Secure a Good Expansion Rights Clause

If you’re fortunate enough to need additional space during your tenancy, you’ll want to make sure your lease gives you a way to secure it. If the expansion clause is too vague, it won’t be easy to apply, and a court may not enforce it. Avoid that by paying attention to the details.

Describe the Space

An Option to Expand clause should clearly identify the space that you have in mind. It can be in the same building or property, or in another property held by the same landlord.

If the option space is in the same building, you’ll want to negotiate for contiguous space, for obvious reasons. In addition, consider what it will cost to integrate the space, contiguous or not, into your operation. Will you need to construct stairways or knock out walls? If so, your option clause should settle the issue of who will pay for this construction. As with the build-out when you first moved in, “designer” improvements, which aren’t likely to increase the rental value of the property, fall on your plate. Structural improvements that will benefit future tenants or those that will support a high rent after you leave can reasonably be shifted to the landlord.

Set the Rent

What will the rent be should you decide to take the optioned space? An expansion clause should answer this important point, or at least give a formula for setting the rent. If your rent is based on a simple per-foot figure (as is true in a gross lease), a common solution is to make the new rent either the prevailing market rate or the rent you’re paying at the time you exercise the option, whichever is lower. This method is most appropriate for tenants who have a gross lease.

Determining the “Prevailing Market Rent”

It’s one thing to say that the new rent for your expanded space will be the fair market value—it’s another to decide how the fair market value will be ascertained. Tackle this issue now, while negotiating the lease. If you leave the valuation method up in the air, you run the risk that the landlord will unilaterally demand an unrealistic amount. If that happens, you and the landlord may end up in court arguing over how to determine the amount of the new rent. Meanwhile, your business will suffer without the needed new space, and your wallet will be considerably thinner by the time a judge decides what the space is worth.

There are ways, however, that you can structure your option clause so that the fair market valuation is both equitable and speedy.

Value the property in the context of the option. If you decide to exercise your option to expand, remind the landlord that he won’t have many of the expenses for that space that normally accompany a completely new tenancy, such as broker fees, advertising costs, and build-out, or improvement, expenses. These areas of cost savings make it less necessary for the landlord to cover expenses and profit margins by setting a high rent. It’s much cheaper, from the landlord’s point of view as well as yours, to lease to you rather than start over with a new tenant.

Provide for mediation, then speedy arbitration. If the two of you can’t agree on the fair market value, you’ll want to turn to a neutral third party for resolution instead of a lawsuit. An experienced real estate appraiser or a broker may be the answer. Use mediation first, and then proceed to arbitration if necessary. The bottom line is that your lease clause should provide a method to deal with difficulties that may arise later.

Setting the Rent in a Net Lease

Many tenants, however, pay rent under a net lease, not a gross lease. The simple formula of “prevailing rent” won’t solve the new-rent problem for tenants who pay a part of the landlord’s operating costs—insurance, taxes, and common area maintenance. How can you determine now what the operating costs will be in five or ten years? In an attempt to estimate future operating costs, landlords often identify a “base year” for purposes of establishing a baseline figure for these expenses. The base year is usually the first year of the lease (though strong landlords may insist on earlier years). Tenants then pay a percentage of any increase to that figure. Assuming that the landlord’s operating costs will rise, it will be to your advantage to establish the base year as late as possible into your lease. Tenants with superior bargaining power may be able to make the first year of the expansion count as the base year.

Exercising Your Option

The option clause should also address when you can exercise your right to take more space. Ideally, you’ll want a fairly large “window”—for example, any time during the third year in a five-year lease. That gives you maximum flexibility to choose the right time.

You’ll be even better off if you can exercise the option in stages, which will give you the opportunity to expand gradually.

Naturally, the landlord will want to narrow your exercise rights as much as possible, since “flexibility” to you spells “tied-up space” to the landlord. Your attractiveness as a tenant and your negotiating power, coupled with the state of the market, will determine how far you can open the window.

Limit the expansion Right Exercise to You

If you sublet or assign the space and the new tenant exercises the expansion option, it’s possible that the new tenant won’t be able to meet its rent obligations. If that happens, you’ll be on the hook as a guarantor (unless you’ve set up the assignment or sublet differently). To avoid potential liability, make sure that the option to expand can’t be used by anyone but you.

This article was excerpted from Negotiate the Best Lease for Your Business by Janet Portman

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