Please Rotate Your Device
If you choose to renew your commercial lease, you want to ensure you are paying fair market rent. Hopefully, you will agree with your landlord on your new rental rate, but you might not, or you might be unsure about what "fair" means. When you signed your commercial lease, you may or may not have noticed an arbitration clause. This clause protects you and your landlord when you disagree about the rental rate for your renewal by clearly defining the terms of your renewal and how other clauses in your lease agreement might be impacted. Yet, the way in which fair market rent is defined can impact your lease. Below you can find some of the common issues determining fair market rent for your lease renewal and how they might be addressed in your current lease.
In the vast majority of commercial leases, your option to renew allows you to extend your lease for a specific amount of time, except your rental rate must be renegotiated in comparison to fair market rent. Many commercial leases don't define or define poorly the exact meaning of fair market rent. Additionally, the language used by the landlord, if he or she drafted the lease, it likely isn't as beneficial to you as it is them. Many different factors contribute to the definition of fair market rent which must be addressed. They include:
Your lease agreement might state that your rental renewal rate is based on the original conditions of the property or on improved conditions. If the property hasn't undergone any improvements since you signed your lease, this is likely not a point of contention. On the other hand, if the property has seen improvements, you will need to address how this impacts your rental rate. The extent to which your renewal rate should increase depends on the cost of the improvements, who paid for them, and their nature.
For example, did your landlord improve common area maintenance items, such as repaving a large parking lot? You will be paying a portion of the cost, so does that mean you should also have to pay a rental renewal rate on an improved property?
The date when a property valuation occurred can impact your renewal rent rate for your lease. Commercial lease rates go up and down with property value, as a function of supply and demand. Your landlord might feel cheated if property values are high at your time for renewal, but they were low when you signed your lease, and vice versa. If property values were high when you signed your lease, and lower at renewal, you will want to find out at what point in time your "fair market rent" was figured in comparison to when the property valuation occurred.
Fair market rent is typically based on comparables (“comps”). One point of contention which might lead to arbitration about your renewal rate is the comps your landlord has used to determine your base renewal rent.
Are comparable properties truly comparable to the property you lease? Factors which make a property comparable include location, use, financial strength of the tenant, and the presence of tenant inducements in the renewal rent rate.
Location. The best comparable property for fair market rent will often be in the same building. Size isn't as much of a factor because commercial rent is per square foot, but similar rental spaces in the same building make it easy to compare. Yet, it's likely the same property owner, so it's necessary to look for comparable properties close by. Ideally, comps should be in the same neighborhood, and on the same street if possible. The further away properties are from one another, even in the same city, the less comparable they are.
Property use. Is your property and the comparable property used for the same thing? Your landlord is not comparing apples to apples if he's trying to compare restaurants to retail stores and retail stores to dentist offices.
Tenant financial strength. The experience a tenant has with his or her business can factor into comparing properties to determine fair market rent. The financial strength of a start-up restaurant will differ greatly with the financial strength of an established retail store. It's also likely the established business will pay a higher renewal rate. You need to make sure your landlord's calculation for fair market rent factors in your financial strength and fairly compares you to other tenants.
Tenant inducements. Base rental rates for commercial leases as well as renewal rates might include a variety of tenant inducements used to attract you to sign on the dotted line. You must decide whether these inducements, such as cash payouts, free months of rent, and others, should be included in your renewal rate.
In most cases, when you choose to renew your lease, your landlord will provide you with the fair market rental rate and you must accept it. On the other hand, if your original lease has an arbitration clause (most do not), you can dispute your rental rate and go through arbitration with your landlord. You typically split the cost of arbitration, so you want to make sure you are being reasonable.
Most arbitration clauses have the following elements:
Each party selects an arbitrator (either a broker or an appraiser)
Usually the arbitrators have a certain level of experience (example: at least 5 years each)
The arbitrators pick a third arbitrator
The third arbitrator makes the ruling
The whole process usually is 30 days or less
The cost is equally split between landlord and tenant
A renewal right without an arbitration clause in a commercial lease is like a ship without a rudder. Though on the surface it seems like you have a right to renew, without an arbitration right, the landlord has the ability to act unreasonably, which will negate your ability to renew at a fair market rent. Therefore every renewal or extension clause must have a mechanism to bring in third party arbitrators to police the process of arriving at a fair rental rate moving forward.