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Determination of Fair Market Rent (Part 1 of 2)

Determination of Fair Market Rent (Part 1 of 2)

In the current commercial leasing market, rent rates for new leases are far below rates from a few years ago.  As a result, if the parties negotiate a renewal option as a term in a new lease, landlords are generally unwilling to commit to a continuation of the “low” rent rate for the renewal term (or a 2%-5% per year increase based on the initial term’s low rent rate).  Regardless of your opinion on when the commercial leasing market will fully recover, most would agree that the market will look different in five years than it does today.  Accordingly, parties commonly agree that the rent rate for a renewal term will be based on a determination of fair market rent at the time of renewal.

In my experience, most tenants do not adequately negotiate the method for determination of fair market rent for the renewal term.  This method is a critical business term.  For example, for a five year renewal term with rent of $5,000 per month, the value of the renewal term is $300,000.  If there are multiple renewal terms, a longer renewal term, or higher rent, the value is even higher.

This two-part blog entry identifies issues for consideration when negotiating the method for the determination of fair market rent.  Part 1 focuses on ambiguous methods and Part 2 focuses on unambiguous methods.  Generally, tenants will desire that the renewal option be as unambiguous as possible.  Tenants want a clear, enforceable right with little wiggle room for the landlord.  The tenant always can elect to not exercise its option and negotiate with the landlord.  On the other hand, a landlord wants the tenant’s rights to be as weak and ambiguous as possible.

A.        Ambiguous Methods (landlord-friendly)

1.         “Mutual Agreement of the Parties

As a baseline for negotiations, even if the lease does not include a renewal option, the parties always can agree to renew the lease upon their mutual agreement of renewal terms.  In other words, if the lease is in year four of five, one party can approach the other and ask for a renewal of the lease upon terms and rent that are mutually agreeable.

Accordingly, if a renewal option provides that renewal rent is determined “as mutually agreed upon by the parties,” the parties still must agree upon the rent.  This makes the renewal option extremely weak for the tenant, because the option is contingent upon agreement of the renewal terms by landlord and tenant.  If the landlord does not agree, the tenant does not have a renewal right.

The only time this determination method should be used is if the tenant acknowledges that it does not have a strong renewal right and simply wants some language in the lease to facilitate the negotiation of a renewal.  Most tenants think they are getting more of a right than this.

For tenants, this language is better than nothing.  If the landlord is unreasonable, it opens the door for a litigator to argue that the landlord has breached its covenant of good faith and fair dealing that is implied in all Arizona contracts.  However, litigation is an undesirable option in most instances.

2.         “As determined by Landlord…

Another frequently used method for determination of fair market rent is “as determined by Landlord in its reasonable discretion.”  This method sounds worse than “as mutually agreed upon by the parties,” but there is little difference.  In both instances, the landlord must be reasonable in its determination or negotiation of the renewal rent.  If the landlord is unreasonable, the tenant must litigate and prove the landlord was unreasonable.  This method is similarly weak for the tenant.

It is worth mentioning that I have also seen “as determined by Landlord in its sole discretion.”  Obviously, this makes the renewal option worthless since the rent can be determined by landlord without the need to be reasonable.

Part 2 will be posted next week and focus on unambiguous methods for determining fair market rent, including pre-established escalations, escalations based on a pricing index, appraisals and “baseball arbitration.”

Prior to using any language or concepts from this blog entry, consult with an attorney.

Ryan Rosensteel is a real estate and construction attorney licensed in Arizona.  You can contact him at ryan.rosensteel@azbar.org.

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