How to Exercise an Option in a Down Market

Business shutdowns in Southern California have wreaked havoc in some sectors of commercial real estate - most notably retail. Others - such as manufacturing and warehouse buildings have barely skipped a beat! Certainly, where our economy is headed with respect to the “new normal” is worth considering. Masks, gloves, sanitizing, distancing, and limited capacity will all have a seat at the company table as we reopen. Add in some down days on Wall Street, civil unrest, and a pending election and the crystal ball is a bit murky. I was encouraged this week to read Disney’s plans for rebirth. Those guys are pros! Watch and learn. Their organization is inspiring.

Occasionally, a long-term decision must be made in the midst of a short term disruption - our present circumstances. If you lease commercial real estate and currently have an option to renew your term or purchase your building - you understand what I mean. You must predict where business will be in the future. An option is a right you have as an occupant. Certain characteristics apply. For one thing - an option is personal. Simply, you cannot transfer it. Dates are critical - also known as “time is of the essence”. A fancy way of saying - if you don’t by then you can’t. Finally, most options contain a mechanism for the exercise of the right plus some means of determining price and terms.

Typical language in an option to extend the term of your lease might be - five years at the prevailing market rents for comparable buildings within your market - but in no event less that your current rent. Ok. Easy enough. Generally, you’ll have to notify your landlord in writing within a window of time prior to the expiration of your lease. Common is, no sooner than nine months or later than six months is common. Got it!

However, here is where things get tricky. What if your window - to extend your term - opened on April 1 of this year and closes June 30? Hmmm. A bit tough to imagine where we are headed - especially if now you must commit for an additional five years.

So what should you do? I’d break it down like this.

Understand your specific option. You could have something of real value here! Or, you might simply have an agreement to agree. In the former, options forged during the last downturn could be at preset rates. Those presets could be substantially below the prevailing lease terms found in today’s environment. Value indeed! You can stay, avoid a costly move, and enjoy a favorable rent. Conversely, your “market rate option” creates a negotiation with the owner. Tenancy continues but at a higher amount. Regardless, spend some time and know how your option reads.

Take a look at the worst-case scenario. What happens if you don’t exercise your option? Will the landlord give you the boot? Certainly, that is a possibility. But how realistic? Here is where you might be vulnerable. Let’s say you moved into your space in 2010. Times were a bit different then. You clipped along for five years and extended for another in 2015. Mid-decade found rents on the rise - but the exponential increase occurred in 2017-2019. So now, a wide gap might exist between the rent you pay and the market. As we explained above - if your extension is tied to current rates vs presets - you’re facing a monthly bump. On your side? The cost to replace you. Don’t forget. Vacancy down time, concessions, abated rent, and brokerage fees - all must be paid by the landlord if you bolt.

Examine where you are - now. Congratulations! We’ve just weathered one of the largest business downturns - if not the largest - EVER! If you’re still standing - albeit a bit wobbly - chances are your operation is built for the long pull. My prediction is we climb from here. Send that letter! Stay and pay. On the flip side - serious concerns about the future don’t bode well for long term commitments.

Talk to the owner of your building. With the understanding of your specific option, a hard look at the worst case, and a view of present and future - schedule some time to talk to your owner. It should be in person. This can be challenging but manageable with ZOOM or other video conferencing tools. Covered during your chat will be your view of the world, your desire to renew or move, and an exchange regarding his situation. We just attended such a meeting. It was enlightening! Resulting was a comfort level. Both sides aired their positions. We will now move forward. However, some tenants use the following strategy. The building works for our business. We’re girded and armed for what’s next. Rent as outlined in the option is too high. What can we do? Your landlord’s answer might surprise you.

Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at [email protected] or 714.564.7104. His website is allencbuchanan.blogspot.com.