Renewal Options and Fair Market Rent Explained

Without a renewal option, your right to occupy the space ends on the expiration date. The landlord may offer to renew, may ask whatever rent it chooses, or may lease the space to someone else, including a neighbor that wants to expand.

A renewal option changes that. It is a one-sided right: you may extend, and the landlord must honor it, but you are not obligated to use it. That protects several things at once. It secures your location and the money you have put into the space. It limits the landlord's ability to price a renewal on the assumption that you cannot leave. And it gives you a fallback while you look at alternatives.

Leases may grant one option or several, each for a stated number of years. The option does not prevent you from negotiating a different renewal outside it. Tenants often do exactly that, using the option as the floor beneath the negotiation.

The option is only as good as its rent provision. There are three common approaches.

• Fixed rent. The lease states the renewal rent or a fixed increase over the last rent of the initial term. This gives certainty, and the risk that the figure ends up above the market when the time comes.
• Fair market rent. Rent is reset to the market at the time of renewal. This is the most common approach for office leases and the one requiring the most careful drafting.
• A percentage of fair market rent. Some tenants negotiate renewal rent at a stated discount to market, on the reasoning that a renewal saves the landlord vacancy and re-leasing costs.

Landlords frequently add a floor: renewal rent will be fair market rent but not less than the rent you were paying at the end of the initial term. A floor means the option only ever adjusts upward. If the market has fallen, you would be better off negotiating a new deal than exercising. Resist the floor where you can.

Fair market rent sounds objective. In practice the landlord and tenant will each read it in their own favor unless the lease defines it. The definition should answer the following questions.

• ✓Comparable to what? Which buildings, of what class and in what area, and for space of what size, floor height and condition?
• ✓New deals or renewals? Is the benchmark what a new tenant would pay, what renewing tenants pay, or both?
• ✓Are concessions counted? Does the rent reflect the free rent, improvement allowance and other inducements a landlord would give a new tenant?
• ✓Are landlord savings counted? Does it account for the landlord avoiding vacancy and paying lower or no leasing commissions?
• ✓What condition is assumed? Is the space valued as improved, and who paid for those improvements?
• ✓Does the tenant's credit matter? Is the comparison to tenants of similar financial standing?
• ✓What term is assumed? Is it compared with leases of a similar length to the renewal period?
• ✓How are operating expenses and taxes treated? Does the base year reset, and is the comparison made on the same basis?

The concessions question carries the most money. A new tenant in a comparable building typically receives free rent and an allowance, so the rent on the face of its lease overstates what the landlord actually nets. If your renewal rent is set at that face rate with no concessions, you pay more than the market. A tenant-favorable definition either provides the same concessions on renewal or reduces the rent to reflect their absence.

Be wary of definitions that describe the rent the landlord is "then quoting" or "then offering" in the building. Asking rents are not completed deals, and such a clause lets one party set the benchmark.

The lease should lay out a sequence. Usually the landlord delivers its determination of fair market rent, the parties negotiate for a fixed period, and if they do not agree, the question goes to a neutral process. Without that last step, a fair market rent option can amount to an agreement to agree.

Common dispute methods:

• Three-appraiser method. Each party appoints a qualified real estate professional. If those two cannot agree, they select a third, and the result is set by the third, by majority, or by averaging under a formula in the lease.
• Final-offer arbitration, often called baseball arbitration. Each party submits its figure, and a single neutral arbitrator must choose one of the two, with no power to split the difference. Because an extreme number is likely to lose, this method pushes both sides toward realistic figures and often produces a settlement before a decision.
• Single neutral expert. The parties jointly choose one qualified person to decide. It is faster and less costly, and it depends on agreeing who that person is.

Whatever the method, check who may serve. The lease should require brokers or appraisers with substantial recent experience in comparable buildings in the same market, and should exclude anyone with a current relationship to either party. Also check who pays, how long each step may take, and what rent you pay if the renewal term begins before the figure is decided, with a true-up afterward.

A renewal option is exercised by written notice within a window that opens and closes well before expiration. Landlords want notice early so they have time to re-lease the space if you leave. Deadlines are usually enforced strictly, and a late notice generally means the option is lost.

Timing creates a real problem. Under many forms you must commit to renew before you know the rent, because the fair market determination happens after you give notice. Tenants can address this in several ways.

• Ask the landlord to state its proposed rent before your notice deadline, upon your request.
• Negotiate a right to rescind your exercise within a short period after fair market rent is finally determined.
• Structure the process so the rent is determined first and your binding election follows.

Landlords resist rescission rights, since they leave the landlord uncertain late in the term. A two-step process, with an early non-binding indication of rent, is often an acceptable middle ground.

Record the first and last day of the notice window, the required delivery method and the notice address on the day the lease is signed. Then start your renewal planning well ahead of the first day, not the last.

Landlord forms attach conditions that can defeat an option. Review each with your attorney.

• Default. The option may be void if you are in default at exercise or at commencement, or if you have ever defaulted. Limit this to an uncured material default existing at the time of exercise.
• Occupancy. Some forms require that you occupy all or most of the space and have not sublet. That can conflict with a hybrid footprint or a partial sublease.
• Personal rights. Options are often personal to the original tenant. Ask that they pass to a permitted assignee or successor, which matters in an acquisition.
• Scope. Confirm the option covers expansion space added during the term, and whether you may renew for less than the entire premises.
• Other rights. State whether expansion rights, parking, signage and any termination option continue through the renewal term.
• Refurbishment. Ask for an allowance or defined landlord work on renewal, or make sure the rent definition accounts for its absence.

Tenant Advisory Group negotiates renewal options and their rent definitions at the outset of a lease, and when the window approaches we survey the market so a client knows whether exercising the option or negotiating a fresh deal produces the better result.