Incorrectly Exercising Options and the Impact on Market Rent Reviews - IPS Consultants - Property Valuations, Advisory & Professional Services

By Simon Fonteyn

BCom, Dip Val, MMGT AAPI

Managing Director

IPS Consultants

An option is the right granted under a lease whereby the Lessor grants to the Lessee the right (but not the obligation) to enter into a further lease term of the premises after the expiry of the initial lease, within a specified timeframe limited in the initial lease.

In Australia, the responsibility for exercising an option correctly always falls on the Lessee, as the lessee receives the benefit of a new lease. In other countries it is at the Lessor’s discretion.

However, exercising an option correctly is not straight forward and requires detailed knowledge of your own lease, relevant Retail Leases Act in the applicable States, relevant case law and Real Property Law. It also requires you to be diligent with regard to managing dates and keeping up with your obligations under the lease.

Remember that leases are complicated financial instruments and expert legal advice should always be sought. Also, if you think you are alone in your dilemma in managing options, take heart – Some of the biggest names in corporate real estate have missed options as well!

Case Study – The Lock Out

The businessman stares at the silver chain strung around the entrance to his once thriving business. He glances up at glass entrance doors which have newspapers and magazines stuck to them that masked ten years of ‘blood, sweat and tears’ plus more than half a million in fitout costs. Disbelievingly he says” I never thought it would get to this.”

This was one extreme case of an option exercise that went horribly wrong. This involved a restaurant with a lease term of ten years plus a ten year option. The restaurants proprietor had a well established and well known business on a prominent corner location, on a busy retail strip.

The owner of the restaurant knew he had an option and with approximately two months left until the expiry of his lease, he shot off an email to his landlord which went like this:

Dear Mr Landlord

Please be advised that I wish to exercise my option, subject to you replacing the kitchen exhaust and for the rent to remain the same as discussed.

Best Regards

Mr Tenant

Approximately one month later, the restaurateur receives a letter via registered mail from the Landlord’s solicitor, which said words to the effect of:

Dear Mr Tenant

We act for Mr Landlord. Your lease at 21 Desolation Row will expire on 31 March 2007. Accordingly the owner will require vacant possession of the premises by close of business on that date.

In accordance with Clause 9 of your lease you are required to make good the premises on or before expiry date. Should you wish to discuss this matter, please contact the undersigned.

A Solicitor

Immediately, the restaurateur picked up the phone to his solicitor and shouts

“Look there has been a mistake here at my restaurant. I just got a letter from the Landlord’s solicitor threatening me with eviction. I exercised my option, I will forward you the email I sent to the Landlord and fax you this letter. Can you immediately sort this out, as this is critical?

The next day the restaurateur receives a call from his solicitor.

“Look, you have a problem. You didn’t exercise your option in time and furthermore it wasn’t done in the correct manner. Unfortunately your option has lapsed. I spoke to the Landlord’s solicitor and he has re-iterated the Landlord’s intention to take possession of the premises at your lease expiry.”

“But I wasn’t aware there was a time limit on when an option can be exercised. Look we can’t just let him take away my business like that. I have always had quite a good relationship with the owner. Let’s offer him an increase on the rent and I will pay the arrears on the place. Lets set-up a meeting for next Monday with the owner and we will finalise this option.”

The result of this case was the tenant lost his right to the option and the lessor took possession of the premises. The tenant lost his business and he also lost his security deposit, as he didn’t make good the premises in accordance with his lease.

In this case, the lessee made several fundamental errors, which will be reviewed at the end of the chapter.

We will start with the basics by examining what an option is, when do they occur, what are the implications for exercising an option or not and review of the methods and techniques to correctly exercise an option under a retail lease. Lastly we will reexamine the Lockout Case to see what should have occurred.

So what is an option under a lease?

An option is the right granted under a lease whereby the Lessor grants to the Lessee the right (but not the obligation) to enter into a further lease terms of the premises after the expiry of the initial lease, within a specified timeframe limited in the initial lease.1

In Australia, the responsibility for exercising an option correctly always falls on the Lessee, as the lessee receives the benefit of a new lease. In other countries, it can be at the Lessor’s discretion.

However, exercising an option correctly is not straight forward and requires detailed knowledge of your own lease, relevant Retail Leases Act in the applicable States, relevant case law and Real Property Law. It also requires you to be diligent about managing dates and keeping up with your obligations under the lease.

In the following sections, we will explain the key elements for exercising an option correctly.

The Option Exercise Window

Example 1

A lease over a shop in NSW commenced on 1 July 2005 for a term of five years with an option for a further five years. The lease contained a provision that stated the option must be exercised no earlier than six months prior to the expiry of the lease and no later than three months prior to the expiry of the lease.

The Option Exercise Window

There are three critical dates here. The expiry date of the lease, the option exercise start date which is the earliest date which the option can be exercised and the option exercise end date, which is the last day an option can be exercised. The Start and End date of the Option Exercise period is known as the Option Exercise Window. If the option is exercised outside the window, either too early or too late, the option will generally lapse.

The option exercise window will vary from lease to lease and therefore each lease must be read thoroughly and the critical dates diarised.

What if you miss your option exercise window?

Generally if a lessee misses their option exercise window, then the option will lapse, unless the lessor agrees to formally extend the option exercise window. There maybe some exceptional circumstances where a lessee maybe able to plead an ‘accident or surprise’2. If you get into that situation you need to immediately seek qualified legal advice.

Whilst getting the dates right is critical in exercising an option, there are equally important factors which must be carried out.

Part 2 – Exercising An Option and being ‘locked in’ without the lessee intending to be

Another common mistake that lessee’s make relates to exercising an option under the misunderstanding that option terms are ‘conditional’, in particular that the rent can be ‘negotiated’ and if the lessee is not happy with that rent proposed by the Lessor then they can walk away from the option lease. In most cases, retail lease options are not conditional, in other words, if the lessee exercises their option they are bound by the terms of the option lease. This will usually involve a market rent review, which is not a negotiation. Market rent reviews will be dealt with in the next chapter.

Lets examine a case involving an exercise of an option, where the lessee didn’t really intend to exercise their option.

Case Two – Locked In

The Board for some time had been unhappy with the premises that the business had been in. They had instructed their general manager to make it known to the Lessor that they wanted a number of items in the building upgraded or repaired, if the Lessor wanted to keep them as a tenant. The General Manager was also asked to conduct research into alternative premises and make recommendations regarding suitable space and appropriate leasing rates.

The Board and general manager were aware that the option exercise window was about to expire, however they had no intention of staying in the premises, if the Lessor was not prepared to upgrade the premises to suit their business needs.However the Board’s intention was to ensure that the business was able to stay in the premises until such time as a commitment to upgrade the building was forthcoming from the Lessor or suitable alternative accommodation could be secured.

The General Manager had a meeting with the Lessor just prior to the last day of the exercise window, in which the Lessor stated that they would be unable to commit to any upgrade to the premises unless the Lessee exercised their option. It was disputed as to what was actually said between the parties. The General Manager then wrote a letter to the Lessor, exercising their option and signed it off as a General Manager of the company. The Lessor acknowledged receipt of the letter and confirmed that the lessee had exercising their option. The Board was not aware that the Lessee had exercised their option and only became aware at their Board meeting which was not for some time afterwards. Furthermore in this lease, there was a fixed rent review at the expiry of the lease. The lessee paid the increase in the rent.

At the next Board meeting it was revealed that the general manager had written a letter exercising their option. The Board immediately wrote a letter to the Lessor, stating the following:

The lessee had no intention of exercising their option, due to the condition of the premises, which was made known to the Lessor on numerous occasions;
The general manager had no authority to bind the company, as he did not have authority to do so
The option letter was null and void, because it was not executed correctly
The option notice was conditional on the Lessor agreeing to upgrade the premises and therefore not valid
The option lease was not signed by the Lessee
The lessee had made it known to the Lessor that they intended to hold over and the lease was effectively a month to month tenancy.

The lessee gave notice to the lessor after several months into the new lease and left the premises. The Lessor sued the Lessee and the case went to Court,for breach of contract. The court held that the Lessee had in fact excercised their option, even though the Board had not approved it, and the option lease was not signed. In this case as the Lessee was a corporation, the court held that Lessor was entitled to rely on the documentation it was provided.

The Impact of Missing an Option on Market Rent

Option provisions within commercial leases usually contain a market rent review. If an Option is not exercised. then the Lessor and Lessee can still agree on a new rent, however the Lessee will not get the benefit of a market rent review, unless both parties agree.

Market Rent Reviews require a third-party professional Valuer, who is independent to consider the value of the premises on a vacant possession basis, meaning that the value of the Lessee’s Business Goodwill, Fixtures and Fittings are excluded from the market rent. Usually, but not always, the Valuer is to have regard to Incentives such as Rent Free and Contributions to Fit out, which further reduce the Market Rent. Furthermore, in relation to Retail Premises covered under the Retail Leases Act, the Valuer is to have regard to the same or similar uses as the lease.

In order to avoid such issues, it is important to understand the process of market rent reviews and how to correctly exercise options .