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Expansion options in leases are a valuable tool for businesses
looking to grow and adapt to changing circumstances.
These options provide tenants with the ability to rent
additional space at a later date without committing upfront and can
be particularly beneficial during economic downturns or times of
economic uncertainty.
Economic uncertainty can make it difficult for businesses to
predict future growth and make long-term commitments, making
expansion options a useful solution to provide them with the
flexibility to adjust to changing business needs.
As landlords compete for tenants in a challenging market,
offering expansion options can be a powerful incentive for
businesses to sign long-term leases. However, as with any lease
provision, it is important for both landlords and tenants to
carefully consider the terms of an expansion option, as they can
have a significant impact on the lease agreement.
By properly negotiating and drafting the terms of an expansion
option, landlords can protect their interests and avoid costly
pitfalls, while tenants can gain the flexibility to adjust to
changing business needs without worrying about the expense of
relocation.
Negotiating Leverage
It is worth noting at the outset that tenants with significant
leverage are more likely to be offered expansion options by
landlords and are better positioned to bargain for more favorable
terms.
There are several factors that can give tenants leverage in
negotiating expansion options with landlords. The amount of space
rented is an important factor, as tenants who rent a significant
amount of space from a landlord may have more leverage in
negotiations because they are bringing in more revenue for the
landlord.
Creditworthiness is also a key factor, as tenants who have a
strong credit history and financial stability may have more
leverage in negotiations because they pose less of a financial risk
to the landlord.
The length of the lease is another factor to consider, as
tenants who have longer leases may have more leverage in
negotiations because they are committing to a longer-term
tenancy.
Finally, the landlord’s need to fill vacant space can be a
factor, as landlords who are struggling to fill vacant space may be
more willing to offer expansion options to tenants in order to
secure a long-term tenant. In general, leverage plays a significant
role in determining the outcome of negotiations for expansion
options, including whether the option is granted and the terms of
the option.
Types of Expansion Rights
There are three common forms of expansion options in leases: (1)
pure expansion rights, (2) rights of first offer and (3) rights of
first refusal.
A pure expansion right grants the tenant the right to expand
into specific additional space when they choose to exercise the
option, and the landlord is then obligated to make the space
available and lease it to the tenant.
This is generally the least favorable structure for landlords
because it encumbers the expansion space while the option is open.
Rights of first offer require landlords to first offer newly
available space to the tenant before advertising it on the open
market.
Rights of first refusal allow the landlord to take the property
to market and solicit bids for the space before making an offer to
the tenant. However, if a third party has agreed to lease the
space, the landlord must present the same deal to the tenant
holding the right of first refusal, and the tenant must refuse the
offer before the landlord can proceed with another deal.
Rights of first refusal can have a chilling effect on the market
for the landlord’s vacant space because potential tenants may
be hesitant to negotiate an agreement that can be taken by a holder
of a right of first refusal. Due to this effect, landlords are
often resistant to offer this right and typically prefer to grant
other types of expansion options.
Personal Right
To reduce risk, landlords often include provisions in expansion
options that restrict a tenant’s ability to assign or transfer
the rights to a third party.
Without such restrictions, the tenant could transfer the
expansion rights to a party with a higher risk profile or who has
significantly lower growth demands, potentially resulting in the
expansion space falling into the hands of a less creditworthy party
or remaining vacant and unable to generate revenue for the
landlord.
To prevent this, landlords may include language stating that the
expansion rights are specific and personal to the named tenant,
meaning that only the named tenant can exercise or benefit from
them.
However, a landlord may allow the tenant to assign or transfer
the rights to designated parties, such as affiliates or successors
following a merger or sale of assets. In some cases, landlords may
also allow tenants with significant leverage to assign or transfer
the rights to any transferee in connection with an assignment of
the lease that is approved by the landlord.
Superior Stakeholders
Landlords usually include clauses in expansion options that
prioritize the rights of other parties over the tenant’s rights
in certain circumstances.
For example, if another tenant party has a prior claim to the
expansion space, the tenant’s rights will be subordinated to
those of the other party. This helps landlords avoid granting
overlapping rights to multiple parties, which can lead to legal
disputes. Landlords may also prioritize the initial lease-up of the
expansion space in order to prevent the tenant’s expansion
rights from forcing the space to sit idle for an extended period or
harming the marketability of the space.
Additionally, landlords may include language that allows them to
renew or extend existing tenants in the expansion space, even if
the tenant does not have a renewal option in their lease, which
takes precedence over the tenant’s expansion rights.
Window Periods
Landlords often include a window period to exercise in expansion
options to specify the time frame in which a tenant must exercise
their right to rent additional space.
This allows the landlord to plan for and control the
encumbrances placed on their space by the option. Without this
uncertainty, the landlord can predict when they may need to spend
resources maintaining the space, prepare it for potential tenants,
or take advantage of any gap before the window period and between
the end of the window period and the end of the lease.
Landlords usually want the window period to be as short as
possible, commencing after the tenant receives notice of the
landlord’s anticipated delivery date for the expansion
space.
However, tenants with significant leverage may seek longer or
multiple window periods over the course of the lease.
In addition, landlords often include language suspending the
tenant’s expansion rights for a certain period before the end
of the lease. This is usually 2 to 5 years before the end of the
term, depending on the length of the lease.
However, landlords may allow the tenant to exercise their option
within this period if they agree to a renewal or extension of the
lease, requiring the expansion space to be included in the renewal
term as well.
Delayed Delivery Date
When a tenant exercises its expansion option, landlords often
want the flexibility to deliver the additional space over a period
of time.
To allow for this, landlords may include a delayed delivery date
in the expansion option. The delivery date will depend on the type
of expansion option being used.
For options that grant a pure expansion right, an outside
delivery date is often set in the lease. For options that use a
right of first offer, the delivery date is typically determined by
the delivery date specified in the right of first offer notice the
landlord delivered to the tenant.
And for options that use a right of first refusal, the delivery
date is usually based on the date that the third-party bidder had
agreed to in the competing offer. A delayed delivery date gives
landlords more control over the timing of the expansion and allows
for necessary preparations or renovations. It also gives landlords
the opportunity to fill any remaining vacant space before the
expansion takes place.
However, it is important for the parties to carefully consider
the length of the delivery period and ensure that it is reasonable
given the circumstances.
Minimum and Maximum Space Requirements
Landlords often require tenants to rent a minimum and maximum
amount of additional space when the option is exercised. By
imposing these requirements, landlords can optimize the use of
space in a building and avoid having to divide or reconfigure the
premises in an undesirable or inefficient way. It can also give
landlords with multiple grants of expansion rights the flexibility
to mitigate the risks of overlapping grants and confusing spatial
configurations.
In most cases, this requirement means the tenant must take the
remaining space on a floor or expand into adjacent space. However,
it could also mean the tenant must take an entire floor or whatever
is being offered, even if they only need part of it.
Minimum Occupancy Requirements
Landlords often also include a requirement that the tenant must
occupy a minimum amount of already-leased space at the time the
option is exercised. This requirement is meant to prevent the
tenant from using the expansion option for purposes other than
obtaining additional space. Landlords are usually concerned with
preventing the tenant from becoming a rival for the landlord’s
vacant space or from unfairly profiting through the assignment or
subletting of the expansion space.
In order to define “occupy” in a way that meets the
needs of both parties and avoids internal competition, landlords
and tenants should work together to determine a suitable
definition. As long as the tenant’s rental obligations are
being met and internal competition is avoided, landlords typically
allow tenants some flexibility in defining “occupy” for
the purposes of this requirement.
Lease in Effect and No-Defaults Requirements
When a commercial tenant exercises an expansion option,
lease-in-effect and no-default requirements may be included in the
lease.
These provisions ensure that the tenant is not in default of the
lease and that the lease is in full effect at the time of the
expansion. This is intended to protect the landlord from the risk
of both the originally leased space and the expansion space being
tied up if the tenant becomes financially distressed.
While the landlord is still at risk for the tenant becoming
financially distressed under the original lease, this risk is
typically contained to the originally rented space until the
expansion option is exercised. By requiring that the tenant is free
of defaults at the time the option is exercised, landlords can
prevent such risks from affecting the expansion space.
However, it is often negotiable between the parties whether
these restrictions apply to past defaults during the lease term,
judgments of default after judicial process or the mere state of
being in breach of an obligation under the lease and defaults at
the time notice of expansion premises’ delivery is given or
only those existing at the time of its commencement.
Conclusion and Summary
In summary, expansion options are agreements that allow tenants
to rent additional space beyond what they originally leased at some
point in the future.
These options can take the form of a pure expansion right, which
guarantees the tenant the right to expand into a designated space
once exercised; a right of first offer, which requires the landlord
to offer the space to the tenant before advertising it to the
public; or a right of first refusal, which requires the landlord to
offer the space to the tenant after receiving a bid from a third
party.
Expansion options can be beneficial for landlords trying to fill
vacant space and attract long-term tenants, and for tenants seeking
spatial flexibility and the ability to accommodate future growth.
However, negotiating expansion options can be complex, and
landlords are cautious when offering them.
To reduce risk, landlords may include certain conditions in the
options to protect their interests, such as requirements around the
structure of the option, the window period for exercising the
option, the amount of space required to be rented upon exercise,
the minimum amount of space required to be occupied before
exercise, the delivery date of the expansion space, consideration
of the rights of superior stakeholders, and the requirement that
the tenant has no defaults and the lease be in full effect at the
time of exercise.
These conditions are usually negotiated and tailored to the
specific circumstances and leverage of the landlord and tenant.
Shearman extern Brandon Naman contributed to this
article.
Originally published by Law360.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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