Expansion Rights Provisions in Commercial Leases

Nemat Law Firm Team
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1. What Are Expansion Rights?

Essentially, an expansion clause is a negotiable clause in a lease that allows the tenant a right to expand within the building they are leasing. There are three provisions that allow the tenant to expand the leased property: the option to expand, right of first refusal, and the right of first offer. These rights are distinct from each other.

2. What Are the Differences Between the Option to Expand, Right of First Refusal, and the Right of First Offer?

The offer to expand is a fixed right that allows the tenant to include additional spaces. This is protected by recording the offer to expand in the original lease or memorandum of lease. The landlord is required to keep the additional space vacant, or leased for a brief period of time, so the space is available when the tenant invokes the offer to expand. The tenant may exercise this right from when the lease is signed to about a year, maybe two. The tenant can exercise this right by distributing a written notice to the landlord, expressing the expansion of the leased premise. The terms governing the original space will follow to the additional space.

A right of first refusal is a tenant’s right to meet the offer of a third-party to the landlord for the additional space. This is different from the offer to expand, because the authority to decide who leases the space is determined by the landlord. It is good practice to record the right of first refusal in the lease of a memorandum of lease by the tenant’s representation. The right of first refusal is valid throughout the entirety of the lease term. Due to the absence of clear standards, it is not certain how a court could sway. Some courts require the tenant’s offer to match the third party’s offer identically, and others require a more lenient match to the third party offer. The right of first refusal in commercial leases depends on the use of the space. For retail purposes, a tenant could be interested in the right for a continuous space. Whereas for a space being used for an office, the right of refusal can be acceptable on any part of the building.

A right of first offer is a tenant’s right to make an offer to the landlord regarding expansion before third parties become involved. This allows the tenant to make an offer or be involved in this process earlier than other third parties to make offers. This right must be clarified within the original lease and memorandum of a lease. This right must be carefully drafted to determine when the right of first offer is invoked. If the landlord is working on a leasing strategy with a broker, the right is typically not invoked. The standard way of applying care when drafting the right of first offer, is to trigger the right when the space is available for a lease. At that point, the landlord makes open negotiations with the tenant and makes good faith negotiations to reach an agreement. If the landlord desires, they may commence marketing the property for third parties, however the landlord cannot accept an offer equal to or less than the tenant’s offer.

3. Why Do Landlords Resist a Tenant’s Request for Expansion Rights Provisions?

A landlord may be reluctant to accept a tenant’s request for expansion rights due to building value, hiring a broker, large space requirements, loss of a bidder, and litigation.

The building value may negatively fluctuate with the presence of expansion provisions. This is because the value of a property is determined by the present value of the building based on the long-term net rent estimates. Therefore, if the net rent value is less than the assumed normal rent, the value of the building will be lower than the building without rental limits.

Hiring a broker may also discourage a landlord from granting expansion rights provisions. This is because the landlord may face difficulty when accepting a lease agreement, where their right to a commission may be lost. This may be due to the fact that the additional property may not be leased for a long period of time.

Large space requirements further the reason for a landlord’s hesitation to expansion rights provisions. This is because the landlord could receive a proposal from a potential tenant for a large portion of the space in a building, including the space from a tenant’s expansion clause. The landlord may lose business from a potential tenant with larger space requirements compared to the tenant, who has a right to the additional space.

The loss of a bidder could cause the landlord to disapprove of expansion rights provisions. The most aggressive bidder is most probably the current tenant without expansion provisions. This is because the current tenant gains from expanding in a space whereas relocating comes with more costs. Therefore, if a landlord agrees to expansion provisions, the landlord loses the business of the current tenant.

The loss of a bidder could cause the landlord to disapprove of expansion rights provisions. The most aggressive bidder is most probably the current tenant without expansion provisions. This is because the current tenant gains from expanding in a space whereas relocating comes with more costs. Therefore, if a landlord agrees to expansion provisions, the landlord loses the business of the current tenant.

Finally, litigation reflects the landlord’s reluctance to approve of expansion rights provisions. Because these matters are litigation prone, and thereby time consuming and costly, the landlord is discouraged from pursuing expansion rights provisions.

4. Why Should a Tenant Want Expansion Rights?

The tenant would want expansion rights to save future costs, consolidation, special requirements of tenants, distribution, and downside protection.

A primary reason to seek expansion is that the tenant has outgrown the space, and desire to possess an ability to grow without relocation and in a timely manner. This could save the tenant from making costly relocation decisions, and invoke the expansion rights provisions in a timely manner. However, a downside to this is that more attractive buildings and locations are not able to be considered by the tenant.

Consolidation is another reason that a tenant may want expansion rights. If a tenant’s parent company is considering consolidation to increase efficiency, then the tenant may be more inclined to invoke expansion rights.

Another reason is the special requirements of a tenant. This is because the expansion clause allows the tenant to remain in the property requirements desires, such as high ceilings, clean rooms, expensive production lines, that another property wouldn’t offer.

Distribution is a reason for a tenant to desire expansion rights. A critical factor of this reason is the prime location of the property. A tenant may want access to efficient transportation. Therefore, location is an important factor to take into consideration.

Downside protection may encourage a tenant to seek expansion provisions. If the tenant’s financial gain declines, but the tenant would like to expand their space, then the expansion clause continues to allow the tenant to expand.

5. What Are Some Key Issues Brought With Expansion Clauses?

Some key issues faced with expansion clauses consist of bankruptcy, a third party offer of a larger space, a third party offer with parent guaranties or creditworthy tenant.

A risk to expansion is in the case where the landlord is in default of mortgage, and is moving towards bankruptcy. The financial state of the landlord is a problematic role, especially if the commercial real estate market is soft, where demand is decreasing.

An alternate risk that arises due to expansion clauses is a third party offer of a larger space. The landlord may receive an offer from a third party to lease space, including the expansion space and additional space. Although the response of the judge varies, the true answer to this situation is to clearly address the matter in the expansion clause of the lease agreement. From the point of view from the landlord, the space that the third party would like to lease, and the original expanded space of the tenant (and additional space) should be equivalent to exercise the tenant’s option to fully expand.

Similarly, a third party offer with parent guaranties or a creditworthy tenant is an additional issue. In some circumstances, the potential tenant may be more financially supported than the current tenant or if a parent guaranty is offered by the third party. The terms of the expansion clause must be followed. As the tenant is not in default under the lease, then the landlord is not fit to accept the third party’s offer. However, if the prospective tenant offers obligations from a creditworthy source, or a security deposit, then the landlord could accept the offer.

The failure to close a deal is another risk of expansion provisions. In this case, the landlord accepts a third party offer, and the prospective tenant fails to close on the deal within the time of the offer. Typically, the relationship between the landlord and the tenant reverts to the expansion clause in the lease, where the landlord may seek other third party offers that the tenant must match.

6. What Are the Components in the Option to Expand?

The option to expand must consist of a detailed description of the expansion space, when the option can be exercised, the length of the lease term, the conditions which discuss the specifics of the provision. The option to expand should additionally include when occupancy begins, tenant improvements and operating expenses. In addition, the provision should discuss rent, allocation of parking spaces, and the landlord’s responsibility to remove holdover tenants.

7. What Are the Components in the Right of First Refusal?

The components of a right of first refusal are a detailed description of the space, when the right of first refusal can be exercised, the lease term, and the conditions to invoke the right. The right of first refusal provision must also address what constitutes as a trigger for the right of first refusal, and carefully structured standards within the lease.

8. What Are the Components in the Right of the First Offer?

The elements of the right of first offer provision are the lease term, and the conditions to exercise the right. The right of first refusal provision must also discuss how the right of first offer is triggered, and other terms, which specify the advertising of the property or provide the tenant with guidance.

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