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Clearing the Hurdle of Lease Renewal Options.

Lease negotiations, more often than not, lead to a request from the lessee for renewal options. And, just as often, such options are given freely, without much thought or negotiation, by even the most sophisticated owners and managers. Yet, lease renewal options (LROs), like other kinds of options, raise some significant hurdles for the lessor.

A Winner for Lessees

It is very easy to understand the position of a lessee in asking for renewal options. A LRO is never a bad idea for a lessee, regardless of the terms of that option. There is no mandatory requirement that a lessee exercise a renewal option in order to renew a lease. If market conditions are beneficial, the lessee will exercise the option; if conditions are unfavorable, the lessee may opt to try and renegotiate better terms with the landlord. In all cases, a LRO is a "free ride" for the lessee, especially when, as is often the case, that option is given free of any charge.

Issues for the Lessor

LROs raise some serious questions from the viewpoint of the lessor. Each basic option formula has its own particular set of problems, but a common problem shared by all formulas is that the terms and conditions of the option provisions are, most probably, absolutely and irrevocably binding on the lessor while being binding to the lessee only if exercised. The exception might be a case in which the option is no more than an agreement to agree without remedy if an agreement cannot be reached. In many jurisdictions, options based on an agreement to agree are not enforceable.

This situation, in effect, transfers some of the future control of the property to the lessee. The fact that the lessee can choose to exercise or to renegotiate, within the time limits and restrictions included in the option, sets up an uneven playing field.

Differences in Options

Renewal options at pre-agreed rents present a problem when the market rents at the time of exercise are substantially higher than the agreed option rent. In this case, the lessee has every inducement to exercise the renewal option. But, in the event the market rents are lower than the agreed rent, there is every reason to believe that the lessee will choose to renegotiate the lease. However, a perceived benefit of options at a specified dollar rent amount is that they do not lead to controversy or dispute at the time of exercise.

LROs based on the percentage increase in the CPI or similar index have a similar problem. There is no true correlation between changes in the GPI and changes in market rents. Market rents are driven much more by the forces of supply and demand in a particular market than national inflation. For example, between 1996 and the present, the surge of demand for many types of space has pushed rents in many markets up by double digits while the CPI has been increasing at a very slow rate. Accordingly, it may be concluded that the probability of a CPI or other index tracking real estate rental markets is minuscule.

CPI or index rent adjustments during a lease term are theoretically different from options in that they are perceived to maintain a purchasing power parity for the rent dollar and are based on a fixed formula in which the inputs are factually established.

The failure of specified dollar options or index adjustments to parallel the actual rental market favor some type of market-rate renewal option over other alternatives. In theory, this is an excellent idea. No owner or manager should expect to get more rent than an existing, renewing lessee would have to pay for comparable space available in the marketplace.

The major difficulty with market-rate renewal options lies in implementing the process and procedures for determining market rent. The real problem for lessors usually lies in the option language, which, more often than not, lacks specificity. On the one hand, there is the practical difficulty of developing option language specific enough to eliminate any controversy on how market rent will be determined.

As might be expected, when market-rate options are granted, the lessor should anticipate that the lessee will employ the most favorable interpretation of the lease language and develop its rental proposal to fit that interpretation. The use of the words "market rental value" or "fair market rental" will most probably not protect against self-interest interpretation.

Self-interest aside, market renewal options have a strong tendency to set up a "game." Assuming that both parties are well informed about current market conditions, the lessor cannot expect to achieve a rent higher than the market. For the lessee, market rent is the worse anticipated outcome. Under such conditions, the lessee has little to lose by playing the game. After all, if the matter proceeds to arbitration-- as it more and more frequently does when corporate tenants are involved--there is still a chance that the rent will be concluded to be less than the market. From the lessee's viewpoint, isn't there a chance that if enough issues are introduced into the proceedings, the confusion will result in a favorable determination for the lessee?

Avoiding Vagueness

To avoid this controversy, it is useful to examine the issues that might arise when lease language is vague.

* How is the term "market rent" or "fair market rent" defined? Several years ago, a court case found that "fair" meant fair to both parties and that the economics of a specific tenant's business (i.e., affordability) did come into play.

* Is the reference to market rent restricted to current use? This question can be particularly important in retail situations where the current business may not always be the best use of the space. If the lease includes a use restriction, some jurisdictions have held that the interpretation of market rent is for that use and no other.

* Is the market rent restricted to market rent for renewals only or does it include new leases?

* Does market rent mean net effective rent to the lessor? There have been numerous situations in which tenants have argued that because renewals do not expose the landlord to lease commissions or lost rent between leases, comparables should be adjusted to reflect these costs.

* What is the impact of tenant improvement allowances on rent? If comparable new leases include a TI allowance, this amount should be deducted in determining true market rent. Or does the renewal include a TI? Again, the question is one of the net effective rent for the landlord, which by definition is different from the market rent. This interpretation also overlooks the fact that the landlord, in most instances, provided the tenant improvements when the renewing tenant originally moved into the space.

* What is the time limit within which the parties must reach an agreement before referring the matter to alternative dispute resolution as set forth in the lease?

* In cases of long-term ground leases, the issues become more complex. Should rental increases assume the highest and best use of the land or be valued as if the land is free and clear of improvements? Where there is an absence of relevant land-sales data, the use of a land residual technique may be appropriate.

* If the appraisers working for the two parties are within 10 percent of each other in determining market rent, an average of the two may become the market rent. If the difference is greater than 10 percent, a third opinion may be needed. In such a case, the party appraiser closest to the third appraisal is the market rent. The major difficulty with this variation on baseball arbitration is that the selected rent is not necessarily the correct rent based on the market.

To avoid such controversies and ensure that the market rate renewal options contain adequate protections against unintended interpretations, it becomes necessary for those provisions to be very detailed and specific. Options may contain some guidelines for determining rent. The lease can specify a formula for calculating current market rent based upon an average of the last three renewals in the building or upon tents for comparable space as calculated by a specific national or local rent index.

Several years ago, an arbitration involving an older lease was conducted under lease guidelines specifying that market rents were to be based on recent leases in comparable one-story buildings in the area. However, at the time of the arbitration, no more one-story buildings existed in the area.

In effect, the lease provisions setting forth the option terms and remedies if the parties fall to agree would rake on many of the characteristics of a detailed arbitration submission agreement. When lease transactions are larger and involve major rent dollars, such specificity may be practical and affordable. However, for the multitude of smaller lease transactions, the legal costs of negotiating and drafting detailed, specific language and the cost of implementing a highly structured process of resolving any dispute may be unacceptable to both landlord and tenant.

An Alternative to Options

Because all forms of options present problems for the lessor, it may be desirable to negotiate another form of agreement for continuation of occupancy with the lessee. One means of providing a lessee future comfort is to include a "first right to negotiate" in the lease. While this does not provide the same degree of security on terms and conditions as an option, it assures that the lessor will not lease the space to someone else before negotiating with the present lessee. This type of right does not bind the lessor to any rent, but does imply a good faith negotiation at fair terms. Provisions of this type usually include a date by which the lessee must opt to commence negotiation and a date by which the lessor is free to begin negotiations with others.

Conclusion

Ultimately, the lessor should avoid freely granting lease renewal options, if possible. They can cause some very complex problems in arriving at future rental value. Nor do they enhance the value of the property or the owner's position. And they may give the tenant an element of control over the future of the property.

There is no question that lessors are frequently compelled by competitive pressures to grant renewal options. However, in markets where the lessor is in the strong position, inducements are unnecessary, especially with smaller tenants.

This article was adapted from Real Estate Issues, Vol. 24, No. 3, Fall 1999, published by the Counselors of Real Estate of the National Association of REALTORS(r) and is used with permission.

Lloyd D. Hanford, Jr., CPM, ORE, is a real estate consultant and appraiser in San Francisco with a western region practice. Mr. Hanford graduated from the University of California at Berkeley. He is the past president of the Institute of Real Estate Management and was 1998 Chair of The Appraisal Foundation. He may be contacted at Lloyd_Hanford@GMACCM.com.
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Author:Hanford Jr., Lloyd D.
Publication:Journal of Property Management
Geographic Code:1USA
Date:Jul 1, 2000
Words:1817
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