Expansion Option
What Is an Expansion Option?
An expansion option is a embedded option that permits the firm that purchased a real option (which is a right to embrace certain activities) to grow its operations in the future at practically zero cost. An expansion option, not at all like normal options that get their value from an underlying security, accepts its worth from the flexibility it gives to a company.
When a company carries out the initial stage of a capital project, an expansion option can assist them with choosing whether to push ahead with the project. In terms of commercial real estate, expansion options furnish tenants with the decision to expand their rented premises. Commonly, this would apply to an office space or retail location where the tenants try to venture into a bordering space.
How an Expansion Option Works
Chiefs of a company frequently like real options since they give management the right (yet not the obligation) to seek after business opportunities or investments. This flexibility permits management to postpone settling on a last choice until they have accessible all the data with respect to economic and market conditions that could impact their decisions. These are called real options since they allude to tangible assets, like property, equipment, buildings, and land.
For instance, on the off chance that a company is uncertain regarding whether its recently presented product will find true success in the market, it can purchase a type of real option called an expansion option. The expansion option will permit the firm to survey the economic conditions from here on out and determine regardless of whether keeping on fostering the product is beneficial.
On the off chance that the firm initially expected to deliver 1,000 units north of five years, practicing the expansion option would let them purchase extra equipment to increase capacity at a cost that is below market value. Assuming economic conditions are great and expansion is alluring, the company will exercise the option. If not, they will permit the expansion option to terminate.
An expansion option ought not be mistaken for a options contract, which is a derivative in view of the value of an underlying security, like a stock.
How Expansion Options Are Applied in Real Estate
From a real estate viewpoint, an expansion option will ordinarily incorporate limitations and expectations of any efforts by a tenant to utilize a property. For example, time requirements may be initiated on any expansion projects, restricting the tenant to a certain window to complete their efforts.
In an office complex, for instance, a tenant might need to take on more space to oblige significant new increments to the staff. The expansion clause in the lease may specify the tenant has just a certain number of weeks or months to have construction teams adjust the building inside to consider the extended floor plan. There will be expectations with respect to which party — the landlord or the tenant — is responsible for paying for the leasehold improvements. The terms of the expansion option could likewise incorporate changes to the tenant's rent to mirror the bigger footprint the tenant will possess once the work is complete.
There may likewise be limitations in view of whether different tenants have previously sought after an expansion option, which could block others from seeking to increase their space. A tenant could likewise wish to develop more buildings, not just office space inside a building, on a property owned by the landlord. The plans for the expansion might be limited to vicinity to different highlights, establishments, and tenant space that is as of now in place.
Benefits and Disadvantages of Expansion Options
Benefits
For a small business or startup company, an expansion option empowers them to rapidly develop their existing operations in the future should the need emerge. Be that as it may, there is no financial penalty or obligation to take on the expansion later on assuming the company rules against it out of the blue. An expansion option empowers management to concede or postpone expansion until all is good and well in view of the company's business conditions.
According to a landlord's point of view, offering a tenant an expansion option can be an effective method for tempting them to sign a long-term lease, particularly during a economic contraction. Instead of face a high vacancy rate and loss of income, owners of commercial real estate will frequently grant concessions they would have no need to during a thriving economy.
Drawbacks
Arranging an expansion option that is fair for the two players can be interesting. For instance, it tends to be trying to determine what a fair market rent will be sooner or later for the proposed expansion. Notwithstanding, it's important to set the rent for the optioned space during the negotiation phase instead of leaving it until the tenant chooses to exercise the option.
Another impediment is that the landlord should leave space empty to oblige the potential that the tenant might exercise the option and venture into it. The cost of keeping up with the space added to the lost rental income might be beyond what the landlord can manage. In this case, the tenant could have better karma in arranging an expansion option that states that the tenant has the right of first refusal on any space that opens up in the building when one more tenant moves out.
Highlights
- An expansion option is an embedded option in a contract that permits a company to grow its operations in the future at practically zero cost.
- In the event that economic conditions are great, a company will frequently exercise an expansion option.
- On the off chance that a company is battling financially or the economy is vacillating, a company might choose not to exercise an expansion option or to defer it until conditions get to the next level.
- An expansion option gives a company's management the right (yet not the obligation) to seek after business opportunities, for example, growing a company's offices or purchasing equipment at a cost below market value.
