Almost all options are written with the assumption that rates will climb forever upwards. That just doesn’t always happen, and even when it does rents may not keep the steady pace of the 3% (or whatever) specified increase compounded over the lease term. Some options are literally not worth the paper they we’re written on. However, there is another reason why exercising an option may not be your best strategy.
It is rare that a tenant has the foresight to specify that an option will take into consideration customary concessions such as free rent, a generous improvement allowance, and resetting the Base Year (in a full service lease) to the current year.
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, although 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 renewal language specifies “market rate” and does not have an “adjustment for market concessions”, the tenant may effectively end up paying the highest possible rental rate a/k/a “the asking rate” without any of the offsetting benefits. This is, with few exceptions, mostly worthless to the tenant who could otherwise significantly improve their terms by simply negotiating competitive market terms.
If on the other hand, the market has declined, the option 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.
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.
Summary: Take the time to evaluate your option, and only exercise it if it clearly provides you with terms below negotiated market terms. Determine if your option is above or below market. If below, simply inform your landlord that you will be exercising the option, and show them the justification of rates if the specified rate is not clearly defined. You may be able to structure immediate rent relief and negotiate in expansion or contraction, immediate improvements, or other concessions.