How do lease options work?
IMPORTANT NOTE – It is necessary to know the deadline for exercising the option. It is most likely going to be 1 month or 3 months before the end of lease, not the last day of the lease.
A retail lease will include an initial fixed-term – the minimum number of years you will be renting the shop. This is often 3, 5, or 7 years.
It may also include an option to renew or extend the lease. If there is an option, it is an agreement negotiated by the lessor (landlord) and lessee (tenant) before entering the lease.
The option is the tenant’s right to another fixed-term of the lease on the same terms as the existing lease. The rent will usually change, according to a pre-determined method, and it will have a new start and finish date.
For example, if your initial fixed-term retail lease is 1 July 2020 to 30 June 2023 (3 years), then a 3 year option would cover 1 July 2023 to 30 June 2026.
Check the lease to find out if there is an option and exactly what must be done in order to exercise the option, including the date of when the option needs to be exercised.
If the tenant wants to take up the option, they should tell the landlord in writing by the deadline. The deadline to exercise the option is usually going to be well before the end of the fixed-term stated in the lease.
For example, if the last day of the initial 3-year fixed term is 30 June 2023, the deadline for exercising the option will likely be 30 March 2023. Check each lease to make sure, as these deadlines may vary.
An option is useful when a tenant isn’t certain how long they want to continue in the premises after the initial fixed-term. Another way to think about a lease under a fixed-term of 3 years, with a 3 year option, is that the tenant could have 6 years, but can get out after only 3 by not exercising the option.
Exercising the option
The option in a lease is nearly always a 'call' option – it means the tenant has the right to call upon the landlord to give them a new lease, on the terms originally agreed.
The tenant should make sure they have met all the obligations of the lease and give the landlord written notice that they are exercising the option.
It’s critical that the tenant exercises the option before the deadline. If the tenant is late or provides notice incorrectly, the right will be lost and they will have to renegotiate a new lease based on the market. In many cases, the tenant will want to stay on, but may need to compete with other potential tenants.
Under the Retail Leases Act 1994, if the exercise of the option requires a “market rent review”, then the tenant can ask for an early determination of the market rent. This will help them decide whether to exercise the option.
The tenant may request an early determination of market rent as early as 6 months prior to the option deadline, and as late as 3 months prior to the option deadline. If the lease is 12 months or less, they can ask for an early determination as early as 3 months prior to the deadline, and as late as 30 days prior to the deadline.
The landlord does not have to remind the tenant or send them a notice about the deadline to exercise the option. However, the landlord may be interested in knowing before the deadline so that they can prepare and may wish to discuss the option before it expires.
Once the current market rent is determined, the tenant will have 21 days to exercise the option.
Rent changes after the option is exercised
A market rent review is only one method of rent review when the option is exercised. The lease may provide for a CPI increase, a fixed amount or percentage increase, or a market rent review.
The parties can agree to a market rent, without needing a valuer. If the parties cannot agree they can have a valuer determine it. Get advice from the Commission’s Mediation Services team if you are thinking of appointing a valuer.