Welcome to Part 2 on “What is an option clause in a commercial lease”. Here we will look at what happens when tenants breach the terms of their commercial lease agreements, the importance of specifying the terms of a new lease, the significance of communicating the method for rent reviews, and how, if it all, these requirements differ in retail leases.
What happens if the tenant defaults?
It is fairly common for an option clause to be conditional on not breaching the terms of the lease agreement. The idea is to protect the lessor from leasing to unfavourable tenants that do not meet their rental obligations throughout the tenancy.
It is very important to have your leasing lawyer draft these terms as clearly as possible so that there is no confusion about what happens upon a tenant defaulting. Here is an example of a default provision:
The tenant cannot exercise the option to renew the lease if they:
- Are in breach of the Agreement at the date of exercising the option and/or on the final day of the initial term; or
- Have been in breach on the Agreement consistently over the duration of the term.
Under the second ground for refusal to grant an option to renew, your leasing lawyer might specify the number of breaches before which the option is revoked to make the clause as clear as possible and avoid any confusion.
What terms will apply to the new lease?
An option clause should always specify exactly what terms and conditions are to apply to the new lease. The option clause should specify the term, rent, and rent review method for the new lease.
Along with specifying the important terms in the option clause, they should also be specified in the Deed of Renewal. If there are any additional terms to be added to the Deed of Renewal, both parties must agree to these new terms. Without agreement to any new terms, the terms of the original commercial lease will continue to apply.
How will rent be reviewed?
When your leasing lawyer drafts the option terms, there should be absolute certainty about which rent review method will be used at the commencement date of the new lease term.
The majority of leases stipulate that a ‘market review’ method of rent review will be used, whereby the ‘current market rate’ is assessed based on the average rental amount of similar properties in the same area. Based on this assessment, the rent either increases or decreases. Otherwise, the rate of rent may be preapproved by both parties, or determined by an independent valuer.
Failure to specify the rent can result in the landlord not being entitled to increase the rental amount for the entire first year on the new term. For this reason, it’s worthwhile speaking with a leasing lawyer about inserting clear terms in the option clause.
As the landlord of a property under a retail lease, there are several considerations worth noting.
The legislation that governs retail leases varies slightly from state to state, however, all tenants of retail leases are entitled to request a market rent review. If the landlord fails to inform the tenant of the new rental amount before the option date, the option date will be extended until the rental amount has been determined. The idea behind this provision is that it gives tenants some idea of what they can expect to be paying in rent before they commit to exercising the option to renew the lease. After all, it is difficult to know whether the rent will increase and by how much, and whether this new rental amount will or will not be affordable.
Determining the new lease term
The length of the lease is typically a matter of supply and demand. Landlords operating in high demand areas might prefer a short-term lease due to the fact that they generate higher income. For landlords with properties in rural areas with much less demand, longer-term leases will provide more income security.
Option clauses benefit both parties. They give landlords income security and tenants security of tenure. Taking into account all of the above considerations, an option clause that is beneficial to both parties should be negotiable.
For assistance with this negotiation, contact LegalVision on 1300 544 755 and speak with one of our experienced leasing lawyers.