Volume 18, Number 6
REAL ESTATE LAW
Making Fair Market Lease Renewals Fair
By Marvin Leon
Since renewal rights do not come into play until far in the future, renewal rights clauses often do not receive the attention they deserve. Because it is quite difficult to set the renewal rent far in advance of the renewal term, some landlords and tenants attempt to finesse the issue by providing for lease renewals at a rent to be agreed on at the time of renewal. If the parties cannot agree at the time of renewal, one of the parties may turn to the courts or to arbitration to enforce a renewal right and set the renewal rent. Most jurisdictions, however, hold that "agreement to agree" provisions are too indefinite and too uncertain to be enforceable.
Need for an ascertainable standard. In an effort to avoid uncertainty about renewal rents, landlords and tenants often agree to renewal options at fair market rent. In this way, the parties hope to establish an ascertainable rent standard and, therefore, sustain the enforceability of the renewal clause. By using a fair market rent renewal standard, the tenant hopes to protect itself from a claim for inordinate rent at the time of renewal, and the landlord expects to receive market rent for the premises.
Several court have found fair market renewal options enforceable. However, fair market rent alone may not constitute an ascertainable standard. In Etco Corp. v. Hauer, the appellate court determined that a provision for renewal of a lease at a rent to be decided in the future is enforceable only if the lease agreement contains terms creating an ascertainable standard for the determination of rent. The court further stated that a standard of fair market rent alone would not reach the level of an ascertainable standard unless the renewal provisions contained instructions for determining what is fair. Thus, according to Etco, the parties must go beyond providing for renewal at fair market rent to have an enforceable renewal provision.
Value of use-in-place or highest and best use. Even in jurisdictions where courts have determined that a renewal option at fair or reasonable rent itself creates an ascertainable standard, there is room for disagreement on what constitutes fair rent when the parties provide no instructions on how to make that determination. Tenants obviously want to limit renewal rent to the purposes for which the premises are being used. Landlords, however, want renewal rent to be based on the highest and best use. Some courts hold that in the absence of any rules of construction provided by the lease, fair market renewal rent should be established based on the purpose for which the premises had been leased. Contrary authority, however, suggests that fair market renewal rent must be based on the highest and best use.
Standards specified in renewal clause. The lesson to be derived from the foregoing is that landlords and tenants who want to avoid difficulties with renewal clauses at fair market rent cannot be content with stating only that the renewal rent is to be set at fair market. The parties must provide the standards for determining fair rent at the time of renewal. Obviously, those standards will differ depending on the type of lease being negotiated. Tenants should understand that landlords of long-term ground leases of what was originally vacant land, later improved by the tenant, generally will insist on fair rent based on the highest and best use of the land rather than use-in-place. Ground tenants, however, will want to limit fair rent to current use of the land at the time of renewal, without having any value ascribed to the building the tenant built. That issue should be negotiated carefully and set forth clearly in the renewal clause.
There are other factors to be considered in determining a fair renewal rent. Assume that a ground lease for a shopping center outparcel is subject to renewal at fair rent. In addition to stating whether rent is to be determined by the highest and best use or use-in-place, consideration must be given to events that may have occurred in the shopping center itself during the term of the lease. For example, a shopping center outparcel leased to a fast food operation may have resulted in a successful fast food operation, but a downturn in the shopping center's fortunes may ultimately have deleterious effects on the outparcel, or vice versa. Changes in parking requirements, elimination of traffic signals, new zoning, new municipal sign requirements, or limitations on opening and closing hours can also affect a determination of fair rent.
Highest and best use criteria. In negotiating a ground lease renewal clause at fair market rental to be determined by the highest and best use; the parties should state criteria for the determination of the highest and best use. Do only the zoning laws govern what may be highest use or should highest use take into account matters such as street access, competition, changing demographics, vacancy rates in the area, or similar matters? Are those concepts to be covered by the words "best use"? If so, how far does the concept of best use go? Is the determiner of fair rent to take into account freeway access, parking needs, parking difficulties engendered by parking structures or traffic requirements, traffic congestion, one-way streets, traffic signals, soil conditions, the cost to construct new and higher density improvements, utility availability, environmental problems, and sign controls? The potential list of variables is extremely broad. Negotiators of fair rental renewal clauses should not be content with a shorthand definition of fair market rents. Failure of negotiators to provide guidelines to the determiners of value, be they arbitrators or the courts, can lead to costly errors.
Use-in-place criteria. Similarly, a renewal provision for a store lease at fair market rent in which rent is to be based solely on use-in-place is not adequate. The continuation of the use might require massive improvements to keep the store competitive or to comply with new zoning or building code requirements. Because of scarcity or overavailability of sites available for the use-in-place (resulting, for example, from new zoning conditions), use-in-place might create an inflated or deflated rent. Tenants and landlords need more certainty than just a use-in-place definition.
Comparability criteria. Perhaps the most common use of fair market rent renewal clauses is in the office building market. These clauses typically base renewal rent on rents in the surrounding area, for comparable space in comparable buildings, or for so-called comparable space in the same building. Using only a radius definition, however, can lead to anomalies if new luxury or new low-income buildings invade the area. Using a comparable building definition alone leaves too much open to question. Comparable buildings may share many, but not all, of the following features: similar size, use, age, and height; similar parking ratios, numbers of elevators, availability and amount of air conditioning; similar electrical and cleaning standards; similar public amenities, such as courtyards, fountains, in-building restaurants, and exercise facilities; and similar tenant mix.
In addition to using a comparable building standard, consideration must be given to a definition of comparable space. "Comparable space" should refer to the following comparable features: size, floor height, floor location, view, number of windows, uses by adjoining tenants, depth from exterior to corridor wall, elevator bank access, and signage.
In any event, the renewal rights clause should provide the tenant with an escape hatch so that it can revoke its exercise of the renewal option once the rent determination is made. The fair market rent determination may not be to its liking or may not be fair in its view. Without an escape hatch, the tenant may be subjected to years of economically unfavorable occupancy cost after renewing at a fair market rent that turns out to be unfair.
Standards are key. In negotiating a renewal clause at fair rent, the parties must provide the arbitrators or rent determiners with standards by which fair rent can be ascertained. Failure to provide those standards may preclude their consideration by the rent determiners, to the detriment of one of the parties, and may even result in the unenforceability of the renewal clause. Forewarned is forearmed. To introduce fairness to the fair market rent determination, standards must be provided. Without standards, the attempt to create fairness may turn into unfairness.
Marvin Leon is of counsel to Mitchell Silberberg & Knupp LLP in Los Angeles, California.
This article is an abridged and edited version of one that originally appeared on page 23 of Probate and Property, March/April 2001 (15:2).