Specify Your Lease Options for Commercial Customers

A commercial property manager’s aim is to protect the interests of the building’s owner. While agreeing to lease options with new tenants may not be an ideal arrangement, their inclusion is often a reality in today’s market. It is important to know if and when they’re adversely affecting your client’s bottom line.

“Property managers need to understand the lease and how it can impact the property,” says Richard Muhlebach, a Seattle-based CPM author of several books on the subject of leasing. Often during lease negotiations, tenants interested in a property request an option to extend their lease.

“An option is a right for a tenant and obligation for a landlord,” he says. The tenant has the choice of whether or not to extend its lease when it expires and the landlord must wait for the tenant to make a decision and then accept that decision, says Muhlebach. “There are times when a landlord would prefer not to renew a tenant’s lease.” When negotiating a lease, Muhlebach recommends that managers should avoid giving tenants a lease renewal option.

But landlords in regions with high vacancy rates may be more open to negotiation. At Commercial Property Management Group in Fort Lauderdale, Fla., for example, the majority of leases include an option to extend, according to property manager Elias Porras.

Porras says, “Nowadays, [owners] are basically giving away more than they were three or four years ago.” Still, when they agree to include an option in the lease, landlords risk locking themselves into an unforeseeable tenant situation in the future. Therefore, be sure to review the lease and consider how the provisions in it could impact the cash flow and value of the building.

The option to renew

Nearly all options that tenants request are to renew the lease. If a lease includes this option, the lease could be extended for a predetermined period of time, providing the tenant has met the requirements outlined in the lease. So that the option also benefits your client, the owner should also negotiate other issues, such as what the rent will be and how the tenant could lose the option.

For example, landlords who agree to an option to renew may require the tenant to pay a higher rent during the extended lease term. “You could keep them at current increases in rent of three, four or five percent,” Porras says. In addition, he recommends ensuring that your client has recourse in the lease in case the tenant breaks the terms of the lease.

The decision to accept their request should also depend on the credit worthiness of the commercial tenants. “If it’s the government, the longer the lease, the better,” he says. “If the tenant is a startup, it’s a higher risk, so you might not want to lock them into a ten-year lease.”

The option to buy

Though very uncommon, occasionally a tenant will request an option to purchase the building when the lease is up. “The option may be based on a predetermined price, a market price or the price an interested purchaser is willing to pay for the building,” says Muhlebach, also a former president of The Institute of Real Estate Management. “Property managers should avoid giving tenants an option to purchase the building because such an option may restrict the building owner from offering the building for sale in an open market."

Although this option could lock the owner into a sale under certain circumstances, in today’s market, there may be cases when it makes sense to accept the option. With a building that is only 50 percent occupied, where not including the option is a deal-breaker, the landlord may feel he has no choice.

In such cases, Porras recommends including a forced savings plan so that the tenant has a vested interest in making the deal work. The owner could also negotiate a price that’s higher than current market conditions in order to compensate for the risk.

Other lease provisions

Typically, tenants pay a portion or all of the building’s operating expenses, says Muhlebach. Nowadays, “property managers are including replacement of capital improvements in the common areas as a building operating expense.”

For instance, replacing the carpet in the halls of an office building would be included as a building operating expense, explains Muhlebach. “The lease must allow for this expense to be included as part of the building’s operating expenses. The costs of such capital expenditures are amortized over their useful life.” In the carpet example, if the carpet has a five-year life, then one fifth of the carpet’s cost is added to the building’s operating expenses for five years, says Muhlebach.

When property managers take the time to review leases and lease options, they can help ensure that their clients are crafting financially sound documents, protecting their business and the property in the long run.