Many commercial leases have a renewal option, often needing to be exercised between six months and one year before the lease expiration date.
Before the time to exercise the option comes around, a tenant should analyze whether to consider remaining in place. The tenant could then approach the landlord to see whether favorable terms can be reached in place of the option terms. Landlords should also be in touch with their tenants to determine whether a deal can be made, or whether to put the space on the market (subject to the tenant’s renewal rights).
Typically a lease renewal agreement will provide for a new rent, new base years for real estate taxes and operating expenses, and any change in security deposit. All of these provisions can be negotiated before the tenant has to send their notice to renew. The parties should be familiar with the changes in the new provisions for the above terms if the option is exercised. While a landlord will be familiar with recent leasing history in his building, a broker may be needed by the tenant to see if the renewal rent is at fair market value (or 95 percent of fair market value as some renewals provide). Landlords generally do not like paying tenant brokers on renewals. They are considered an unnecessary extra expense by some landlords who require the tenant to pay the broker or embed the cost in the fixed rent. A small percentage of landlords say the rent will be at the market rate, which does not take into account whether or not the tenant engages a broker. The provisions are of course subject to negotiation unless stated in the option paragraph of the lease.
A landlord must check the broker commission agreement for the original lease to see if a commission is automatically due if a tenant renews, under their option or by negotiated agreement. One common solution is to provide in the brokerage commission agreement that renewal commissions are paid only if the broker is actively involved in the renewal negotiations.
The most important consideration in a renewal is the rent. Notwithstanding a renewal option, the parties can and should try to reach agreement on rent, even before the option is exercised. This would avoid arbitration or other determination by an outside appraiser of the renewal rent. That is not to say that each party refrains from consulting with an expert before such discussions.
A renewal option may provide for a fixed increase, a fixed increase versus a CPI index, whichever is greater, or a mutual agreement, failing which there is arbitration with appraisers or arbitrators selected by each party or selection of a single appraiser to make the final determination. The qualifications of the appraisers or arbitrators should be stated, such as being a member of M.A.I. or a licensed broker, in each case with more than 10 years experience within the local area. Decide and state in the option paragraph if prior dealings with the landlord or tenant is to be a disqualification, who pays the appraiser, and if it is to be a single appraiser whether he/she is selected by landlord alone, or with tenant approval, or by an impartial real estate organization. A good renewal option will require appraisers to take into account all relevant factors, including broker’s commissions, free rent, any construction allowance or additional landlord work, escalations, or lack of any of the foregoing.
Baseball arbitration is commonly used to determine fair market rental rate. Here, each party selects an appraiser to make a determination of the fair market rent. If the two appraisers are within 5 percent of each other, it often states the average of the two appraisals should be used. Otherwise, the two appraisers select a third appraiser. That appraiser can only select one of the two appraisals. He or she cannot come up with a different number. This keeps each party from designating a fair market rent that is far from reality. A regular three appraiser determination will give the independent appraiser selected by the other two appraisers full discretion to determine fair market rent outside the appraised values of the two appraisers selected by the parties.
A renewal option should state any change in the security deposit. If negotiating outside the option terms, the security deposit may be renegotiated. A good paying tenant, perhaps with better financials than at the time it signed the lease, will want a reduction or a series of reductions. A landlord may want to increase the security deposit to keep the original lease proportion the same, e.g., if originally two months security, then increase security so it remains equal to two months new rent.
New current base years for taxes and operating expenses will prevent any decrease in fixed rent if these escalations somehow decrease in the renewal period. If setting new base years which are future years (e.g., a 2018 base when renewing in 2017), a year of tax increases may be lost if the new fixed rent does not include all the taxes being paid or to be paid for the current year.
Finally, if an agreement is being made in substitution of strict exercise of the renewal option, thought should be given to additional provisions or changes to the current lease. This could be to take into account new laws or regulations, or even to give the tenant a new renewal option.
Gerald H. Morganstern
Goetz Fitzpatrick LLP
One Penn Plaza, Suite 3100
New York, NY 10119
212-695-8011 ext. 257