What’s a Renewal Option Worth?

It is a great time to be a tenant, and here is another example.  Because almost all options are written with the assumption that rates will climb forever upwards, we’re seeing some interesting effects as rental rates tumble.  Some options are literally not worth the paper they we’re written on.  However, declining markets have made some usually unattractive renewal options have new value.  Here’s why:

In an appreciating market, it is typically most desirable for a tenant to have a “defined” option.  That means that the rent is spelled out in an actual dollar rate/SQFT or a percentage increase over the last year of the original lease term.  Simple enough, and in a declining market, of limited value.

In recent years, however, many landlords resisted defining future rates and instead insisted on “market rate” renewals.  You can guess where this is headed, right?

If the options provided for market rate renewals and especially if the option has a well constructed method for determining market rate – such as an appraisal or “comparable space within the project adjusted for concessions and construction allowances” – there may be a tremendous opportunity to lock in attractive rental rates.  Best of all, many options can be exercised at any time before a certain date meaning that the tenant can lock in while rates are low even if the expiration is years away.

Be prepared for the landlord to scream bloody murder because they may have a more optimistic view of future market conditions.  At the time of writing, many markets are still in relatively early stages of decline so if your expiration is a long way off it may be best to wait it out a bit longer.  Real estate values are difficult to predict more than 18 months out although can be gauged with relative accuracy within the next 18 months.  Watch your market(s) closely and exercise your market options near the bottom of the cycle.

Better yet, simply inform your landlord that you will be exercising the option, show them the justification of rates, and then negotiate revised terms beginning now.  You may be able to structure immediate rent relief and negotiate in expansion or contraction, immediate improvements, or other concessions.  Either way, you should end up paying less rent.