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Your commercial lease renewal is coming due and you would like to renew, extend or renegotiate the lease. Here is what you need to know. You actually may not have the right to renew your commercial lease.
Unlike residential real estate in which laws generally favor the resident, commercial landlords are not necessarily under the obligation to renew your lease.
It could be that they have another tenant or use in mind for your space at the expiry of your term. There could a growing tenant in the building that will move out of the building if the landlord cannot satisfy their demand for square feet.
Before reading the rest of this lease renewal article, it may be worth spending the time with this quick video tutorial:
Step 1: check the lease. You can find out under "Option to Extend", or "Right to Renew" (or you can have a lease abstractor review the lease for you).
Step 2: what is the notice period? Rights to renew usually have a deadline - usually 6 months prior to the expiry, but in some cases for small tenants it can be three months and larger tenants are typically 9-12 months.
Step 3: is the extension rate fixed or fair market rent?
Now that we have covered the basics, let's look at a sample commercial lease renewal clause (taken from a recent lease from California):
The Tenant shall have the option to extend the Term of this Lease for a further term of five (5) years ("Extension Term"). Such extension shall be on the same terms and conditions as contained in this Lease, except that:
Such right to extend shall be exercisable by notice to the Landlord by not later than nine (9) months prior to the expiry of the original Term hereof, failing which such right shall be null and void and forever extinguished.
Translation: all of this is normal. When exercising an option to extend there is no further option thereafter.
The lease clause goes on to read:
ii) The Base Rental for the Extension Term shall be the greater of:
As used herein, "Market Rent" means the annual rental which could reasonably be obtained by the Landlord for the Leased Premises from a willing tenant or willing tenants dealing at arms' length with the Landlord in the market.
Note: this is a rent floor.
Most landlords will agree to remove the wording that calls for the extension rental rate to be at least equal to that in the last year of the term. After all, market should be...market!
Imagine what a landlord would say if you wanted to negotiate a rental rate that was no MORE than the last year of the term - they would not cap themselves, and you should not agree to a guaranteed minimum amount for the landlord.
If the market goes down, you should be able to benefit on the renewal lease term.
There are no hard and fast rules for triggering the option to renew the lease.
It will be whatever it says in your lease.
The normal time periods are:
1. At least 12 months before the lease expiry (common for big tenants)
2. 9-12 months before expiry
3. 6-9 months before expiry
If the renewal notice date is tied to the lease anniversary, is that date clear?
For example on a 5 year lease, if the renewal notice date has to be provided by the 4th anniversary of the lease, and the commencement date was a "floating" date (not the first of the month, but whenever the landlord was able to provide possession), does everyone know about and agree to that date?
This is the least understood part of commercial lease renewals. Unless otherwise stated in the lease, the tenant is under no obligation to notify the landlord that they will be vacating at the expiration of the lease.
It's just courteous to let the landlord know so she can begin the market the space to the next tenant.
Here is the problem with the conventional system of renewing a commercial lease - you first commit to renewing, and only THEN do you find out what the rental rate will be.
It's like having a set of golden handcuffs.
The good news is that nobody gets your space except for you, but you don't know what the price is until after you commit.
Did you also notice that in the example above there was no arbitration right?
That is the case of so many leases, and there is what happens to many business owners:
What a mess!
There are two strategies to avoid this.
1. Prepare an offer to lease, letter of intent or renewal proposal. They are all synonyms and they just mean a document that outlines the business terms you would like to see moving forward. They are all binding documents - you should have a cooling off clause inserted to ensure that you can negotiate with these documents on a conditional basis and then sign a waiver letter later on.
The tenant's condition could read something like this (taken from a recent lease in Florida):
This Offer to Lease is conditional upon the Tenant obtaining the approval of its Senior Management within five (5) business days of acceptance of this Offer to Lease by both parties. Should the Tenant not notify the Landlord in writing within five (5) business days from the date of conditional acceptance of this Offer to Lease by both parties of its Senior Managements' approval, then this Offer to Lease shall be null and void and of no further effect.
2. Exercise the option to renew, with one caveat - insert what the rental rate will be. This is a "work-around" solution. The renewal right clause was not designed to work this way, but your landlord should be fine with it if he is truly interested in keeping you as a tenant.
The commercial lease renewal letter could read something like this (taken from a recent lease in Texas):
Further to clause x of our lease dated x between <tenant> and <landlord>, we hereby exercise our option to extend the lease for 5 more years, subject to the net rental rate being $X for the extension term.
Option 1 above is a wise move if there are other items you would like to renegotiate in the lease - like some free rent, or a cash allowance to improve your premises.
Option 2 is the better move if there is competition for your space or if the landlord wants to tinker with your lease and you have some favorable clauses you would like to keep locked in.
The biggest issue with exercising your option to extend the lease is that you cannot improve any of the terms of the lease.
Exercising the right to renew means the lease lives on with only the term of the lease and the net rental rate to be changed.
Therefore if you can just work out a new deal, then those items can be on the negotiating table.
There are really three risks in missing the notice date for renewal:
1. You have no right to stay in your premises, and the landlord has another tenant to fill the space (usually an expanding tenant or one that is willing to pay a higher rent than you).
2. Your landlord does not have another tenant, but is pretending she does to increase the rent.
3. The landlord wants to sell or redevelop the property and can do so when your lease expires.
In checking the notice requirements in your lease, check for:
1) Are the dates for notice of exercise absolutely clear?
2) Are the parties to give notice clearly identified?
3) Is the landlord required to provide the tenant notification of the tenant's notice deadline?
4) Are the notice periods reasonable, or does it require the tenant to provide notice too far in advance of the lease expiry?
5) If the notice date or periods are tied to the lease commencement anniversary, is that date clear?
So regardless of what method you take to arrive at a new commercial lease agreement (exercising the right, or just negotiating a new deal), it is better if that negotiation is completed before the expiry of the notice period.
Only if the lease says that the renewal can be for "all or part" of the premises.
Most landlords by default will refer to the renewal right as a right that applies to "the Premises", which is defined as the entire space.
This is important because if you want to stay in your space and renew, but do not want the entire premises, then your renewal right is null and void.
If your landlord is not willing to compromise on this, then perhaps you can negotiate for a percentage (for example, you have the right to renew if it is for at least 80% of the Premises).
Landlords like to avoid providing the right to renew for a part of the space, as it introduces logistics.
For instance, who has the right to decide what portion of the space the tenant stays in - the tenant or the landlord?
Who pays for the demising of the space?
This is easier if the tenant is renting multiple units and everything is clearly defined upfront.
It depends on what it says in the lease.
Most landlords include the lease renewal qualifier of "provided the tenant has not been in default of the lease".
This gives the landlord the ability to take away your renewal right if you were in default just one time.
Other leases are more forgiving where they would require that you are not consistently in default, or as long as you are not in default as of the date you are renewing the lease.
If your lease is silent on this that should work in your favor.
By and large, no.
Most leases have within their template that the right to renew is a right solely provided to the tenant, and shall not be a right inherited by the subtenant.
Your sublease is an agreement between you and your subtenant, and the landlord is not a party to it - they just approve it.
This can be overridden by you, your subtenant and the landlord if all three parties are in agreement.
For this reason sublets are one day less than the full length of your term.
Although rare, some commercial leases have automatic renewal clauses. They are usually an alternative to completing a longer term deal.
For instance, a tenant and landlord may agree to a 5 year term with an automatic renewal right for another 5 years, instead of a 10 year term.
The rental rate for the renewal term is usually explicit.
The lease automatically renews, UNLESS the tenant notifies the landlord otherwise.
Such a structure provides the tenant in this case with protection on a 10 year term with known rental rates but the tenant can still get out of the lease at the 5 year mark.
The goal here is to provide enough guidance on a formula so that both parties can find enough comparables to come up with a reasonable number for fair market rent. I would suggest the following (taken from a recent lease in New York):
The Base Rent for the extension period shall be at fair market rent, as defined as comparable to similar premises used for a similar purpose in comparable buildings in the immediate area.
This just comes down to your negotiating leverage.
What is common is a term and a renewal rate that are the same length (5 year term, right to renew for 5 years).
If your business has uncertainty and you have an agreeable landlord, you could achieve several rights to renew at one year each, though this does not create much value for the landlord (property value is achieved with tenants committing to lengthier terms).
Big tenants are able to achieve multiple 5 year rights (for example, a grocery store may do a 10 year or 15 year deal, with 5 rights to renew at 5 years each).
If you are negotiating a deal right now, you could also structure the deal so that you do a longer term with a right to cancel.
For example, instead of a 5 year term with a right to renew for 5 years at fair market rent, you could commit to a 10 year term with rental rates you know for the entire 10 years.
Then have a right to cancel at the 5 year mark.
The landlord may want a termination penalty, especially if he is paying real estate commissions and/or is spending money on the space.
There really are only a few scenarios:
1) You have a fixed renewal right that is below market and your landlord would prefer to achieve a higher rental rate from a new tenant.
2) There are other tenants in the building who need expansion space and your landlord would prefer to offer your space to them.
3) Your landlord does not like your use (or you!) and would prefer to have a different tenant in your premises.
4) There is more value for the landlord to sell the building or redevelop the property.
If any of these apply to you, it may be wise to actually exercise the option, rather than deal with a landlord who will be impossible to deal with in simply working out a new lease.
Once you exercise your renewal right, or work out a new firm and binding deal, the onus is on the landlord to prepare and provide a formal lease amending agreement.
This document will act as an appendix to your existing lease, and all the terms in your existing lease will survive, except for what is outlined in the lease amending agreement.
Simply exercising a commercial lease renewal right can mean that a tenant will miss out on lease incentives such as free rent or a tenant allowance, and will not have the ability to improve or remove existing lease clauses (such as removing a personal guarantee).
It is normally the case that a tenant is better off simply working out a new lease arrangement by negotiating with their landlord rather than triggering the option to renew.
Additional Reading: 3 Biggest Mistakes Tenants Make (SmartCEO.com)