Negotiating a new commercial lease is tricky in many ways. The Landlord and Tenant are both focused on establishing their relationship and the business terms for the lease deal. However, both parties should give thought at the outset about whether or not they should consider opportunities to continue their relationship beyond the initial term of the lease.
By doing so, both sides can help assure themselves of consistency in their business planning and the possibility of a jointly-planned future. The Tenant will have the confidence knowing that so long as they have remained a good Tenant, they are ensured of a location for their business in the future. The Landlord will know that they are likely to have good tenants in their building for an extended period of time.
Strong leases with pre-negotiated renewal terms may also be attractive to Landlords to show their lenders the financial strength of the property when refinancing, or to show potential purchasers of the property’s future rental profits. On the other hand, a Landlord may not want to tie up a property too far into the future because they may not know what the market will be like then. Rather, they may want to redevelop the property themselves, or sell the property to someone else with different plans.
If the Tenant is a newly-established business and not able to commit to a longer initial term, then a shorter initial term with renewal options may give the Tenant more flexibility. At the same time, a Landlord may be willing to give a Tenant a better rental rate for a longer initial term as the Landlord would be assured of the longer rental income stream.
When negotiating renewal terms as part of the initial lease, the parties need to consider how rent will be determined in the future. The parties have to weigh whether it would be better to have certainty or flexibility. If certainty is desired, the parties could agree to specific rent amounts for the renewal term, such as an annual percentage increase over the amount of rent during the last year of the initial term (e.g. a three percent (3%) annual increase). On the other hand, flexibility can be achieved by agreeing to only determine the fair market rental amount at the time of renewal. The parties should start by discussing and negotiating what they believe to be a fair market rent. If they cannot come to an agreement, then they can use what is referred to as the “3 broker method” to establish the fair market rent. In essence, this method allows for knowledgeable brokers to arbitrate the fair market rental rate at a future point in time.
With the flexible approach, the parties are also taking the chance that the fair market rent during the renewal term will be significantly higher or lower than rent during the initial term. Often Landlords will add protective language to the 3 broker method provision providing that the rent during the first year of the renewal term will not be lower than rent during the final year of the initial term (or no lower than a certain percentage increase over the rent during the final year of the initial term). As part of determining fair market rent, the parties will also want to decide if such things as rent concessions, improvement allowances from Landlords and other monetary incentives should be considered.
Depending upon the length of the initial term and the type of use, the parties may also want to decide whether alterations will be required at the time of lease renewal to make the premises appear clean and new. Especially in retail settings, it will be important for Landlords to ensure that Tenants keep their premises clean, modern and in good condition. If Landlords require this, Tenants should consider whether they need an alteration allowance from the Landlord to help defray this cost.
For Tenants, it is very important to calendar the time by which you have to give notice to exercise the renewal option. This time period could be something such as “at least nine (9) months, but no earlier than twelve (12) months, prior to the end of the then applicable term.” This allows both parties the time to plan. If the Tenant does not exercise the renewal option then the Landlord would have at least nine months to find a replacement Tenant. The Tenant would have time to look for a new location, negotiate the lease, and have the new premises built out. By exercising a renewal option far enough before the expiration of the initial term, the parties can determine the fair market rent. If the parties cannot come to an agreement they will still have time to seek other options.
Another issue that the parties may want to consider is whether the renewal option will be available if the Tenant assigns the lease or subleases the premises to a third party. Typically, an assignment or sublease will be subject to the Landlord’s prior approval. The Landlord may not, however, want to have the additional obligation to renew to an unknown third party. At the time the lease is first signed, the Landlord knows (or has had an opportunity to vet) the current Tenant. Committing at the beginning of the lease term to allow a future party who they have not yet met to have a right to use part of their property may not be enticing. From a Tenant’s standpoint, having the renewal option available for any parties to whom they may assign the lease or sublease the premises may be a valuable part of their business. The renewal option is attractive to the assignee or subtenant, and if the Tenant is selling their business to the assignee or subtenant, then the specific location may be a major factor. Ensuring the ability to stay at the same location can certainly help in the sale of a business.
If the parties have not included any renewal options in the initial lease then the Tenant has no absolute right to stay beyond the lease term, even if the Tenant has otherwise been a stellar performer. As the initial term comes to an end, if the Tenant wants to stay at the premises they should approach the Landlord as if they were a new Tenant requesting a new lease term. The Landlord might be agreeable and negotiate with the Tenant for a new lease moving forward. Unfortunately, without the renewal language in the initial lease the Landlord has no legal obligation to negotiate at all with the Tenant. The Landlord may simply have other purposes for the premises and therefore have no desire to engage in renewal discussions.
Clearly, whether or not renewal terms are included in a commercial lease can have a great impact on the parties’ future ability to extend their relationship after the initial term ends. Careful thought should be given to the issues raised in this article and how they may affect the differing business concerns of both the Landlord and the Tenant.
Michael A. Faerber is a member of our firm’s Real Estate and Commercial Leasing practice groups. A substantial portion of his practice involves negotiating all types of leases for both landlords and tenants, ranging from office leases, medical leases, retail leases and restaurant leases, to warehouse leases and industrial leases. Please call him directly if you have any questions regarding the topics in this article.