lease option to renew

Renewal options grant the tenant the right, but not the obligation, to renew lease. Tenants would prefer. All else being equal, the option to renew the lease with the same terms and conditions as the original lease, including the rental rate. Owners, of course, are reluctant to agree to such renewal options for several reasons. First, market rents may increase, perhaps significantly, over the first lease term; thus, owners could be forced to renew the lease at below-market rental rates. This potential loss is not offset by the probability that tenants will renew at above-market rents if market rents decline over the first lease term. Why? Because if rents decline, tenants will not exercise the option to renew at the original contract rental rate. therefore, this option-like all option-has a one-sided (asymmetric)payoff: If rents decline the payoff to the owner is negative; if rents rise the payoff will be zero because the tenant will not exercise the option to renew. In short, from the owner's perspective this renewal option has a negative net present value. Thus, owners are reluctant to grant such option unless the buyer is willing to pay for it in the form of a higher initial base rent. Assume a law firm has negotiated a five-year office lease with a flat rental payment of $18 per square foot. The property owner also has agreed to include an option clause that permits the tenant to renew the lease at expiration for a second five-year term at $18 per square foot. Thus, $18 is referred to as the exercise price of the option.
If market rents in five years are less $18, the tenant will not exercise her renewal option at the $18 exercise price. Thus, the option pay off to the tenant and cost to the owner would zero. In option terminology, the option is said to be "out-of-the-money" if prevailing rents are below $18 per square foot. However, if market rents exceed $18 in five years, the option is "in-the-money" and the tenant will likely exercise her option to renew at $18, assuming she still requires the space. The higher market rents are in five years, the greater the payoff or benefit to the tenant from exercising her renewal option. Note that the owner's negative payoff from option exercise mirrors the positive payoff to the tenant.
A more common from of the renewal option gives the tenant the right to renew the lease, but at prevailing market rate. Granting this option is much less costly in present value terms for the owner. However, the expected payoff on the option is still negative. Why? Because the option, if exercised, does not permit the owner to lease the space to an alternative tenant whose business might better match the owner's current marketing and leasing strategy. As previously discussed, the owner's ability to alter the tenant mix is potentially valuable, especially in retail in retail properties and, to a lesser extent, office properties.