Leases: Hidden Issues in Market Rate Renewal Options

A renewal option in a commercial lease often is freely granted to the tenant by the landlord even though the option is one-sided—it will be exercised only if it is beneficial to the tenant. Even when the option is given in exchange for some concession by the tenant, the landlord should be diligent in drafting language to ensure that the renewal rental will match as closely as possible the fair rental value of the premises at the time the new lease term begins.

Fixing a rent in advance or tying the rent to an outside standard such as the consumer price index has obvious risks for both landlord and tenant. Thus a common provision is that the renewal rental will be based on the "market rate" at the time of renewal, with the issue to be settled by arbitrators in the event the parties themselves cannot agree. However, a market rate option has a number of hidden issues that can make negotiations or arbitration an expensive and frustrating one for the parties.

Examples of Hidden Issues

The hidden issues in a market rate renewal option generally involve the context in which the "market rent" is to be determined. For example, is the rent to be affected by the tenant's specific use of the premises or by the highest and best use of the premises? If the former is the case rather than the latter, the renewal rent may well be lower than that anticipated by the landlord. A specific reference in the option clause will avoid disputes on this issue.

A tenant may argue that market rent is to be determined by comparison to market rent for renewal leases only and not include new leases. Renewal rents could be lower than initial rents for several reasons, such as: (1) no portion of the rent need be applied to amortize tenant improvements paid for by the landlord; (2) no brokerage commissions need be payable and (3) no "turnover" period occurs during which no rent is payable. In effect, the tenant is arguing that market rent should be the equivalent of "net effective" rent to the landlord.

The parties may differ as to whether size is to be considered in choosing space comparable to the premises in question. A tenant leasing small space may argue that it is entitled to the same square foot rental paid by a much larger tenant.

Ground Leases

When the option to renew applies to a long-term ground lease, the issues become very complex. One particular issue that has given rise to litigation is whether the ground rent is to be determined on the basis of the highest and best use of the land as vacant or as improved with the present structure. This involves assumptions not only about the highest and best use to which the property may be put many years in the future, but also whether new zoning laws will change the permitted use of the property.

Alternative Right to Negotiate

So long as the landlord and tenant negotiate in good faith, each can hold to their respective positions on the various issues discussed. However, a renewal option typically will provide for arbitration if the parties cannot agree, and the arbitrators' resolution of these issues inevitably will differ from one of the parties. This may be unsatisfactory to the landlord as well as the tenant.

A possible alternative to the renewal option is to include in the lease a "first right to negotiate." This assures the tenant that the landlord will not lease the premises to a third party before negotiating with the tenant. While the tenant cannot be absolutely assured of continued occupancy, the obligation to conduct negotiations in good faith offers some protection. Provisions of this type usually include dates by which the parties must begin negotiations and when the landlord will be free to negotiate with others.