The lowdown on options in leasing
As an accountant, you will more than likely be familiar with the process of leasing premises, either for your own business or for your clients’ businesses. As part of this process, you may have heard about options in leasing but do you actually know what they are and how they can impact a lease?
Landlords and tenants are always seeking security when engaging in a lease. In addition to security in the form of a cash deposit or security bond, landlords can also find security in a lease through an ‘option to renew’ term as it can secure rent payments for an extra term. An option to renew also benefits tenants as they have the power to decide whether they would like to occupy the premises for an extra term. However, it is important that both parties understand their rights and obligations when exercising or denying the option to renew a lease.
What is an option in a lease?
An option is a term in a lease which allows a tenant to renew their occupation of a premises before their tenancy comes to an end. The amount of additional tenancy time which the option offers is detailed in the initial lease. There is usually a specific window of time to exercise the option. The tenant has no obligation to renew the lease however, the landlord does not have the right to deny the tenant from exercising their option unless there is a breach of the lease.
What are the benefits of having an option?
An option provides security for the tenant as they can secure their premises for an extra period of time if they find that it is well suited. The landlords also benefit from an option as they can secure rent payments for another term and avoid looking for a new tenant.
How and when is an option exercised?
The specific requirements of how the option may be exercised by the tenant are usually detailed in the lease. For example, the specific form type (i.e. in writing) and delivery type of that notice may be outlined. If the tenant fails to adhere to these formalities, they may be denied the right to exercise their option to renew.
In addition to the formalities, there is usually a specific ‘window’ of time in which the option may be exercised. This period is most commonly between three to six months before the lease ends. If the tenant fails to exercise their option within the specified period, they usually lose their option to renew.
What conditions must the tenant meet in order to exercise their option?
Whilst tenants generally have the right to exercise their option, there are certain conditions which must be met.
There are two circumstances which will deny the tenant the right to exercise their option:
- If they are in breach of the ‘window’ of time allocated to exercise their option; or,
- They have repeatedly breached the essential terms of the lease.
In addition, the tenant must ensure that they have served the appropriate notice.
How can a landlord deny the tenant’s right to exercise the option?
If there has been any breach which the landlord would like to rely on in order to deny the tenant’s right to exercise their option, they must serve an appropriate form of notice to the tenant.
The notice must satisfy the following (as per the Conveyancing Act 1999):
- It must specify the particular breach relied on;
- If the breach is capable of a remedy, it must detail how the lessee must remedy the breach; and,
- If the landlord claims any compensation because of the breach, the notice must detail what the tenant must pay.
If the above details are not referenced appropriately in the notice, the landlord can’t deny the tenant’s right to exercise their option.
How is the new lease drafted once the option is exercised?
Once a tenant has successfully exercised their option to renew a lease, a new lease must be drafted. The new lease is called an ‘option lease’. It is important that the lessor’s solicitor make specific amendments to the initial lease when drafting the new lease. For example, the lessor’s solicitor must remove any clauses which no longer apply to the new option lease. Examples of clauses which no longer apply include rent free periods or lessor incentives. The solicitor must also include the new rent and lease term, and any amendments to the rent review.
An option term is an important part of many leases. It provides security of the premises for the tenant and security of rent for the landlord. It is therefore integral that both parties understand how an option can be exercised and what rights and obligations they have. It is also important that the terms of the new option lease are carefully considered.
A tenant should also remember that once they have exercised their option, they can’t walk away from their obligations under the new lease even if lease documents haven’t been signed. Once the exercise has been made, in most cases, the tenant is bound for the further term.
Also, consider carefully how rent will be determined. If there is a market review on exercise of option, look at what is the mechanism for disputing any market determination.
Taking into account the above, if you’re aware that your clients have the right to an option, it’s critical that they are notified of not only the right itself, but specifically, the conditions that must be satisfied before their option can be exercised should they decide to do so. Failure to do so may result in your client not receiving the full benefit that they would have ordinarily had under the lease, as well as them potentially incurring substantial additional costs for relocation and make good due to the expiry of the lease.
For more information on options in leasing and how they may impact your clients, please contact:
Andrew Grima, Principal
Phone: +61 2 9895 9271
If you would like to receive our regular legal Updates, please subscribe here.