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Right of First Refusal / Extension Option (Creating More Renewal Leverage for Tenant)

Right of First Refusal / Extension Option (Creating More Renewal Leverage for Tenant)

I often hear from commercial real estate brokers that renewal options are not that critical during lease negotiations.  Renewal options sound good in theory, but most tenants reach lease renewals by mutual agreement with their landlords and not by exercising an existing renewal option from the lease.  Brokers claim that the value of renewal options for tenants is in leverage for negotiating with the landlord for more favorable renewal terms when it is time to renew.

As discussed in a prior blog entry (https://azleaselaw.wordpress.com/2010/02/08/determination-of-fair-market-rent-part-2-of-2/), methods for determining fair market renewal rent such as appraisals, broker opinions and arbitrations tend to be burdensome, time consuming and expensive.  While tenants may prefer easier methods such as rent adjustments based on CPI or pre-established rates of increase, most landlords are unwilling to agree to these methods because they are generally unfavorable to the landlord in today’s leasing market where rents are considered relatively low (i.e., landlords do not want to be stuck increasing rents based on a number that is artificially low to start).  Further, even with pre-established rates, tenants use the renewal rates as a starting point in negotiations with the landlord and end up reaching a renewal without exercising the renewal option.

Tenants and tenant rep brokers should consider using a right of first refusal for an extension of the term to create additional leverage.  Rights of first refusal are commonly used with respect to expansion (i.e., if the tenant needs more space, it has a right of first refusal on adjacent space).  However, a right of first refusal could be very powerful with respect to lease extension.  To illustrate, when the tenant is in its last year of the lease term, the landlord likely will market the space for lease.  If the landlord obtains an offer from a prospective tenant, the right to match that offer would be valuable to the tenant.  Since a new tenant likely would receive incentives that are not applicable to a continuing tenant (e.g., tenant improvement allowance), the value of the incentives could be amortized over the entire lease term for the existing tenant to achieve the same financial deal.  Even better, the tenant could negotiate for the right to accept the terms of an offer from a new tenant, but at 95% of the offered rental rate.

A right of first refusal for an extension of the term should be negotiated in the letter of intent and included in 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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