Granting Expansion Options to Tenants

Which of these classifications of expansion rights a tenant is given will depend on many factors; however, a landlord would be well-served to avoid granting rights of first refusal when possible. As any real estate broker will tell you, time can kill deals, and having to go back to your existing tenant when a deal is in hand with a third party is never an ideal situation. When market or business factors require that a right of first refusal be granted, landlords should keep the tenant's response period as short as possible. A five-day right of first refusal response period is much less likely to impact your third-party offer than a 30-day right of first refusal response period.

Conditions on the Right

The next consideration for landlords when granting expansion rights is the conditions that are placed around the tenant's exercise of those rights. It should be a condition to the tenant's exercise that, at the time of exercise and as of the commencement of the lease of the expansion space, the tenant not be in default under the lease and that no event has occurred that with the passage of time or the giving of notice would constitute a default by the tenant under the lease. Additionally, the tenant's exercise of the expansion right should be conditioned upon the tenant's having not assigned or sublet the existing premises. The rights the landlord grants on the front end of the lease are intended for and relate to that particular tenant and the landlord may not want a successor tenant to have those rights.

Many tenants request that this condition be limited such that it does not apply to their assignment to an affiliate. While every situation is different, that limitation is often acceptable from the landlord's perspective. Another important condition for landlords to consider when granting expansion rights is the amount of term remaining under the lease. Many landlords will limit this to three years, so if a tenant has less than three years remaining on its term, it cannot exercise the expansion right. If a tenant is granted renewal options under the lease, it may be appropriate to qualify that limitation by stating that if the tenant exercises a remaining renewal option and thereafter more than three years remain under the term of the lease, then the condition is satisfied. Finally, any termination of the lease should terminate all rights the tenant has in the expansion space.

Any expansion rights granted to a tenant should be expressly subject
to the rights of the current tenant(s) in that space to renew their lease, whether pursuant to an existing renewal option or otherwise. Additionally, all such rights should be subordinate to the rights of other tenants existing as of the date of the lease (or the amendment if the expansion right is granted in an amendment). A landlord cannot commit to provide greater rights than it has. Often, tenants will ask for a list of those with prior rights in the expansion space. From a landlord's perspective, handling this outside of the lease document is preferable, but when necessary a list can be attached as an exhibit. If such an exhibit is attached, then it is obviously imperative that such list is complete and accurate.

Terms of the Option

The next item for a landlord to consider when granting an expansion option to a tenant is the terms under which the tenant will lease that space. Where a right of first refusal has been exercised, business terms will generally be determined by the bona fide third-party offer that the tenant is matching, subject to any specific exceptions called for in the lease. A pure expansion option or right of first offer, however, require that the mechanism for determining those terms be expressly set forth in the lease. Generally speaking, the term of the lease of the expansion space should be co-terminus with the term of the lease of the existing premises. If that is not the case, the lease should
specifically address who is responsible for demising the space back in accordance with all applicable laws and codes.

The terms of the lease must clearly designate the space to which the expansion right applies. This will typically either be done by attaching an exhibit showing such space or with a statement that specifically describes the space. Regardless of how this is accomplished, specifically and clearly describing the property to which an expansion right applies is imperative for landlords. To avoid future problems, a lease must be 100% clear about to which property the tenant has rights.

The lease must also be clear that the expansion right applies only to the entire space and does not grant the tenant a right to lease less than all of the subject space (unless only a portion of such space comes available). If the tenant's bargaining power or the specifics of the transaction lead to a situation where the tenant is granted the right to take a portion of the space, landlords should include a minimum square footage that the tenant must take, and reserve the right to approve the remaining space for marketability and codes compliance. Landlords should also provide that the expansion rights they grant are one-time rather than ongoing rights.

Rent is obviously near and dear to the hearts of all landlords and an expansion right must clearly set forth how rent on the expansion space will be determined. Other than rights of first refusal, which will generally derive rent from the bona fide third-party offer being matched, rental rates under expansion options are commonly determined in one of two ways. Generally, rent will either be at the then current rental rate under the lease (determined on a per-square-foot basis), or it will be at market rent. Setting rent at the per-square-foot rate currently being paid under the lease is the cleanest and quickest way to arrive at rent for the expansion space.

The risk here for a landlord is the same as the risk when granting renewal options to tenants at preset rental rates: that the tenant will only exercise such right if the preset rental rate is below market rent and otherwise will simply approach the landlord about leasing the space outside of the terms of the expansion right set forth in their lease. Setting rent based on market rent is more time-consuming and can involve costs (if arbitration is required) and there is no guarantee as to what that rate will ultimately be determined to be. The best solution from the landlord's perspective is often to set rent at a market rate, but provide for a floor of the current per-square-foot rate under the lease.

Another important consideration with expansion rights set at market rent is to make sure the tenant is bound upon exercise of the option (i.e., the tenant cannot proceed and rescind the exercise of the expansion right based on a disagreement over market rent). In this situation the landlord would have incurred costs that ultimately did not lead to leasing the space, but more importantly, the landlord would have held the space off the market for a period of time thinking the space was leased, only to have to remarket the space later.

Final Consideration

One final consideration for landlords when granting expansion options is whether an expansion could trigger a violation of an exclusive use provision under another tenant's lease. Assuming your exclusive use provisions are well drafted and well thought-out, the answer to this question should be no. Nonetheless, it is a topic that deserves careful consideration. The most likely scenario where an expansion would trigger a violation of another tenant's exclusive use provision is when there is a square-footage threshold in the exclusive use provision.

For example, the existing tenant was not in violation when operating a sporting goods store in 5,000 square feet, but once it crossed the 10,000 square-foot threshold, it triggered a violation. Any prudent retail landlord must have a firm grasp on the exclusive use provisions that encumber their property, so the additional analysis required here should not be a significant burden.

Conclusion

As previously stated, expansion rights can be an ideal tenant inducement, as they provide tenants the flexibility they want and need and, when properly drafted and thought out, do not carry a significant burden for the landlord. Paying attention to the details touched on in this article will help landlords to ensure that the theoretical “win-win” situation is actually a “win-win” situation.

Matthew B. Mattingly is a partner at Bradley, Arant, Boult Cummings, LLP, resident in its Nashville, TN, office. The majority of his practice is concentrated on real-estate-related transactions with a specific emphasis on acquisition and development, and commercial leasing transactions.

Flexibility is an important consideration for tenants when approaching a commercial lease. That has likely never been more true than it is in today's market, as tenants have one eye on a prosperous future, but still have the sting of the recent economic downturn fresh in their minds. One way that tenants seek that flexibility is through expansion rights. Whether in the form of pure expansion rights, rights of first offer or rights of first refusal, such rights can provide an enticing incentive for tenants who desire long-term flexibility, but either cannot predict the amount of space they will need long term, or cannot commit to that much space at the time of lease execution. When properly drafted, such expansion rights should not be a significant detriment to the landlord, making them the perfect incentive for both sides. Nonetheless, a prudent landlord must consider a number of factors when granting expansion rights to a tenant.

Type of Right

The first consideration is simply the type of right that will be granted. These can come in many forms. However, this article places them in three basic categories: 1) pure expansion rights; 2) rights of first offer; and 3) rights of first refusal. A pure expansion right means that a tenant has the right, either on a set date or for a given period of time, to expand into additional space. Rights of first offer require the landlord to provide notice to the tenant when certain space comes available or is to be marketed. Rights of first refusal require the landlord to provide notice to the tenant when the landlord has received a bona fide third-party offer for space that it intends to accept, and then allow the tenant a period of time to match that offer. (See “In the Spotlight,” infra.)

Which of these classifications of expansion rights a tenant is given will depend on many factors; however, a landlord would be well-served to avoid granting rights of first refusal when possible. As any real estate broker will tell you, time can kill deals, and having to go back to your existing tenant when a deal is in hand with a third party is never an ideal situation. When market or business factors require that a right of first refusal be granted, landlords should keep the tenant's response period as short as possible. A five-day right of first refusal response period is much less likely to impact your third-party offer than a 30-day right of first refusal response period.

Conditions on the Right

The next consideration for landlords when granting expansion rights is the conditions that are placed around the tenant's exercise of those rights. It should be a condition to the tenant's exercise that, at the time of exercise and as of the commencement of the lease of the expansion space, the tenant not be in default under the lease and that no event has occurred that with the passage of time or the giving of notice would constitute a default by the tenant under the lease. Additionally, the tenant's exercise of the expansion right should be conditioned upon the tenant's having not assigned or sublet the existing premises. The rights the landlord grants on the front end of the lease are intended for and relate to that particular tenant and the landlord may not want a successor tenant to have those rights.

Many tenants request that this condition be limited such that it does not apply to their assignment to an affiliate. While every situation is different, that limitation is often acceptable from the landlord's perspective. Another important condition for landlords to consider when granting expansion rights is the amount of term remaining under the lease. Many landlords will limit this to three years, so if a tenant has less than three years remaining on its term, it cannot exercise the expansion right. If a tenant is granted renewal options under the lease, it may be appropriate to qualify that limitation by stating that if the tenant exercises a remaining renewal option and thereafter more than three years remain under the term of the lease, then the condition is satisfied. Finally, any termination of the lease should terminate all rights the tenant has in the expansion space.

Any expansion rights granted to a tenant should be expressly subject
to the rights of the current tenant(s) in that space to renew their lease, whether pursuant to an existing renewal option or otherwise. Additionally, all such rights should be subordinate to the rights of other tenants existing as of the date of the lease (or the amendment if the expansion right is granted in an amendment). A landlord cannot commit to provide greater rights than it has. Often, tenants will ask for a list of those with prior rights in the expansion space. From a landlord's perspective, handling this outside of the lease document is preferable, but when necessary a list can be attached as an exhibit. If such an exhibit is attached, then it is obviously imperative that such list is complete and accurate.

Terms of the Option

The next item for a landlord to consider when granting an expansion option to a tenant is the terms under which the tenant will lease that space. Where a right of first refusal has been exercised, business terms will generally be determined by the bona fide third-party offer that the tenant is matching, subject to any specific exceptions called for in the lease. A pure expansion option or right of first offer, however, require that the mechanism for determining those terms be expressly set forth in the lease. Generally speaking, the term of the lease of the expansion space should be co-terminus with the term of the lease of the existing premises. If that is not the case, the lease should
specifically address who is responsible for demising the space back in accordance with all applicable laws and codes.

The terms of the lease must clearly designate the space to which the expansion right applies. This will typically either be done by attaching an exhibit showing such space or with a statement that specifically describes the space. Regardless of how this is accomplished, specifically and clearly describing the property to which an expansion right applies is imperative for landlords. To avoid future problems, a lease must be 100% clear about to which property the tenant has rights.

The lease must also be clear that the expansion right applies only to the entire space and does not grant the tenant a right to lease less than all of the subject space (unless only a portion of such space comes available). If the tenant's bargaining power or the specifics of the transaction lead to a situation where the tenant is granted the right to take a portion of the space, landlords should include a minimum square footage that the tenant must take, and reserve the right to approve the remaining space for marketability and codes compliance. Landlords should also provide that the expansion rights they grant are one-time rather than ongoing rights.

Rent is obviously near and dear to the hearts of all landlords and an expansion right must clearly set forth how rent on the expansion space will be determined. Other than rights of first refusal, which will generally derive rent from the bona fide third-party offer being matched, rental rates under expansion options are commonly determined in one of two ways. Generally, rent will either be at the then current rental rate under the lease (determined on a per-square-foot basis), or it will be at market rent. Setting rent at the per-square-foot rate currently being paid under the lease is the cleanest and quickest way to arrive at rent for the expansion space.

The risk here for a landlord is the same as the risk when granting renewal options to tenants at preset rental rates: that the tenant will only exercise such right if the preset rental rate is below market rent and otherwise will simply approach the landlord about leasing the space outside of the terms of the expansion right set forth in their lease. Setting rent based on market rent is more time-consuming and can involve costs (if arbitration is required) and there is no guarantee as to what that rate will ultimately be determined to be. The best solution from the landlord's perspective is often to set rent at a market rate, but provide for a floor of the current per-square-foot rate under the lease.

Another important consideration with expansion rights set at market rent is to make sure the tenant is bound upon exercise of the option (i.e., the tenant cannot proceed and rescind the exercise of the expansion right based on a disagreement over market rent). In this situation the landlord would have incurred costs that ultimately did not lead to leasing the space, but more importantly, the landlord would have held the space off the market for a period of time thinking the space was leased, only to have to remarket the space later.

Final Consideration

One final consideration for landlords when granting expansion options is whether an expansion could trigger a violation of an exclusive use provision under another tenant's lease. Assuming your exclusive use provisions are well drafted and well thought-out, the answer to this question should be no. Nonetheless, it is a topic that deserves careful consideration. The most likely scenario where an expansion would trigger a violation of another tenant's exclusive use provision is when there is a square-footage threshold in the exclusive use provision.

For example, the existing tenant was not in violation when operating a sporting goods store in 5,000 square feet, but once it crossed the 10,000 square-foot threshold, it triggered a violation. Any prudent retail landlord must have a firm grasp on the exclusive use provisions that encumber their property, so the additional analysis required here should not be a significant burden.

Conclusion

As previously stated, expansion rights can be an ideal tenant inducement, as they provide tenants the flexibility they want and need and, when properly drafted and thought out, do not carry a significant burden for the landlord. Paying attention to the details touched on in this article will help landlords to ensure that the theoretical “win-win” situation is actually a “win-win” situation.

Matthew B. Mattingly is a partner at Bradley, Arant, Boult Cummings, LLP, resident in its Nashville, TN, office. The majority of his practice is concentrated on real-estate-related transactions with a specific emphasis on acquisition and development, and commercial leasing transactions.