What Is an Expansion Option?

An expansion option is an embedded option that allows the firm that purchased a real option (which is a right to undertake certain actions) to expand its operations in the future at little or no cost. An expansion option, unlike typical options that obtain their value from an underlying security, receives its worth from the flexibility it provides to a company.

Once a company implements the initial stage of a capital project, an expansion option can help them decide whether to move forward with the project. In terms of commercial real estate, expansion options provide tenants with the choice to add more space to their rented premises. Typically, this would apply to an office space or retail location where the tenants seek to expand into an adjoining space.

Key Takeaways

  • An expansion option is an embedded option in a contract that allows a company to expand its operations in the future at little to no cost. 
  • An expansion option gives a company's management the right (but not the obligation) to pursue business opportunities, such as expanding a company's offices or purchasing equipment for a price below market value.
  • If economic conditions are good, a company will often exercise an expansion option.
  • If a company is struggling financially or the economy is faltering, a company may decide not to exercise an expansion option or to delay it until conditions improve.

How an Expansion Option Works

Managers of a company often like real options because they give management the right (but not the obligation) to pursue business opportunities or investments. This flexibility allows management to delay making a final decision until they have available all the information regarding economic and market conditions that might impact their choices. These are called real options because they refer to tangible assets, such as property, equipment, buildings, and land.

For example, if a company is unsure as to whether or not its newly introduced product will be successful in the market, it can purchase a type of real option called an expansion option. The expansion option will allow the firm to assess the economic conditions in the future and determine whether it is profitable to continue developing the product or not.

If the firm initially expected to produce 1,000 units over five years, exercising the expansion option would let them purchase additional equipment to increase capacity for a price that is below market value. If economic conditions are good and expansion is desirable, the company will exercise the option. Otherwise, they will allow the expansion option to expire.

An expansion option should not be confused with an options contract, which is a derivative based on the value of an underlying security, such as a stock.

How Expansion Options Are Applied in Real Estate

From a real estate perspective, an expansion option will typically include restrictions and stipulations of any efforts by a tenant to make broader use of a property. For instance, time constraints might be instituted on any expansion projects, limiting the tenant to a certain window to complete their efforts.

In an office complex, for example, a tenant may want to take on more space to accommodate considerable new additions to the staff. The expansion clause in the lease may stipulate the tenant has only a certain number of weeks or months to have construction crews adjust the building interior to allow for the extended floor plan. There will be stipulations regarding which party—the landlord or the tenant—is responsible for paying for the leasehold improvements. The terms of the expansion option could also include changes to the tenant's rent to reflect the larger footprint the tenant will occupy once the work is complete.

There may also be stipulations based on whether other tenants have already pursued an expansion option, which could preclude others from seeking to increase their space. A tenant might also wish to construct more buildings, not just office space within a building, on a property owned by the landlord. The plans for the expansion may be limited to proximity to other features, installations, and tenant space that is already in place.

Advantages and Disadvantages of Expansion Options

Advantages

For a small business or startup company, an expansion option gives them the ability to quickly grow their existing operations in the future should the need arise. However, there is no financial penalty or obligation to take on the expansion in the future if the company decides against it for whatever reason. An expansion option enables management to defer or delay expansion until the time is right based on the company's business conditions.

From a landlord's perspective, offering a tenant an expansion option can be an effective way to entice them to sign a long-term lease, especially during an economic contraction. Rather than face a high vacancy rate and loss of income, owners of commercial real estate will often grant concessions they wouldn't need to during a booming economy.

Disadvantages

Negotiating an expansion option that is fair for both parties can be tricky. For example, it can be challenging to determine what a fair market rent will be at some point in the future for the proposed expansion. However, it's important to set the rent for the optioned space during the negotiation phase rather than leaving it until the tenant decides to exercise the option.

Another disadvantage is that the landlord will need to leave space vacant to accommodate the potential that the tenant may exercise the option and expand into it. The cost of maintaining the space added to the lost rental income may be more than the landlord can afford. In this case, the tenant might have better luck in negotiating an expansion option that states that the tenant has the right of first refusal on any space that opens up in the building when another tenant moves out.