Who Exercises A Renewal Right?

Tenants “renew” leases all the time, but almost always outside the legal bounds of the renewal right in their lease.  Technically, most tenants negotiate a “lease extension,” as opposed to “renewing” the lease.  As a matter of fact, I have been in the business for almost a quarter century (Did I just say that?  Ouch!), and I have only witnessed one tenant actually exercise a renewal right by way of giving notice.

There are several reasons that most lease extensions occur outside of the “renewal right.”  First, the actual renewal language in most leases is not tenant oriented. Secondly, the renewal and other lease language is generally at least five years old and circumstances have usually changed.  The tenant may need more or less space, or aren’t willing to stay in the building without remedying certain issues that may have come up during the initial term (HVAC, parking, tenant improvement needs, etc).   Thirdly, most tenants want to know exactly what the “renewal” lease terms are before they sign on for another 3 to 5 years.

The best way for a tenant to extend its lease under the most favorable terms is to go to market and create real leverage for itself, prior to the renewal right notice date.  At a minimum this will help a tenant understand the market and realize if the option in the lease is worth the paper it is printed on.  Ninety-nine percent of the time tenants will find that it is not!

Regardless, the renewal right is an important clause in any lease and it can provide unique advantages to a tenant in certain situations, whether it is exercised or not.  Some details to be focused on are pointed out by my friend and associate Gregg Pasternak below:

Renewal Rights – By Gregg Pasternak
Most office leases contain renewal rights of some kind. Typically a tenant can, upon prior notice to landlord, elect to extend its lease of the Premises for a specified period of time (usually 3-5 years, depending on the length of the initial term), and generally tenants pay fair market value “FMV” during the renewal term.  These provisions are usually heavily negotiated, which is interesting because they’re almost never exercised.  However, merely having the right is the key, and having a good one can give your client significant leverage when negotiating a lease extension. The following are the most important issues to cover in order to best protect your client.

No Minimum Rent Floor
Landlords often try to stipulate that rent during a renewal term will be the fair market value, but in no event shall Tenant pay less than the Rent payable as of the expiration of the prior term.  The argument landlords most often make is that they would rather not give a renewal right in the first place, and they have to at least ensure that rents will not go down during the renewal term.  This is silly of course, since if FMV is less than what Tenant was paying at the end of the prior term, rents ARE going to go down, since Tenant simply will not exercise its renewal right if doing so would cause Tenant to pay a higher rent than any tenant off the street would pay.  The effect of this provision is really that Tenant loses its renewal right if rents go down. That’s unreasonable, especially considering the obvious reality that in such a scenario, Tenant has been paying above-market rent for a period of time already. These floors should be avoided whenever possible.

Make Sure Concessions are Considered
There are a million different fair market value definitions, and you can and should leave it to the lawyers to fight to the death over the language.  That’s what many of them find fun, and it keeps them off the streets at night, so let them have at it.  However, from the first proposal on, you should make it clear that all relevant factors and concessions will be considered in the FMV calculation. If a landlord wants to say that no improvement allowance or free rent will be provided for the renewal term that’s fine, but those concessions (or lack thereof) must be considered, so that comparable transactions are looked at on an apples-to-apples basis.  For example, if a “comp” for the Premises is a $3.00 Base Rent with 3% annual increases, a $30 allowance and 6 months of free rent, the $3.00 Base Rent and 3% increases have to be materially decreased to take into account the removal of the TI’s and free rent. 

ALWAYS Secure an Arbitration Right
An FMV definition, no matter how well crafted, is something of an abstraction, and Tenants MUST have the right to have an independent arbiter ultimately decide what the rent will be. Landlord and Tenant should try to agree on FMV, but if they cannot, Tenant needs the right to submit the determination to binding arbitration.  Without this right, landlord can offer an unreasonable renewal rent, and Tenant’s only options are then to relocate or pay above-market rent.  This is especially important in a rising market, as landlords may try to get ultra-aggressive and push rents higher than the market currently supports. In such a case, the only way to force a landlord to negotiate more fairly before exercising the renewal right is the threat of arbitration.

“Comparable” Buildings is more than the Building
Fair market value is determined by looking at comparable transactions, and one of the keys is defining the applicable universe of comps.  Obviously geography plays a huge role, as rents in New York City are in no way comparable to rents in other cities.  Each party will try to define which buildings in the vicinity of the Building are truly “comparable,” and your expertise of the local market will be instrumental in this discussion.  But regardless of how the words “Comparable Buildings” are defined, you should always try to include SOME buildings outside of the current building, or other buildings in the project (if a multi-building project). If you let the Landlord control the universe of comps, you lose a ton of leverage.

Personal Nature of Right
Landlords want renewal rights to be “personal,” meaning that only the original Tenant can exercise the right, not a subtenant or assignee.  This is generally OK, with two caveats.  First, affiliated assignees must be able to exercise the right.  Your client cannot lose its renewal right because it changed its state of incorporation from California to Delaware.  Secondly, a small sublease should not void the right.  If your Tenant leases 15,000 rentable square feet and realizes a few years into the term that only 5,000 is needed and finds a good subtenant, renewal should still be possible.  Landlord is largely unaffected by the sublease.

Default
Almost all clauses provide that Tenant cannot exercise the renewal right if it is in default of the Lease at the time of exercise.  This is perfectly acceptable, but be sure that the language does NOT say that Tenant loses its right to renew if it has EVER been in default under the Lease.  An overlooked $75.00 after-hours HVAC bill from 4 years ago shouldn’t void a negotiated-for renewal right.

 If you have any questions please comment below and I will respond.  Thanks for reading.