Leases: Option to Expand Space

By Brian Bader, CPA

A tenant's inability to obtain additional space is one of the most common reasons for non-renewal of a commercial lease. Owners of growing businesses often wish they had thought ahead about seeking an expansion option when they negotiated their leases. Expansion options come in a number of different formats, although all have the same purpose of assuring the tenant that additional space in the building can be obtained. At given times during the lease term.

The most direct method of granting an expansion right is an option to lease additional space, either contiguous to the tenant’s existing space or elsewhere in the building, at one or more times during the lease term. Since the landlord will not keep space vacant on the possibility that the option will be exercised, the landlord must have the right to relocate other tenants (or in some cases to terminate or buy out existing leases) in the event the option is exercised. In the case of a long-term lease, the landlord may be willing to grant more than one expansion option; if this is done, the expansion space and the time of exercise for each separate option should be clearly stated in the lease.

The lease should specify the period of notice the tenant must give of its intention to exercise an expansion option. Tenants always want to minimize the notice period so as to be as certain as possible of the need for the additional space. The landlord will want to lengthen the notice period because an existing tenant who must be relocated needs sufficient notice to do so. The more specific the space covered by the expansion option and the shorter the time period in which the landlord must provide the space, the longer will be the notice period required.

Contiguity of the initial space and the expansion space is usually a primary concern for the tenant because of the inherent efficiencies in operation. In addition, contiguous space can more readily be subleased if the tenant seeks to do so at a future date. Some tenants may be satisfied with additional space on the same floor, while others may not be unduly concerned if the space is on a separate floor. In some cases, a tenant may be willing to accept expansion space in a separate building owned by the landlord. The less specific the tenant's demand, the more likely the landlord will agree to the expansion option and the shorter the required period of notice.

Ordinarily, the expansion space will be leased for a term that ends on the same date as does the initial lease. However, it is possible that a tenant may want an expansion area for a limited period that ends before the initial lease or indeed, one that extends beyond the initial lease. Any such provision should be carefully spelled out in the option clause.

The rent for the expansion space is likely to be the rent paid for the initial premises plus accrued escalations. Alternatively, the landlord may want the rent to be the market rent for comparable space at the time the option is exercised if this is higher than the initial rent. If rents have declined in the interim, the tenant can choose not to exercise the expansion option unless a lower rent is negotiated.

The option provision should make clear that the lease for the additional space will include the same terms as the existing lease unless otherwise specified. Both parties should carefully examine the existing lease to be sure that no inappropriate clauses (such as the expansion provision itself) are included in the new lease. The landlord may insist that the new lease contain new clauses relating to security or environmental matters that then are part of the landlord's standard lease or that are required by law.

A tenant unable to obtain a fixed option to expand has one of two alternatives: a right of first offer or a right of first refusal. In addition, two other expansion techniques are the automatic pickup and the sublease.

The right of first offer requires the landlord to notify the tenant of the availability of space in the building (or in designated portions of the building) and to grant the tenant an option to lease the space prior to the landlord entering into a lease with a third party. The new space can be at the same rental as the existing space or at a rent to be negotiated when the right of first offer is exercised. Other lease provisions can be identical to those in the original lease or amended to reflect new provisions in the landlord’s standard form lease.

At the very least, this imposes an obligation on the landlord to negotiate in good faith even if the landlord would prefer a new tenant to take the space. The provision granting the right of first offer should specify whether the right can be exercised only once or whether it will survive a non-exercise by the tenant following one (or more) notification(s) by the landlord of space availability.

The right of first offer can be in addition to a fixed option to expand. A landlord often will insist that a fixed option be exercisable only at certain times and with respect to certain space, since the option hinders the landlord's ability to freely lease space in the building. On the other hand, a right of first offer merely obligates the landlord to negotiate terms when and if space is available.

A right of first refusal (RFR) requires the landlord to notify the tenant of an impending lease on designated space and grant the tenant an option to lease the space under the same terms as offered by the landlord to the third party. Third parties generally dislike RFRs (if they know about them) because the third party's negotiating efforts may end up benefiting the existing tenant.

As with other options, it should be clear whether an RFR will survive a non-exercise of the right by the tenant, either with respect to the particular space or to other space in the building. As with a right of first offer, the RFR can be combined with a fixed option to expand, each being exercisable at different times during the lease term. A tenant with an RFR should try to assure it has adequate time to respond to the landlord's notification of an impending third party lease. A large corporate tenant often needs the time to obtain internal approvals necessary to exercise the option.

A landlord unwilling to grant a fixed option, right of offer or right of first refusal nevertheless may agree to make additional space available to the tenant at a future date, even though the landlord may have to keep the space vacant for a period of time, provided the tenant agrees now that it will take the space. Such an automatic pickup provision (also known as a put-of-space) imposes a present obligation on the tenant to lease the space under specified terms at the future date. Since the tenant cannot be sure it will need the space, it should agree to this only when vacant space is at a premium.

A tenant determined to have future space available for expansion can take the ultimate step of leasing at the outset all the space it believes will be required, with the landlord's consent to sublease the space currently not needed. This gives the tenant maximum flexibility for future growth, because the tenant can structure the sublease terms as it wishes. However, this puts the tenant in competition with the landlord in marketing space in the building. For this reason, it can prove to be an expensive way to meet uncertain future space needs.

Brian Bader is a Partner in the Real Estate and Hospitality Services practice in BDO Seidman’s New York office. He can be reached at (212) 885-8203.

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