROFR) or by a “right of first availability.” A ROFR gives the tenant the first chance to renew or refuse a lease on the same terms and conditions as those that the owner is offering to a third party interested in renting the space. A ROFR is triggered when the owner has already marketed the space to the public and actually has found a prospective tenant that wants to lease it. At that point, the owner has to offer the terms to the “option holder—the existing tenant that has the options right in its lease.

A right of first availability is triggered before the owner markets the space to the public, when the space becomes available either because the other tenant's lease is ending or it has defaulted on its lease. The owner must offer the space to the current tenant before marketing it to the public.

“Many owners like to use the right of first availability as opposed to a ROFR,” says Denver real estate attorney and Insider board member Neil Oberfeld. “That's because if a tenant chooses to exercise its ROFR and expand, the owner has already gone to the trouble of finding an outside tenant that it will lose. On the other hand, a right of first availability happens at the beginning of the process, when the owner can offer to the tenant the rent that it will be offering to the public for the space, and possibly get the space leased without having to go to the trouble of marketing the space and finding a prospective tenant,” he explains. Moreover, many owners feel the existence of a ROFR chills the interest of other prospective tenants that don't want to go through cumbersome lease negotiations knowing that another party has the right to match those lease terms and scoop up the space.

Whether you negotiate a ROFR or right of first availability, you should tighten the time frame that a tenant has to respond to your notice letting it know that space is available and stating the terms. That's because, if you're using a ROFR, you already have a viable tenant for the space, and you don't want to keep that tenant waiting for more than a few days, or it may move on to a different space.

“What an owner wants is a really short period of time for the tenant to respond—for example, three days,” notes Oberfeld. “If the current tenant says it won't exercise the option, it's critical for you to quickly get back to the interested new tenant,” he adds. And if you're using a right of first availability, you still want to get an answer quickly from the current tenant so that if it doesn't want the space, you can begin to market it or offer it to another current tenant that might also have option rights, he stresses.

PRACTICAL POINTER: Be clear when defining the expansion space. “Sometimes an owner will just say ‘all adjacent space' or ‘all contiguous space,’ and that's not really a clear way to define it,” Oberfeld warns. For example, would contiguous or adjacent space include the floors above or below? Lack of clarity can cause complications. Even using suite numbers has its pitfalls. The best practice is to show the expansion space on a space plan that is attached as an exhibit to the lease.

Change Only Economic Lease Terms

An expansion should be on the exact same terms of the tenant's existing lease—except for the rent and any other economic terms that were outlined in your notice. (Those would be based upon the offer that another tenant agreed to if a ROFR was involved.) Terms like base rent, free rent, or a tenant improvement allowance should be specified in your notice. However, other terms of the lease like assignment or sublease provisions would stay the same.

Be prepared for pushback on this from tenants that have a right of first availability. They may want to negotiate a more favorable base rent or additional option rights or other new terms. Because the owner is coming to the tenant before it markets the space, there's some room for the tenant to negotiate because the owner may be concerned that it won't get what it's asking for the space from outside tenants. But with a ROFR, there usually isn't any negotiation on rent because the owner already has another tenant lined up that's willing to pay that amount; there's no reason for the owner to negotiate and charge less, says Oberfeld.

The expiration date of the extension term is typically established in your notice. But in some cases, you may want to agree ahead of time to give the tenant a hybrid ROFR or right of first availability—that is, make the lease for the expansion space “coterminous” with the lease term for the current space. But consider this carefully. It may only be worth doing to cater to a tenant that is crucial to your property, like a retailer that's a strategic part of the tenant mix at your shopping center. You could have the opportunity for a 10-year lease from a prospective tenant, whereas the tenant with the ROFR has only three years left on its original lease and might want to leave the original and expansion space in three years.

You should also be careful on a ROFR to provide in the extension option that any tenant improvement allowance, free rent, or other concessions will be prorated based on the difference in the length of the lease term. Make sure that a tenant is worth an expansion space lease that's “coterminous” with its original lease.

Reserve Right to Cancel Option

Remember to make a default by the tenant (either at the time it exercises the option or at the commencement date of the new space) trigger your right to cancel the exercise of the expansion option and prevent the tenant from renting the space. “You certainly wouldn't want to lose a new tenant that has good credit because you're being forced to expand the space for a tenant that's in default,” says Oberfeld. In some leases, Oberfeld has conditioned the expansion option upon the tenant's financial condition not having materially or adversely changed. Even if a tenant isn't in default, many owners won't want to take the risk of building out its space if its financial condition is shaky, he points out.

Your lease already may contain a provision, either in the expansion option clause or in another section, requiring the tenant to give financial statements to you at specified times. Regardless of where you include this requirement in the lease, say in the expansion option clause that you have the right to review the creditworthiness of the tenant and decide whether its financial condition has, in your sole discretion, deteriorated so that you may refuse the exercise of its expansion option.

Make Option Subject to Current Arrangements

Make your tenant's expansion option subject to all current existing leases and other option rights for the expansion space. “Some owners give a ROFR to several tenants that began leasing space at different times,” says Oberfeld. When you have multiple tenants with expansion rights to the same space, it's important to put in the lease provisions that the option you're granting to this tenant is subject to all currently existing leases and options, he stresses.

Make Right Personal to Tenant

Oberfeld suggests making an expansion right personal to that tenant. That is, the option would terminate if it assigned or sublet its original space. “The whole point of an expansion option is that you're willing to give this tenant the opportunity to expand. But if it assigns or sublets to a tenant with a whole different use, then why should the owner be stuck letting the assignee or sublessee have the same rights?” he notes.

However, a savvy tenant will ask for a “carve-out” for a “permitted transfer—that is, assigning the lease to an affiliate of the tenant or the new owner if the tenant sells its business. “Effectively, if the tenant is just putting its parent company in the lease or if it's selling its business and it's basically the same business staying in the space but with a new operator, the owner shouldn't strip away the option right,” Oberfeld suggests. Owners typically allow replacement franchisees to have the same rights as the franchisor leaving the space. “But if the tenant assigns the lease to a complete stranger—for example, a shipping retail store assigning its lease to a hair salon—there's no reason to let the new tenant have the option,” he adds.

Use Lease Amendment

When your tenant exercises its expansion option, it's crucial to enter into a lease amendment memorializing the new lease terms. That way, you have an amendment that shows that the tenant is occupying the space, the date that the lease started, and the rent amount. The expansion option in the lease should require the parties to enter into a lease amendment following any such extension.

This is also important for debt financing. “You'll be able to show your lender the lease amendment, rather than the tenant's letter to you exercising its option and your letter back to the tenant,” says Oberfeld. “You'll avoid having to piece it all together if you need to refinance,” he adds.

Make Only Lease Trigger Option

While a ROFR or right of first availability is triggered by predetermined space becoming available, you can specify in the lease that certain things are not going to trigger this right, or include carve-outs, so that if you want to sell or use the space in a way aside from leasing it to that tenant, you're free to do so.

You could specify in the provisions that the tenant's ROFR or right of first availability doesn't apply for certain carve-outs—for example, leasing the space to yourself or an affiliated entity, leasing to other right holders that have existing option rights that were prior in time, or leasing the available space to a specific tenant.

Give Few Expansion Rights

Beware of giving expansion rights to multiple tenants for the same space or multiple expansion rights to one tenant. “Some owners give tenants multiple expansion rights in their leases, including a right of first availability and a ROFR,” notes Oberfeld, who says that giving layers of options can be a mistake. This becomes very complicated to manage when space becomes available. Also, if you give every tenant in the building an expansion option, you have to notify and offer each tenant the opportunity to exercise its option in order.

If, for example, you have eight tenants and each tenant has five days to exercise its option, you could have to wait up to 40 days to respond to your new tenant. This is a long time to keep an interested outside tenant waiting. And if you inadvertently fail to notify tenants in the order they should be, you could face a lawsuit from a tenant whose priority has been ignored and the tenant that, as a result of the mistake, exercised its option, but may not be allowed to move into the space.

“Fight the temptation to give everybody an expansion option, which will force you to manage and keep track of the priorities of your tenants,” advises Oberfeld.

Consider Creditworthiness

While it's wise to offer expansion options sparingly, it can be difficult to decide which tenants should get that valuable right. Tenants with lots of leverage, such as national retailers or large office tenants, could have the power to demand an expansion option. But if you're considering giving the right to smaller tenants without much bargaining power, reserve it for those with the best credit.

This is especially important as the percentage of your center or building that's occupied by the tenant increases. The larger the tenant is, the greater your dependency on its economic status is. Pleasing an anchor that's negotiating for an expansion option is probably more important than giving an option to a tenant that's not the main attraction. But checking a smaller tenant's credit history can help you determine whether it will be a viable option. If the tenant fails, will you have a substantial hole in your center or office building? And, at a center, there are additional “use” considerations, such as whether the tenant is a significant part of the tenant mix and would create a huge problem if it goes under. A tenant that has good credit is more likely to do well, and be able to take advantage of an expansion option if its business is growing—giving you an advantage for filling vacant space.

EDITOR'S NOTE: For a Model Lease Clause: Right of First Offer Is an Attractive Compromise, see Best Commercial Lease Clauses, Fourth Edition, available at www.CommercialLeaseLawInsider.com.

Insider Source

Neil Oberfeld, Esq.: Shareholder, Greenberg Traurig, 1200 17th St., Ste. 2400, Denver, CO 80202; www.gtlaw.com.