The ability to expand your office footprint within your own building can be a valuable asset for quickly growing companies. But how do you do that in a competitive market like Austin, where spaces lease quickly and building vacancy is low?
This is why negotiating an expansion clause into your lease can be important.
There are a number of different types of expansion clauses, each with their own intricacies. In this article, we will explain:
- The three primary types of expansion clauses
- The pros and cons of each clause type
- Why landlords may be hesitant to offer expansion clauses
What Are Expansion Clauses?
An expansion clause is something that can be negotiated into a commercial real estate lease that allows the tenant guaranteed or preferential rights to expand within the building or portfolio from which they are leasing.
Types of Expansion Clauses
There are three basic types of expansion clauses seen most often in Austin. These are Right of First Offer, Right of First Refusal and Must Take.
Right of First Offer (ROFO)
A ROFO (pronounced “row-foe”) gives the tenant the first right to lease a space in the building should it become available before the landlord can market the space for lease or accept offers from any other tenant.
A ROFO will typically only apply to specific suites within the building and is usually limited to adjacent spaces. The spaces included in the ROFO should be detailed in the lease. Potential expansion spaces could also include other suites on the same floor or entire floors directly above or below the tenant’s space, depending on the size of the tenant and the building. For example, a full floor tenant may have a ROFO on the floor or floors above and below them.
However, this does not necessarily mean that the landlord must rent the available space to the tenant. A ROFO simply guarantees that the tenant will have the chance to take the available space before the landlord can market it to third parties. If the tenant and landlord cannot agree to terms, the landlord can then market the property to the public.
When a landlord has a new space available, it’s common for the leasing broker to approach the adjacent tenant to see if they’re interested in the space, regardless of any official rights. For this reason, the ROFO clause is more ceremonial than it is particularly beneficial, but it is better than nothing!
The tenant essentially has “dibs” on space in their current building. If a tenant is looking to expand within the same building, it gives them a leg up on the competition, which can be particularly advantageous in a competitive market where space leases quickly.
A ROFO does not guarantee the tenant will be able to lease the new space, only that they have the first right to the space. The landlord can potentially ask for unfavorable conditions, such as above market rent or a long lease term that the tenant does not want to commit to. In this case the tenant will need to either negotiate with the landlord or pass on the space.
Right of First Refusal (ROFR)
A ROFR (pronounced “row-fur”) clause works in a slightly different way than a ROFO clause. Similarly, however, the clause will typically apply to specific, adjacent spaces that are outlined in the lease.
But with a ROFR, the landlord is free to begin attempting to lease the available space to a third party. However, the landlord must then give the tenant the right to match a third party offer on the space. This means that if the landlord and a third party agree to a signed Letter of Intent signifying that the landlord will lease the space to the third party, the ROFR clause allows for the tenant to then assume those terms that had been negotiated by the third party and expand into the space in question under those terms.
The tenant can ensure the opportunity to expand regardless of what happens with competing tenants negotiation. Additionally, the tenant can typically get market rates or better, rather than relying on the landlord to set the terms.
The tenant does not get to negotiate the lease terms directly. The tenant is faced with the decision to either block the third party and expand with the given lease terms presented to them, or let the third party lease the space and forgo their expansion right.
With a Must Take clause, the tenant agrees up front to lease the entire space they will anticipate needing in the future. However, in many cases, the tenant only pays rent on the part of the space they actually need for a certain negotiable period of time (a so-called “ramp up” period). Once the period of time is up, they begin paying rent on the entire space. This is a great way for a fast-growing company, or a company with a firm grip on their growth projections, to reserve space they may not currently need, but will need in the future.
The tenant gets “free rent” on part of the space they are renting for a given time period. This can be great for growing companies that currently do not need a large space but know they will as they grow. The tenant can also rest easy knowing that their growth needs will be secured and put off the hassle of going through a completely new search and possibly needing to sublease their smaller space that has been outgrown.
The tenant is contractually obligated to eventually pay rent on the entire space, even if they currently only need to use part of it. If the tenant does not grow at the pace they expect, they will eventually be paying rent on space they do not need.
How to Execute Your Expansion Right
No matter what type of expansion right you (the tenant) have, there will be terms outlining how and when they can be executed.
With a Must Take clause, these are generally straight forward. After a certain number of months, you will begin paying the increased rate for the additional space. However, with a ROFO or ROFR, terms can become more complicated.
When written in a commercial lease, a Must Take clause is shown in the rent schedule. It may be written something like:
Tenant shall only pay rent on 50% of the Premises for the first six (6) months of the Term. Beginning on Month thirteen (13) of the Term, Tenant shall pay on the entire Premises. Tenant shall have full access and use of the entire Premises for the entire Term of the lease”
With a ROFO, the landlord is required to notify you with an offer to the available space. You can then either accept or deny the offer. The time period you have to accept or deny the offer will be specified in your lease, typically between 5 and 10 days.
With a ROFR, the landlord and a third party agree to terms on the available space. Once the landlord offers you the terms the third party agreed to, you can either accept the terms or allow the third party to move in. The length of time you have to decide whether to take the terms or not is specified in your lease and is also typically between 5 and 10 days.
If you agree to expand into the newly available space, it is common that the landlord will require you to increase your security deposit and pay the first month’s rent – both are expected when leasing any new space. However, beyond that, there are typically no additional fees to be expected.
Similar language is written when including a ROFO or ROFR in a commercial lease. Below is an example of a ROFR clause:
Provided Tenant is not in material default hereunder, Tenant shall have the ongoing right of first refusal (“Refusal Option”) to lease any space contiguous to the Premises in the building which is currently available or which comes available during the Term (“Refusal Space”) for a lease term coterminous with the Term. Upon notification in writing by Landlord of the receipt of a letter of intent from a third party tenant (the “Refusal Space Notice”) on the Refusal Space, Tenant shall have ten (10) business days in which to notify Landlord in writing of its election to lease the Refusal Space on the same terms and conditions (other than Term, which will run coterminous with the Lease) as those contained within the Refusal Space Notice. In the event that Tenant elects not to exercise its Refusal Option for an offer on less than the full Refusal Space, Tenant’s Refusal Option shall survive on the remainder of Refusal Space. Should Tenant exercise its Refusal Option on the Refusal Space within ten (10) months of the Commencement Date, the terms and conditions shall be the same as those contained within the Lease, including a prorated Tenant Improvement Allowance, free rent period, and other concessions.”
Why Landlords Are Hesitant to Include Expansion Clauses in Leases
Expansion clauses give tenants significant advantages at the expense of the landlord and can make available space difficult for them to lease. ROFR clauses are especially burdensome on the landlord.
Prospective tenants usually look elsewhere if they find out a tenant has a ROFR on a space, as their deal can potentially be taken out from under them.
Additionally, if there are multiple tenants in a building with expansion rights, there may be an issue regarding which tenant has the right to different spaces. It can become difficult for a landlord to keep track of the cluster of rights and first priorities, and can put landlords at risk. As a result, landlords usually prefer to exclude them from the leases.
Whether the landlord will agree to an expansion clause often comes down to the tenant’s negotiating leverage. Large tenants in a weak market typically have significant leverage, whereas smaller tenants in a strong market will have much less leverage, if any at all. In Austin’s strong landlord market, expansion clauses are rare, as landlords typically will not allow them in a lease.
Having a professional tenant rep with strong negotiation skills is necessary if you are looking to include these types of clauses in your commercial lease.
To contact an AQUILA tenant representative to help negotiate a lease that best fits your needs, schedule a consultation here.
To better understand the different elements of a commercial lease, below are two articles that may help:
- Your Guide to the Elements of a Commercial Lease (Terms, Definitions)
- Lease Negotiations: What You Need to Look for Besides Rental Rate