Commercial leases either give a tenant the right to remain in a property at the end of the lease term on the same terms; or the lease comes to an end and the tenant has to vacate. Often tenants will want to remain – if their business has been successful and they still need the property then why wouldn’t they – however, the landlord might require the flexibility of knowing that they can get the property back at the end of term with minimal fuss; and in this situation typically the landlord has the upper hand.
One way of attempting to strike a balance is to use lease option agreements. Options to renew and/or extend a lease have been used by landlords and tenants for many years but they are becoming increasingly common as landlords and tenants strive for flexibility and certainty in an ever-changing market.
Here our commercial property solicitors explore some key issues of lease option agreements, including the advantages for both landlord and tenant, what to look out for and alternative options which could also work for your business.
What is a lease option agreement?
A lease option agreement is where a tenant is granted an option to either renew or extend its existing lease of a property. It is important to understand the difference between an option to renew versus an option to extend as they work differently and can each carry their own implications. An option to renew results in the original lease coming to an end and a brand-new lease is created, either on the same terms of the original lease or subject to variations. A renewal lease extends the term of the original lease without any variation.
The terms of the option to renew or extend must be clearly stipulated in the original lease and at a minimum, it should include the length of the term of the new lease, the new rent and any other specific modifications that are agreed between the landlord and the tenant.
What are the advantages and disadvantages of using a lease option agreement?
Here we consider some of the advantages and disadvantages for landlords and tenants using a lease option agreement.
Advantages for landlords
- If the lease option agreement is well drafted by the solicitor acting on behalf of the landlord, the option can be made conditional upon the tenant being up to date with their rent payments. If the tenant is not up to date with their rent payments, then the lease option will fall away. This provides the landlord with additional protection as it prevents them from being tied in with a tenant that is not paying the rent. The same is true for other breaches such as lack of repair and unauthorised alterations.
- If the tenant chooses to exercise the option, it saves the landlord from having to pay to remarket the property.
- If the tenant chooses to exercise the option, the landlord has the security of granting a renewal or extended lease to an existing tenant with a good track record rather than granting a new lease to a new tenant.
- Usually, it will be a condition of the lease option that the tenant pays for the landlord’s legal fees incurred in connection with the new/renewal lease. This will be much cheaper for the landlord than if they were to grant a new lease to a new tenant.
Disadvantages for landlords
- Landlords generally prefer to grant longer leases to tenants without options to renew or extend. There is no guarantee that the tenant will exercise the option at the end of the current lease. If the tenant does not exercise the option, then the landlord must find a new tenant and they also potentially face lost income from a vacant property together with more legal and other professional costs incurred in connection with the grant of a new lease to a new tenant.
- There is seldom any compensation paid to landlords for the granting of a lease with an option to renew or extend. This could have a long-term impact on the value of the landlord’s investments.
Advantages for tenants
- It allows the tenant a contractual right to renew their lease which provides the tenant with more security and certainty for the future.
- It provides a tenant with more flexibility than if they were to agree to a longer initial lease term. The lease option agreement is exactly as it says on the tin – an ‘option’ and the tenant is therefore not obliged to exercise the option if they do not wish to do so.
- It can reduce the amount of Stamp duty land tax (SDLT) liability payable by the tenant as a shorter lease term with a lease option will attract lower SDLT liability than a longer lease term without a lease option would. It is worth noting here that a tenant would not be entitled to a SDLT refund if they terminate their lease by exercising the break right.
Disadvantages for tenants
- The tenant can be ‘locked-in’ to taking the renewal/extension lease on the same terms as those included in the existing lease. If specific variations to the terms of the existing lease were not agreed at the outset, then the tenant is not able to negotiate new or more favourable terms for the renewal/extension.
- The mechanisms of a lease option to renew or extend are dependent on the tenant’s performance and compliance with very specific lease provisions, for example, notice must be served on the correct date and by the correct method of delivery. Failure to comply with the option provisions will result in the option falling away.
- A shorter lease with an option to renew can mean less flexibility for a tenant than if they were to agree a longer lease term with frequent break rights. A longer lease term provides the tenant with more security, but they would have the added benefit of regular break rights which they could exercise if the lease was no longer sustainable for their business.
What are the alternatives to lease option agreements to renew/extend?
Here we explore alternatives to lease option agreements.
Longer lease term with break rights - A longer lease term gives a tenant the comfort of a longer term but with the flexibility to terminate the lease on the various break dates. Just because a lease includes break right(s) does not mean that they will automatically apply and the tenant must exercise the break right by serving a break notice on the landlord. Often a break notice will be subject to various pre-conditions; the main ones being that the rent is paid in full and that the tenant is not in breach of any of its covenants contained in the lease. A longer lease with break rights will attract higher SDLT liability for a tenant than a shorter lease with an option to renew or extend.
Reversionary lease - A reversionary lease is a lease granted with term to commence at a future date. The reversionary lease will take effect once the existing lease has expired and the reversionary lease term will start the day after the last day of the existing lease. Although the reversionary lease is completed at the same time as the existing lease, the terms of each lease do not overlap, and the reversionary lease term will kick in a day after the existing lease term expires.
Whether you are a landlord or a tenant, it is important to understand what your options are and also what your obligations are regarding a contractual agreement you may be considering or have already entered into. It is important to be clear on the type of document you require and that it is carefully drafted to meet your specific business requirements. If the terms of a future lease, however it is going to be granted, are not picked up at the heads of terms stage or in the drafting stage, then this can create uncertainty later on down the line.
For further assistance, please do not hesitate to contact one of our commercial property lawyers who would be happy to discuss your options with you.