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Determination of Fair Market Rent (Part 2 of 2)

Determination of Fair Market Rent (Part 2 of 2)

As discussed in the previous blog entry, a tenant should negotiate a renewal option with a clear, unambiguous method for determination of fair market rent.  The tenant wants a neutral, well-defined calculation, appraisal or arbitration process.  The tenant does not want to further negotiate with the landlord at the time of renewal, since the tenant always can negotiate with or without a renewal option.

This blog entry focuses on unambiguous methods for determination of fair market rent.  While the ambiguous methods described in the previous blog entry are “landlord-friendly,” the methods described in this entry are generally fair and likely more consistent with the intent of the parties.  Again, when a tenant negotiates a renewal option, it typically believes it is getting a clear right and not one that depends on the reasonableness of the landlord.

B.        Unambiguous Methods

1.         Pre-Established Escalations

The most straight-forward method for determining fair market rent is based on a pre-established escalation.  For example, the renewal option may provide as follows: “The terms and conditions during the Renewal Term shall be the same as during the Term, except that the Base Rent for the first Lease Year of the Renewal Term shall increase by two percent (2%) over the Base Rent from the final Lease Year of the Term, and the Base Rent shall increase by two percent (2%) annually for each subsequent Lease Year of the Renewal Term.

As mentioned in the previous blog entry, most landlords are unwilling to agree to this type of increase because they believe that rents are very low at the moment (i.e., the pre-established escalations will not reflect the actual fair market rent at the time of renewal).  In this regard, since the market is so volatile, it does not make sense for the parties to base renewal rent on pre-established escalations.  However, this method provides a clear, well-defined right, which is desirable for the tenant.

2.         Escalations Based on a Pricing Index

Escalations based on a pricing index operate the same way as pre-established escalations.  However, instead of a pre-established rate of increase, the rate is based on a pricing index.  The only pricing indices that I have seen used are CPI (Consumer Price Index) and S&P (Standard & Poor’s).

The most common mistakes in lease provisions using rent escalations based on a pricing index are: (a) failure to specify which index series will be used (e.g., CPI-U, West Region Urban Size A, All Items, 1982-84=100) and (b) failure to specify the reference period from which changes in the CPI will be measured (e.g., the last published index prior to Tenant’s notice of exercise of its renewal option).

Practice Pointer: At the time of lease renewal, it may be difficult to find the applicable index from the commencement date of the lease (often 3, 5 or 10 years earlier). Accordingly, I recommend referencing the applicable index (i.e., the actual number) as of the commencement date in the lease.

Following is a sample provision

The terms and conditions during the Renewal Term shall be the same as during the Term, except that the Base Rent shall be adjusted in accordance with the CPI-U, West Region Urban Size A, All Items, 1982-84=100 (the “CPI”) as described in this section.  The Base Rent for the first Lease Year of the Renewal Term shall increase or decrease, as the case may be, to an amount equal to the product of: (a) the Base Rent for the first Lease Year of the Term, and (b) a fraction in which the index from the last published CPI prior to Tenant’s notice of exercise of its renewal option is the numerator, and 223.058 (the index from the last published CPI prior to the Commencement Date) is the denominator.  Thereafter, the Base Rent shall increase by two percent (2%) annually for each subsequent Lease Year of the Renewal Term.

Last, a good website on price indices is: http://www.bls.gov/cpi/cpi1998d.htm.

Introductory Note for Appraisal and Baseball Arbitration Method

The appraisal and baseball arbitration methods both require the involvement of neutral third parties to determine the fair market rent.  Due to time and cost considerations, the parties first should try to reach an agreement on the fair market rent.  Following is a sample provision that allows the parties to try and reach such an agreement:

Landlord shall notify Tenant in writing of Landlord’s determination of the Fair Market Rent within fifteen (15) days following receipt of Tenant’s renewal notice.  If, within fifteen (15) days after receipt of such notice, Tenant accepts Landlord’s determination, Landlord will prepare an appropriate amendment to the Lease. If, within fifteen (15) days after receipt of such notice, Tenant fails to notify Landlord in writing of Tenant’s objections to Landlord’s proposed Fair Market Rent, Tenant shall be deemed to have rejected Landlord’s Fair Market Rent, and the parties agree to negotiate their differences in good faith within thirty (30) days following Tenant’s notice of objections to Landlord.  If the parties fail to agree on a Fair Market Rent within the 30-day period, then Tenant shall have ten (10) days thereafter within which to withdraw its renewal notice or to notify Landlord of its desire to [obtain an appraisal of/ arbitrate] the Fair Market Rent.  If Tenant fails to notify Landlord of its election within the 10-day period, Tenant shall be deemed to have elected to [obtain an appraisal/ arbitrate] as of the last day of the 10-day period, and the determination of Fair Market Rent shall be settled by [an appraisal/arbitration] in accordance with the provisions below.

3.         Appraisal Method

The parties could agree that an appraiser or broker will determine the fair market rent.  The lease should provide the name of an appraiser/ broker or appraisal/ brokerage firm acceptable to both landlord and tenant to perform the appraisal.  Alternatively, the lease should provide a method for selecting an appraisal.  Following is a sample provision:

In the event of a continuing dispute concerning Fair Market Rent, within ten (10) days after the appraisal election date, Tenant and Landlord shall select a local appraiser who is a member of the American Institute of Real Estate Appraisers, or if it shall not then be in existence, a member of the most nearly comparable organization, and who has a minimum of five (5) years experience in the Phoenix, Arizona commercial office leasing market, who is licensed by the State of Arizona, and who is not affiliated with either party or involved in an active transaction in which either party is also involved.  The appraiser shall determine the Fair Market Rent by evaluating the bona fide rates, terms and conditions then being paid by tenants in “arm’s length” transactions for comparable space in comparable buildings in the same geographic submarket as the Project, recognizing that there shall be no brokerage fees payable in the transaction.  The determination of the appraiser shall be final and binding on Landlord and Tenant.

4.         “Baseball Arbitration” Method

“Baseball Arbitration” is considered high stakes arbitration where both sides make their own determination of fair market rent and let a neutral third party decide which determination is more accurate.  Following is a sample provision:

In the event of a continuing dispute concerning Fair Market Rent, Tenant and Landlord shall each appoint a local appraiser who is a member of the American Institute of Real Estate Appraisers, or if it shall not then be in existence, a member of the most nearly comparable organization, and who has a minimum of five (5) years experience in the Phoenix, Arizona commercial office leasing market, who is licensed by the State of Arizona, and who is not affiliated with either party or involved in an active transaction in which either party is also involved.  Each party shall notify the other as to the name and address of the appraiser selected within ten (10) days after the arbitration election date.  Each appraiser shall, during the next fifteen (15) days, calculate the Fair Market Rent and notify both parties of said determination of Fair Market Rent.  If the two appraisers agree upon a Fair Market Rent, such determination shall be final and binding on the parties.  If the difference between the rate calculated by each appraiser is One Dollar ($1.00) per rentable square foot or less, the rates calculated by the two appraisers will be averaged and the resulting figure will be the agreed upon Fair Market Rent.  If the difference between the rates calculated by each appraiser is more than One Dollar ($1.00) per rentable square foot, the two appraisers shall select a third appraiser, who shall satisfy the same professional qualification requirements set forth above, and the appraisers will then notify Landlord and Tenant of such appraiser’s name, address and selection within ten (10) days following the failure of the appraisers to agree upon the Fair Market Rent.  The third appraiser will select one or the other of the two calculations of Fair Market Rent submitted by the other two appraisers and will notify the parties and the appraisers within ten (10) days of being selected to make the Fair Market Rent determination.  The determination of the third appraiser shall be final and binding on Landlord and Tenant.

There are endless variations for arbitration provisions.

Final Note:  After the appraisal or baseball arbitration process has been concluded, the parties should negotiate whether the tenant may withdraw its renewal notice if it does not agree with the determination of fair market rent.  Some landlords take the position that if the tenant elects to force both parties go through the process, the tenant should be bound by the final determination.  An alternative is for the tenant to reimburse the landlord for its costs if tenant elects to withdraw.  Following is a sample provision allowing tenant to withdraw its renewal notice:

Once the Fair Market Rent has been established by [an appraisal/ arbitration], Tenant shall have the option to withdraw its renewal notice within ten (10) days following the date Tenant receives written notice of the Fair Market Rent.  If Tenant does not withdraw its renewal notice by written notice to Landlord within the 10-day period, Tenant shall be deemed to have accepted the Fair Market Rate and Landlord will prepare an appropriate amendment to the Lease.

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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