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 the initial stage of a capital project has been implemented, an expansion option holder can decide whether to move forward with the project.

In terms of real estate, expansion options provide tenants with the choice to add more space to their living premises.

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 an expansion option. The expansion option will allow the firm to assess the economic environment in the future and determine whether it is profitable to continue developing the particular product. If the firm initially expected to produce 1,000 units five years, exercising the expansion option would let them purchase additional equipment to increase capacity for a price which is below market value. If economic conditions are good and expansion is desirable, the option will be exercised. Otherwise, the expansion option expires.

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 tenant may be given several weeks to have construction crews adjusting the building interior to allow for the extended floor plan. The terms of the expansion option could also include changes to the tenants rent to reflect the larger footprint the tenant will occupy once 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. The plans for the expansion may be limited to proximity to other features, installations, and tenant space that is already in place.