What is an Option to Extend a Restaurant Lease?
Most restaurateurs will sign a lease for a period of 5 to 10 years. If the restaurant is successful, the operator will want to extend the lease term when the lease expires or sell the restaurant for a profit.
Since the restaurateur is often personally liable for the lease, many restaurateurs prefer to keep the Lease shorter to hedge their bets if things don’t work out as planned, but want the ability to extend the lease if the business succeeds.
For example, a restaurateur may sign a 5-year lease with two 5-year options to extend.
The Options to Extend grants the restaurateurs the option to extend the Lease, so long as certain conditions are met.
As simple as this appears, there are many loopholes in the standard lease and option to extend clause that can either void the option to extend or render the terms financially unacceptable for the restaurant operator to continue to run a profitable business.
6 Important Option to Extend Clauses You Need to Understand
Let’s dive into a typical Option to Extend clause. I have included just a few paragraphs of the language in the Lease Agreement and Option to Extend.
1. Option Periods.
The Tenant shall have the option to extend the Lease Term hereof for one (1) additional period of sixty (60) months (hereinafter “Option Period”), subject to the Tenant’s compliance with the conditions set forth in this section.
The paragraph above provides for one five (5) year option to extend the lease.
2. Notice Requirement.
The tenant may exercise each option by giving Landlord written notice of its intent to exercise the said option, such notice to be received by Landlord at least twelve (12) months prior to the expiration of the original Lease Term, or a previous Option Period (“Notice Period”).
The paragraph above states that the Tenant must provide such notice to extend the Lease at least 12 months prior to the expiration of the original lease term.
It’s difficult to make business decisions a year in advance. For example, if the Tenant is considering a sale within the next few years they would need to extend the Lease in order to sell the business. If the Tenant exercises the Option a year in advance and decides not to sell, they will be liable for another five years.
The notice date should be closer to the expiration of the original lease term.
In order to exercise an option to extend, Tenant must give written notice of such election to Landlord and Landlord must receive the same at least 4 but not more than 6 months prior to the date that the op?on period would commence, time being of the essence. If proper notification of the exercise of an op?ton is not given and/or received, such op?on shall automatically expire.
3. Conditions Precedent to Exercise of Options.
At the time of exercise, Tenant (i) is not in Default, and (ii) is operating a business in the Leased Premises in accordance with the Permitted Use.
The paragraph above is vague and could cause problems down the road. Although the definition of a default is spelled out in the body of the Lease, this paragraph should be specific to certain types of default such as a monetary default. There should also be a period of time for the Tenant to cure the default prior to losing their right to exercise the option.
4. Base Rent Payable During First Option Period.
During the Option Period, all other terms and conditions of this Lease shall remain unchanged and apply except that the minimum Rent shall be the then-prevailing fair market value for use of the Leased Premises during the Option Period (“Fair Rental Value”), taking into consideration bona fide third-party offers, then-current rental rates in the area, and then-current rates charged by Landlord in surrounding properties. Notwithstanding anything to the contrary contained herein, in no event shall the Fair Rental Value be less than one hundred five percent (105%) of the Minimum Rent due and payable for the last Lease Year of the First Option Term (the “Renewal Floor”).
The paragraph above states that the rent will be based on “Fair Market Value” at the time the option is exercised. In addition, it states in no event shall the rent be less than 105% of the rent during the last year of the lease.
In essence, this clause states that the rent has no chance of going down if the real estate market plummets, but every chance of going up at least 105%.
In this situation, both parties will hire an appraiser or qualified brokers to determine the market value. Often, they will then have a third appraiser or broker determine which appraisal is closest to market value and use that valuation. This process would be fine if there was not a floor of 105% on the amount of the rent increase.
Whenever possible, the Tenant should negotiate the Option Rent in advance so the Tenant knows their rent exposure and can plan in advance if it makes sense to exercise the Option or let the lease expire.
In the event, you cannot get the landlord to agree to a stated rent in advance, be sure to include a clause that provides the right not to exercise the Option to Extend if you do not agree with the Fair Market Rent after the appraisal process.
Two Risky Option to Extend Mistakes Almost All Restaurateurs Make
Most restaurateurs don’t realize the importance of the Option to Extend until they decide to sell the business and assign the Lease.
The two biggest issues that come back to haunt unsuspecting restaurant tenants are the language does not allow the tenant to assign an option to a buyer and the personal guaranty.
5.Option Personal to Tenant
This Option is personal to the original Tenant, and cannot be assigned or exercised by anyone other than said original Tenant and only while the original Tenant is in full possession of the Premises and without the intention of thereafter assigning or subletting.
Let’s assume a restaurant tenant signed a 5-year lease with a 5-year option to extend. They have been in the space for just over four years and decide to sell. In their minds, they have a 6-year term remaining that the buyer can assume. In fact, they list the business with a restaurant broker to sell the business.
If the broker is not a savvy restaurant real estate advisor, the seller soon learns that the Option to Extend is void and the seller only has one year remaining on the Lease and his business has no value.
Had the Tenant hired an experienced restaurant real estate advisor and/or an attorney specializing in commercial lease agreements, they would have noticed this little clause hidden in the Lease and/or Option to Extend.
Worst case scenario the Tenant cannot sell the business and will either close the business or risk signing a new lease with the intention of selling at a later date.
Best case scenario, the Landlord will agree to allow the Option to Extend to be assigned but will require a substantial payment from the Tenant.
Most restaurant leases will include a personal guaranty unless the operator is a large corporate chain with strong financials. In the event of a lease assignment, the assignor (original tenant) often remains liable for the lease after the assignment. In the event the assignee (new tenant) defaults on the lease in the future, the landlord has the right to pursue damages from the prior tenant.
This becomes an even bigger issue if the guaranty includes the option periods. It’s extremely important to negotiate that upon any assignment of the lease or if the original tenant exercises an Option to Extend that the guaranty becomes void.
Now that you know the 6 Little Known Factors About Options to Extend Your Lease that Can Kill Your Restaurant Business, you will be able to negotiate a lease that protects your long-term interests.
By carefully following the tips below you’ll be well on your way.
- The Option to Extend grants the restaurateurs the option to extend the Lease
- The notice period should be as close to the lease expiration as possible
- If the Tenant defaults but cures the default the Option to Extend should not be void
- Negotiate a rental rate for the Option to Extend in advance if possible
- Have the right to not to exercise the Option to Extend if you do not agree with the Fair Market Rent after the appraisal process
- Make sure the Option to Extend is not personal to original Tenant
- Include language so a personal guaranty will become void upon lease assignment and/or upon exercise of the Option to Extend
Lease negotiations are often hectic as the restaurateur has many moving pieces to deal with at once. Often the restaurateur has focused on the near -term deal points such as rent and how much time do they have to build out their store before paying rent.
It’s important to think about worst-case scenarios, exit strategies, and the fine print.
Many restaurateurs have no issue spending thousands of dollars on a new sign or remodel but balk at spending a few thousand dollars to protect their investment.
This decision can be the difference between a walk down the yellow brick road or the boulevard of broken dreams.
Prior to signing a Lease, it is highly advised you retain an experienced restaurant real estate advisor and/or attorney specializing in commercial Lease agreements to protect yourself.
Lease agreements are complex. This article is a great start, but I recommend you read more about this so you fully understand how your lease can make or break your restaurant.
Do you need a restaurant real estate advisor and/or attorney specializing in commercial Lease agreements? Shoot me a message below and we will connect you with a professional in your area.