Please Rotate Your Device
When renewing a commercial lease, most renewal rights indicate that the tenant will have the right to have a fair market rent moving forward. Sounds comforting, but should it really make the tenant feel safe?
Here are the most common misconceptions about fair market rent:
Tenants have a high cost of switching. Picking up and moving your business and employees for office space users is a huge pain. It is even worse for retail and industrial companies. Landlords understand this and aim for a premium from renewing tenants.
New tenants have not established themselves in the building and invested a fortune into their leaseholds yet, so landlords dig deeper for those tenants since they are talking to other landlords.
Take the following renewal clause from California for example:
The Tenant shall have the option to renew the Lease for a further term of five (5) years (Renewal Term). Such renewal shall be on the same terms and conditions as contained in this Lease, except that the Net Rental Rate shall be "Market Net Rent" means the net rental which could be obtained by the Landlord for the Premises from a willing renewing tenant dealing at arms' length with the Landlord in the market.
Sounds fair. But notice that the landlord inserted "a willing renewing tenant"
Given that renewing tenants typically pay more, agreeing to this clause is very specifically defining your renewal right as something to be compared to just renewing tenants, not all deals.
What if you are larger than other tenants in your building?
Is it fair that you pay the same renewal rate that a 1,000 square foot tenant pays if you are 15,000 square feet?
Likewise, if you are the 1,000 square foot tenant, you will want wording that includes the bigger tenants' lease renewals for comparison.
What about other, comparable buildings in the immediate area?
It could be that your landlord is just such a tough negotiator that tenants end up paying a bit more on renewal in your building compared to the market.
The clause above only mentions what your landlord thinks he could obtain. It would be prudent to modify this to include landlords that own comparable buildings in the immediate area for tenancies of your size.
That will ensure you are getting a balanced sample of the market.
Do you know the circumstances of the last deal done in the building?
Was the tenant in a rush?
Was it a tenant the landlord was indifferent about?
Landlords are quick to point out high rental rates and usually are quiet about the rest of the details.
Many lease renewals with high rental rates are padded with upfront free rent, leasehold improvements, or quite a bit of landlord work included.
A tenant can renew at $26 net rent but the "effective" deal is really $16 when accounting for those incentives.
Most landlords will advertise a rental rate that accounts for 4 costs to be included:
In this example, the landlord's asking base rent for the building is $28 per square foot, but the landlord was willing to provide some landlord work, a cash allowance, negotiated a bit and paid the tenant's broker.
It all added up to an effective base rent of $15 per square foot.
First of all, many leases allow for a renewal right, and most have a definition of fair market rent. But not all actually have a right to arbitrate.
Without a right to arbitrate you effectively do not have a right to renew. If the landlord does not want you to renew, he will simply set the price too high.
It will be obvious what he is doing, but without a right to arbitrate you have no recourse.
Ensure that your lease talks about the right to arbitrate, who pays and what the process is.
In most cases both sides each pick an arbitrator and those arbitrators pick a third arbitrator.
All three work together to figure out what the rental rate should be. The cost of the process is normally split 50/50 between tenant and landlord.
Here is a sample arbitration clause from a retail lease in Florida:
In the event that the Landlord and the Tenant are unable to agree on the rental rate for either Extension Term by not later than three (3) months prior to the commencement of the Extension Term in that given year, then the Tenant shall have the right to have the Net Rent determined by arbitration.
There shall be no right of appeal, even on questions of law. Any such arbitration shall be "baseball" arbitration, where each party submits a proposal on the Net Rent for the Extension Term and the arbitrator is required to select one such proposal without modification.
1. Try to get a renewal rental rate at a fixed rate if you want certainty.
2. You could peg the renewal rent to a cost of living index, like the consumer price index (CPI) for a more refined definition of fair market value.
3. Are age, location, and class of building being taken into consideration for the comparables?
4. Should use be taken into consideration? For example, what if you are the only dentist in town?
5. Should your financial strength be taken into account? If you have a strong ability to pay rent, that should allow you to have a lower rental rate compared to the average tenant (example wording: comparable tenants with comparable financial standing as the tenant).
6. Term - the comparables should consider the length of the lease term. The longer the term, the more value for the landlord.
7. Inducements / allowances - do the comparable rental rates include any tenant improvement allowances or any free rent?
8. Level of finishes - is there anything special about your premises that would make it expensive to replicate elsewhere?
9. Special Rights - are there any special perks associated with your lease that call for a higher rental rate (such as flexible expansion rights).
10. Is there a rent floor? This obligates the tenant to pay no less than the base rent from the last year of the previous term.
11. Is arbitration a single arbitrator, a panel of arbitrators, or "baseball" arbitration (where the arbitrator selects one proposal over the other).
12. What qualifications do the arbitrators require?
13. What are the time frames from the landlord delivering notice of the fair market rent, to the final decision made by the arbitrator(s)?