For a tenant, a renewal option is included in a lease as a method to reduce future uncertainty. This renewal option provides the tenant comfort that they have the option to extend an existing lease at predetermined terms, if they so choice.
Because the tenant has the right, but not the obligation to exercise a renewal option, there is an alternative way to look at certain types of renewal options.
Renewal options with a predetermined base rent schedule (i.e. ones with stated rental rates or increases) are basically a call option on market rents increasing above this predetermined schedule.
In the stock market, call options are used to make bets on future stock price increases. Only if the stock price increases above the price of the option, is this option worth anything.
The same can be said for a lease renewal option. The option is only worth exercising if the prevailing market rent has increased to a rate above the renewal option rate. If the market rent less than what is scheduled in the renewal option, the tenant is better off not exercising the option and negotiating a lease extension from scratch.
For example, consider a lease with a renewal option of $25.00 per square foot.
So long as the market rate is $25.00 or more, the tenant should elect to exercise the renewal option. If the prevailing market rental rate is below $25.00, the tenant should elect to negotiate fresh terms for a lease renewal.
For this reason, many landlords will propose a renewal option at a rate of 95% of the market rate. This does a couple things:
- No matter the market rent, it incentivizes the tenant to renew, because the rate is (slightly) less than the prevailing market rate.
- Renewing an existing tenant benefits the landlord because the renewal avoids lost revenue due to the time it would take to re-let the space. This could be a couple months of downtime, or a couple years; many times it is a gamble. For this reason, many landlords prefer to take a haircut on the rent in order to avoid this risk.
The downside of a percentage of market rent renewal option is going through the actual process of determining what the “market” rate actually is. Get it wrong and this can be a painful process.
For tips on negotiating a renewal option, check out Coy Davidson’s post Negotiating the Renewal Option.