5 vs 3 Year Options

[willister]

Hi All,

Newbie here, I have a question if anyone can offer any advice about the length of options. We recently signed up a new tenant (phew, the last one was a troublesome ****) - upon the lease offer, he had offered a 3x5x5 rather than a 3x3x3. What are the pros and cons of each? We need to get back to him this week which way we want to go...

Some points:

* We don't intend on selling this place, but long tenancy tenures don't hurt.
* Building is relatively old - circa 1960s and does need a bit of work here and there but he offered to help out.
* Tenant is in the trades industry, 20 years experience and is trying to use the warehouse as a retail outlet/service his exisiting clients.
* We fear 5 years may be locking ourselves in...
* Currently agreed to a 4% increase on rent per anniversary for 3 years.
* We we intend to do is this, see how he goes for 3 yrs and if business successful, we want to increase the second term to +3,000 on the year 3 rent + continue at 4% increase per year.
* Current tenancy rate at roughly $48/m2, well below market rates.

Thanks in advance.

 

[chilliblue]

Never offer an option. Why should you tie your property up when the tenant is making all the decisions.

Your are worried about locking yourself in for 5 years when in fact the lowest period you nominated is actually 9 years (3+3+3 years).

If you must issue an option, then the have the initial term as 5 years with a 3 year option but the tenant is to advise in writing if they do not wish to take up the option no later than 12 months the initial terms expiry date.

Keep the increases at 4% and have a market review on the 4th year.

Seeing that the rental is below market, place a % rental clause into the lease that if the tenant achieves X business each year, then you receive a % of those sales.

Just a question. Why are you not undertaking the works required and have the tenant pay market rent.

You can then depreciate the fittings and fixtures?

 

[Kristine..]

Chilliblue - willister is talking about a commercial / retail facility, not a residential property.

Of course there will be options, that's what commercial leases are about!

willister - if the tenant is going to be using the property for retail space (and the property has the zoning / permit for this), and has never had a retail lease before, than 'as of right' they have the option for 5 years in the initial term even this was agreed as a 1 year lease ie you cannot 'unreasonably refuse' to allow them to have the use of the property for 5 years if they request to do that.

With regards to options following the first term of the lease, you will all know by then whether they have a viable business

The value of their business, and of your property, turns on the strength of the lease

Why would you not allow them the initial 3 year term, with two further options of 5 years each? Value for them, and value for you.

When are you going to review to market? To the best of my knowledge, ratchet clauses are not allowed and you cannot predetermine what the rent will be. Fixed percentage increases are generally not favoured and CPI increases are generally used in between reviews to market which must be clearly stated in the lease.

This is a commercial deal. There is no such thing as 'offered to help out' with regards to maintenance or upgrading a commercial facility - or residential, for that matter. 'Helping out' is a recipe for disasaster. Either the landlord, or the tenant, is responsible. It can't be both.

Any improvements or fitouts which he requires for the operation of the business are his expense and he is also responsible for removing these at the end of the tenancy and restoring the property to as it was at the commencement of the lease.

If you have already signed the lease, it's a bit late now for working out the finer details. If all that has happened thus far is an 'Expression of Interest' then you may still be able to negotiate. But sign it, and the door closes.

Cheers
Kristine

 

[chilliblue]

Kristine, with due respect, I have negotiated commercial/retail/industrial leases in the thousands over the past 20 years and I can tell you that over 95% of those leases DO NOT have an option.

An option binds a landlord to a "maybe" from a tenant and should never be taken a surety of tenure for the entire period. So why would any landlord place their property under a lease wherein the tenant has the upper hand and the control?

Generally options do not increase the valuation as there can never be any guarantee that the tenant will take up those options. Longer initial terms and the quality of the tenant however do.

There are no rights for a tenant to have an option.

Further, you will find that the smaller tenant prefer fixed rental increases as they are better able to work out their budgets and it is often easier for the landlord if they are self managing.

For the record, CPI generally tracks around 3% and the minimum that I allow in my talks are 4% so Willistar is on the right track.

Before you commit yourself to anything to this tenant, I strongly suggest that you speak to either a commercial agent or similar to ensure that what the tenant is proposing is actually on par with the market.

 

[newbyinvestor]

Kristine, with due respect, I have negotiated commercial/retail/industrial leases in the thousands over the past 20 years and I can tell you that over 95% of those leases DO NOT have an option.

An option binds a landlord to a "maybe" from a tenant and should never be taken a surety of tenure for the entire period. So why would any landlord place their property under a lease wherein the tenant has the upper hand and the control?

Generally options do not increase the valuation as there can never be any guarantee that the tenant will take up those options. Longer initial terms and the quality of the tenant however do.

There are no rights for a tenant to have an option.

Further, you will find that the smaller tenant prefer fixed rental increases as they are better able to work out their budgets and it is often easier for the landlord if they are self managing.

For the record, CPI generally tracks around 3% and the minimum that I allow in my talks are 4% so Willistar is on the right track.

Before you commit yourself to anything to this tenant, I strongly suggest that you speak to either a commercial agent or similar to ensure that what the tenant is proposing is actually on par with the market.

The tenant always has an option.. They can either sign or not sign the lease.

 

[chilliblue]

The tenant always has an option.. They can either sign or not sign the lease.

Only IF the landlord grants them an option in the lease.

Hence my point. Why give away something that locks a landlord in for an indefinate period when the tenant has not the same requirements.

Tenants would also love not to pay rent but we as agents and landlords have to achieve at the very least market rent and we sit down and negotiate that.

Many tenants would also love for the landlord to pay for all the refurbishment of the premises and maintain those fixtures and fittings at the landlord costs and how often do you see those clauses in a lease.?

However, when it comes to granting of options, many agents and landlords simply take the easy way out and issue them like they are a legal requirement.

As a landlord, it is your responsibility to attain the best possible terms for you not the tenant.

 

[Jacktej]

The issue of weather or not an option is included is part of the terms that the landlord and the tenant negotiate. every negotiation is dependent on the market conditions including the desperation of each party in relations to the property. Most discussions here seem to suggest that the landlord can dictate terms to the tenant. Further, it should always be remembered that in general, tenants well being is in the interest of the landlord

Only IF the landlord grants them an option in the lease.

Hence my point. Why give away something that locks a landlord in for an indefinate period when the tenant has not the same requirements.

Tenants would also love not to pay rent but we as agents and landlords have to achieve at the very least market rent and we sit down and negotiate that.

Many tenants would also love for the landlord to pay for all the refurbishment of the premises and maintain those fixtures and fittings at the landlord costs and how often do you see those clauses in a lease.?

However, when it comes to granting of options, many agents and landlords simply take the easy way out and issue them like they are a legal requirement.

As a landlord, it is your responsibility to attain the best possible terms for you not the tenant.

 

[HiEquity]

We recently signed up a new tenant

....

We need to get back to him this week which way we want to go...

So did you sign them up or not? If you have already signed, this would have been agreed? I'm confused...

* We fear 5 years may be locking ourselves in...
.....
* We we intend to do is this, see how he goes for 3 yrs and if business successful, we want to increase the second term to +3,000 on the year 3 rent + continue at 4% increase per year.
* Current tenancy rate at roughly $48/m2, well below market rates.

Why on earth would you be offering your property at well below market rates? Is this the rate you have committed yourself to for the next three years (+4% per year)? If the tenant's business can't afford to pay market rates yet then perhaps they should go somewhere they can afford? Are you desperate for the cash flow?

As for locking yourself in, I'm no expert but options can either lock yourself in or not, depending on how they're structured. As has already been stated, they don't increase the value of the property materially for the landlord so one has to be predisposed to not granting them.

However, an attractive and creditworthy tenant might come along, willing to pay market rents and wanting to spend significant sums renovating the place. Say they insisted on twenty years of options because they needed the option of security of tenure but weren't sure enough of the suitability of the property for their operations to lock in a long initial term. Then you would have to consider it.

Your proposal to lock in pre-determined amounts of rent increases at option takeup doesn't seem particularly attractive because either:
- Market rents may have softened in the meantime and your tenant can find a much more attractive property elsewhere for the same price as taking up the option when the time comes, so they'll never take up the option; or
- Market rents may be well above the increase, in which case your tenant will take up every option you have given them, ensuring you have to endure years of below market returns.

To get around these issues, you may want to grant a market rent review at option take up but make sure the tenant has to take up their option prior to the market review taking place (eg decide on whether they want the option six months prior to end of lease and conduct market rent review three months prior). This way they can't play option take up against rent review (well they can always try but the landlord has to just point to the lease and respond that option take up is a separate issue to the question of determining the market rent). This allows the possibility to squeeze a bit more out of the market rent process as well.

A properly stuctured (ie LL friendly) market rent review process on option takeup (or before in the case of a long initial term), preferably with a ratchet where possible, may not raise any material issues for the LL (if you know you don't wish to owner occupy or sell and are happy with the quality of the tenant) as it allows fully exposure to rental upside. It may also be very valuable for a tenant's operations. Hence you may wish to consider it...

 

[willister]

So did you sign them up or not? If you have already signed, this would have been agreed? I'm confused...



Why on earth would you be offering your property at well below market rates? Is this the rate you have committed yourself to for the next three years (+4% per year)? If the tenant's business can't afford to pay market rates yet then perhaps they should go somewhere they can afford? Are you desperate for the cash flow?

As for locking yourself in, I'm no expert but options can either lock yourself in or not, depending on how they're structured. As has already been stated, they don't increase the value of the property materially for the landlord so one has to be predisposed to not granting them.

However, an attractive and creditworthy tenant might come along, willing to pay market rents and wanting to spend significant sums renovating the place. Say they insisted on twenty years of options because they needed the option of security of tenure but weren't sure enough of the suitability of the property for their operations to lock in a long initial term. Then you would have to consider it.

Your proposal to lock in pre-determined amounts of rent increases at option takeup doesn't seem particularly attractive because either:
- Market rents may have softened in the meantime and your tenant can find a much more attractive property elsewhere for the same price as taking up the option when the time comes, so they'll never take up the option; or
- Market rents may be well above the increase, in which case your tenant will take up every option you have given them, ensuring you have to endure years of below market returns.

To get around these issues, you may want to grant a market rent review at option take up but make sure the tenant has to take up their option prior to the market review taking place (eg decide on whether they want the option six months prior to end of lease and conduct market rent review three months prior). This way they can't play option take up against rent review (well they can always try but the landlord has to just point to the lease and respond that option take up is a separate issue to the question of determining the market rent). This allows the possibility to squeeze a bit more out of the market rent process as well.

A properly stuctured (ie LL friendly) market rent review process on option takeup (or before in the case of a long initial term), preferably with a ratchet where possible, may not raise any material issues for the LL (if you know you don't wish to owner occupy or sell and are happy with the quality of the tenant) as it allows fully exposure to rental upside. It may also be very valuable for a tenant's operations. Hence you may wish to consider it...

Sorry, not yet, they've only put in an offer, which we haven't signed as yet, but time is near.

Problem with market rates is this, the property is does not have a high clearance and contains a sump pit (which was a deal broker for many potential clients.) I spent about close to $10K doing a partial roof reconstruction. The sump pit contains 2 sump pumps which must be turn on a daily basis, if not, the premise may be flooded.

All in all, it was on the market for about 7 months before we got an offer, so it was not easy to market the place. Speaking to the agent, he thought that the current per m2 rent rate was "ok" considering the building was aging and the sump pit was a deal breaker for most.

The tenant agreed to install a new roller door (current one is not electronic) which is about $3K+ as well as paint the building in a new colour scheme both inside and out (at least another $4K). If he is paying for these, hey I can't complain...

I ask about the leases because I had another offered which was:

* a 3x3 lease
* 3.5% increase annually - rent to be reviewed at end of first term before option kicks in.
* he is a startup mechanic who has never operated a business before, so a bit more risk there.
* He will not replace the manual roller door (we have 2 - 1 manual, 1 electric) or do any other repair work.

FYI the commercial property is in a Business Zone 3.

 

[RPI]

Out of interest the 3 year part is the minimum to not be a short term lease and therefore under common law gives the tenant an interest in the property.

 

[Kristine..]

Out of interest the 3 year part is the minimum to not be a short term lease and therefore under common law gives the tenant an interest in the property.

What rot!

Love and kisses
Kristine

 

[RPI]

What rot!

Love and kisses
Kristine

Hi Kristine

thank you for your considered rebuttable of my aside. Your attempt to educate me in the error of my statement by pointing out the relevant precedents was very helpful.

I am assuming then that you don't agree with the common law differentiation between short and long term leases (3years). And that prior to the enactment of the Real Property Act in 1877 short term leases, those being less than 3 years duration, did not create a common law interest in the land. And further, that this distinction is the historical common law connection as to why leases of 3 years duration or longer must be registered to create an interest in the land.

Also that the short term lease exception enacted in the Real Property Act of 1877 and subsequently reinforced and extended in the Land Title Act of 1994 means that short term leases, that being less than 3 years, will not protect options to renew, rights to acquire the fee simple or other reversionary interest beyond 3 years.

I believe that there may also have been something in relation to this distinction in the 1677 Statute of Frauds reinforcing the common law position prior to that.

So my humble understanding of all that lead me to my simple aside, that you so eloquently rebutted, that the 3 year thing is a common law legacy.


ps I just noticed you are from Victoria, where the legal system is a law unto itself. It is the most dissimiliar of all the states so the legislation in relation to leases may well have been very different. Although they still inherited Englands common laws so the pre 1788 still applies. You guys even sit on the wrong side in court and that I have no idea as to why

 

[PrimeCommercial]

Dont offer an option where you dont need to.

Most discussions here seem to suggest that the landlord can dictate terms to the tenant.

I very much agree...when in reality tenants currently have a choice of many other properties and most with Landlords desperate for a tenant.

 

[AAA]

Hi Willister, would be interested to know which tenant/terms you finally decided on and why? Would you do anything differently?
Anything you can share would be great.

Thanks

 

[willister]

Hi Willister, would be interested to know which tenant/terms you finally decided on and why? Would you do anything differently?
Anything you can share would be great.

Thanks

We went for a 3x5 in the end, as that gave 3 years for the tenant "to try out" and enough time for me to assess whether they would be a quality tenant or even if they could be "financially aloat" after 3 years...

Bear in mind the tenant offered a 3x5x5 and initially we did a 3x3x3 offer, none of these however were contractural, only the 3x5.

Client was in the "clean energy" industry with a focus on solar panels and water tanks/pumps with a bit of a smaller sector in insulation (fatt batts) - so what I would classify a "trade". He had 200m2 showroom/warehouse which he outgrew and was mainly used for office than storage...because I offered a substaintially bigger premise at a very competitve rate, he was going to open up a retail outlet to try his luck. He initially was looking for just 500m2 for a office/showroom structure.

He also liked the property's location, adjecent Bunnings and other trades.

On hindsight, I would have have offered a 3x3 instead, it gives more room for me to move and doesn't "lock me in" as much. If I had a view to sell, then I would offer the 3x5, after the 3 year period, if he signs up and proves to be a quality tenant, the value for the property would have been better.

 

[AAA]

Thanks for the detailed reply Willister.
Still learning mate so asking lots of q's.
Cheers

 

[Lbrus]

I am aware that this is an australian forum, I think it is more of a question of is it realistic enough or not?

 

[Aaron Sice]

To get around these issues, you may want to grant a market rent review at option take up but make sure the tenant has to take up their option prior to the market review taking place (eg decide on whether they want the option six months prior to end of lease and conduct market rent review three months prior). This way they can't play option take up against rent review (well they can always try but the landlord has to just point to the lease and respond that option take up is a separate issue to the question of determining the market rent). This allows the possibility to squeeze a bit more out of the market rent process as well.

^^^^ see that?

that's experience talking that could save you tens (upon tens) of thousands of dollars in lost rent.

that's gold my friend.

kudos.

 

[Peterw]

Chillieblue, I am surprised by your post, when you say you have been involved in thousands of leases, and 95% have not had an option in the lease. When I say surprised, I accept that you are sharing your experience, however in my 30 plus years, my experience has been the reverse. As both an owner and a tenant, as well as an agent, options have been in 95% plus of the leases I have been involved with.
From a tenants perspective, you look at the cost of your fitout, amortised over the "whole" term of the lease, including options, and that becomes your premises costs. As most leases, require personal guarantees by directors etc, by having say 3 years plus lots of 3 year options, if the market your business operates in goes belly up, you may loose your shirt, trousers etc, but you may save your house. I once asked a landlord to provide a personal guarantee, for their obligations under the lease ....... the answer cannot be printed.
Now what is the issue with a landlord, having options that can only be exercised by the tenant .... I see that as a good position. At the end of the first term, they are going well, have invested in fitout, they will pay market rent, and stay. Is that not what a landlord wants, a profitable tenant, with skin in the game, paying market rent. If you limit the tenant to one term, they will factor their fitout over that period, and may choose not to take the lease, as they have no certainty after the initial term. They may during the initial term, look for more secure premises, and you end up with a revolving door, and gaps in your income stream.
If you wish to sell the property, if the tenants has a substantial investment in their fitout, the prospective buyers confidence is increased, that the tenant will take up the option, so security of income is high. I think most people that have been involved in businesses for some time, can walk into a business, and know if the till is ringing. You may not know if the boss is playing around, and the partner is about to throw them out of the family home, and world war 3 is about to erupt, however in the big scheme of things, I thing long range connections have greater benefits than short range plans.
Any way, just my thoughts.

 

[chilliblue]

Unfortunately it is the agents that have created the marketplace for options and many give an option without a second thought of either not offering it or simply arguing for it to be included.

As you state in your post, the option favours the tenant and not the owner. It binds the owner and places a "maybe if I want" on the tenant. Where is the equity in that equation?

Personally, as an owner and agent, it is not my responsibility to ensure a system that favours a tenant and create an environment to shelter them from their inability to run their business. I have my own interests and I need to focus on that.

There is no surety of tenure with options. Surely as owner and agent you can see the benefit of having a tenant on 6 year lease is much better than a tenant on a 3 + 3 and having them leave at the end of the first term.

Reducing the lease into smaller terms allows a tenant to seek alternative locations and/or negotiate better terms. In one fixed term, the negotiations have been done.

My preference is not have options and in most instances they are not detailed in my leases. Where they are, there is a significant reason for doing so and as I have stated before, the tenant must give 12 months minimum notice of vacating.

What I have noticed is that the larger businesses agree not to include them and the smaller ones tend not to ask until their solicitor becomes involved but then they are essentially committed.

Owners do have obligations written in their leases. Where I have acted on behalf of the tenant, it is often better to have these negotiated rather than an option.

I need to reference to a point in your post. As a potential purchaser, you should never under any circumstances assume that a tenant will take up their option unless is has been excerised correctly and in writing. As an agent, this should be your thinking each and everytime. I hope you have not advised any purchasers of same.

I know that many people disagree but that is great for me. I have a strong client base of owners and tenants who agree with my way of thinking and it keeps me gainfully employed.

I simply think if more people actually try for longer lease terms without an option, theymight be pleasantly suprised. Agents and owners alike need to stop assuming and accepting that options are a given.