Commercial Property Lease Options - A Full Explanation for Landlords and Tenants

As a commercial landlord, you are often faced with the decision of whether you should grant your tenants an option to renew their lease. While an option to renew can be an attractive proposition for tenants, it can also pose significant risks to landlords if not properly managed. In this blog post, we will explore the potential impacts of commercial property lease options and granting a tenant an option to renew their commercial lease and provide some guidance for landlords looking to minimise their risk.

First, it’s important to understand what an option to renew is. An option to renew is a provision in a lease agreement that gives the tenant the right to extend their lease for an additional term.

We often hear inexperienced owners say something like “I have a nine year lease” but with further digging we discover they actually have a three year term with two three year options. They don’t have a nine year lease – it is a set lease term and have granted the right to the tenant to stay longer if the tenant chooses.

On the surface, granting an option to renew to a tenant may seem like a win-win situation. The tenant gets the opportunity to potentially extend their lease, and the landlord gets a steady stream of income from the option term. However, there are a few potential pitfalls that landlords should be aware of in relation to commercial property lease options.

One risk of granting an option to renew to a tenant is the potential for the market value of the property to decline. If the market value of the property declines significantly during the initial lease term, the landlord may end up having to accept a lower rental rate when the tenant exercises their option to renew that is tied to a market review. This can result in a financial loss for the landlord.

We have also seen landlords grant an option to renew without a market review, instead opting for a set increase or worse still no rental change. Therefore if the market rate increases the tenant’s rent does not keep in line with this change. Or if the market rent decreases during the lease term and there is a set rental increase for the option, the tenant can simply choose to not renew the lease or threaten to leave and negotiate a lower rent.

Another risk to consider regarding commercial property lease options is the possibility that the tenant will exercise their option to renew at a time when the landlord has other potential tenants interested in the property or they may wish to utilise the premises for their own use. If the tenant exercises their option, the landlord may have to turn away other potential tenants or not get access to the property themselves, potentially resulting in lost income.

Finally and potentially the most important risk, granting an option to renew to a tenant can also complicate the landlord’s ability to sell the property in the future. If the tenant has an option to renew their lease this could restrict the ability to sell the property to an owner occupier. This can hold back the value of the sale price such as when owner occupiers may be wanting to pay more than investors for the asset. This could result in the seller receiving lower offers to purchase and could add time on market while the right buyer is found.

There are some safeguards that a landlord could consider inserting into a lease such as a demolition clause or a rachet clause, the latter being restricted under the Retail Leasing Act in Queensland. This could provide an additional lever for the landlord or someone who buys the property in the future.

In conclusion, while granting an option to renew to a tenant can have its benefits, it is important for landlords to carefully weigh the potential risks before making a decision. Landlords should evaluate the financial stability of the tenant, the current market value of the property, and the potential impacts on their ability to sell the property in the future. By considering these factors, landlords can minimise their risk and make informed decisions about whether or not to grant an option to renew to their tenants.

Crew Commercial agents and property managers are experts in negotiating sales and leases for industrial real estate and commercial property. We have encountered countless situations in Brisbane, Gold Coast and Northern New South Wales where lease options have effected the value of our client’s properties. We encourage landlords to contact our team to discuss their individual situation before committing to an agreement with their tenants.