Friday, 28 July 2017

Lease Options: How They Work

What is a lease option? And how does it work? Lots of businesses operate from rented premises. Which means the operators of the businesses have signed a lease with the owner of the premises, which is a contract to occupy the premises for a certain period of time (the term) and pay a fee for that privilege (the rent) and also the expenses incurred in occupying and using the premises, like water, electricity and gas charges (the outgoings).

A lease option is how the tenant (the person who is occupying the premises) can choose to extend the  term beyond an initial period. The use of options recognises these things, among others:
  • It may be difficult for a tenant to commit to a very long period of occupation. The economy can change, and customers' tastes can change, and it might not be possible to operate the same business in the same place for a very long time. Having the choice to extend the term for a fixed perod, or give up the lease at the end of the initial term, is a good balance.
  • The costs to the land owner (landlord) of maintaining the business will change over time. Therefore, the landlord will want to periodically review and increase the amounts of rent and outgoings charged to the tenant. The end of the initial term presents a good opportunity to do this, so that any changes in rent and outgoings will apply for the renewal/extension term.
It is common for shop leases in Australia, where I live and work, to have 5-year terms initially, with one or more 5-year or sometimes 3-year optional extension terms. Usually, the tenant does not have an absolute right to extend the term. The tenant must have complied with the lease correctly, up to that point, to "earn" the right to extend. Also, the option must usually be exercised within a certain limited window of time, e.g. no sooner than 6 months before the end of the lease and no later than 3 months before that time. This gives the landlord the opportunity to advertise the premises and get a new tenant lined up, if the current tenant is going to leave, but also to assess the tenant's behaviour over most of the term of the lease, if the tenant wishes to stay.

Having a lease option up your sleeve is also a very valuable asset in the event that the tenant decides to sell its business. Not having a long-term location will usually affect the price of most types of businesses that rely on goodwill, i.e. the support of returning customers. The option mechanism is a very important part of a commercial or industrial lease. If you are thinking about signing a lease, you should study the option clause carefully.

This blog post supplements our earlier post (2016) also on commercial lease options. You may like to read that post also.

[Photo credit: 2011 Newsagent Edinburgh by Ronnie Macdonald, a public domain image courtesy of Wikimedia Commons, used here under a CC BY 2.0 licence. This blog post is not intended as legal advice for any particular person. The author, James Irving of Irving Law, is a commercial and Wills  lawyer practising in Perth and Melbourne, Australia.]

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