The owner of a local business wants to lease commercial property to use as a retail storefront or for office purposes. When she finds her ideal space, the landlord suggests an initial 10-year term. The potential tenant envisions staying in the space longer than that, so she wants to negotiate for the option to renew the lease at its termination. However, the landlord is reluctant to agree on a fixed amount of rent for the renewal term, as market conditions will undoubtedly change over the course of a 10-year period. So, how will the parties agree on the future rental amount?
Most commercial leases include a renewal option for the tenant, providing for the time the option is to be exercised, and the length of any renewal periods. If the parties are unable or unwilling to agree on a future rental figure, the most common approach is to state that the renewal rental rate will be mutually determined in the future based on fair market value (FMV). But how do the parties define what the term “fair market value rent” means? This article discusses the competing interests and criteria of landlords and tenants in defining fair market value, explores various mechanisms used for resolving disputes over fair market rental rates, and concludes with proposed language that represents a healthy compromise for both sides.
Landlord’s vs. Tenant’s Criteria in Determining FMV
Before we delve into the various drafting methods for determining “fair market value rent,” it is important to understand the competing goals of landlords and tenants, and which criteria each party wants to have included in the calculation. Fair market value rent is generally based on “comparable leases of comparable space,” similar to how properties are appraised before sale. However, the parties must negotiate which aspects of other leases they will compare in determining whether they are in fact comparable or not.
Landlords, naturally, want fair market value rent to be as high as possible, taking into account things like the most highly valuable potential use of the premises, and refusing to consider all or most rent concessions offered by other landlords of similar properties. The landlord will likely want to avoid focus on the characteristics of the current tenant, such as size, creditworthiness and specialty, and rather, take into account the possibility of leasing to larger and deeper-pocketed potential tenants.
Tenants, on the other hand, want future rental rates to be as low as possible, insisting on basing the determination on the current use of the property and considering comparable leases with substantial landlord concessions, such as tenant improvement allowances, brokerage fees and free rent. Tenants want the standard to be much narrower, comparing only those leases and properties that are the most similar with their own. Tenants also want any improvements or fixtures added during the initial term to be excluded from fair market value rent, on the theory that they shouldn’t be charged for them twice.
These competing criteria set the stage for (commonly heated) negotiations regarding fair market rental rates that often end in deadlock. Having an efficient dispute resolution mechanism in place to determine fair market value is crucial to a successful renewal process.
Common Methods for Determining FMV
Practitioners have come up with various methods for landlords and tenants to determine fair market value rent when a rental figure cannot be agreed upon. The most common are the Average Method, the Three Broker Method, and the Baseball Arbitration Method.
The Average Method
Under this method, the landlord and tenant each appoint a duly qualified real estate broker, appraiser or similarly qualified individual (as defined in the lease) to make a determination of fair market value based on the criteria agreed upon by the parties. If the two appraisers’ figures do not match up, the amounts are averaged, with the resulting amount representing fair market value rent. The upside of this method is clearly its simplicity: The parties agree in advance that a simple averaging of each side’s appraisal will result in a final determination of FMV, without the need for further evaluation. However, this method has obvious pitfalls, including that landlords or tenants could skew the determination in their favor by simply submitting an inflated or deflated evaluation of fair market value. Additionally, some critics argue that the Average Method fails to produce a figure that actually replicates true market rent.
The Three Broker Method
Many leases recognize the potential for abuse of the simple average method, and instead utilize what is known as the “Three Broker” or “Three Appraiser” Method. In these cases, in the event the landlord and tenant cannot agree on FMV, each party appoints its own broker or appraiser (having certain qualifications as set forth in the lease). If the two representatives can agree on FMV, that figure will be binding on the parties. If not, the two will agree on a third, impartial appraiser, who then either makes an independent determination of FMV that is binding on the parties, or some calculation is done to average two or all three of the appraisers’ proposed rental figures.
The Three Broker Method is very common in modern commercial leases, due to the added protection of the third, independent broker, which can ensure the integrity of the process. Still, this method has a downside, in that it may be more costly and could lead to further disputes as to how the neutral appraiser should fashion a reasonable compromise between the two submitted proposals. Also, this method may leave room for arbitrary or unpredictable decisions by the independent appraiser.
The Baseball Arbitration Method
Another popular method for resolving FMV disputes is to use what is known as the “Baseball Arbitration Method,” aptly named for its origin in Major League Baseball’s player arbitration system. Under this mechanism, the landlord and tenant each submit their respective estimates of fair market value (either directly or through brokers appointed by each party) to a neutral arbitrator mutually selected by the parties. Unlike with the Three Broker Method however, the arbitrator here is required to select from the two proposals submitted, with the goal of reaching the most realistic choice based on actual prevailing market rates. The arbitrator’s choice then becomes binding on the parties.
Where the Average Method provides a simple but mechanical approach to reaching a compromise amount, but is subject to abuse by the proposing parties, and the Three Broker Method provides for a third-party determination of a compromise amount between the two proposed rental rates, the Baseball Arbitration method reaches some kind of middle ground. The potential for abuse is limited, due to the reality that the arbitrator will likely choose the proposal that most closely resembles fair market rent, and the level of arbitrariness may be reduced due to the requirement that the arbitrator choose from the two amounts on the table rather than creating some sort of settlement. Arbitration can come with a heavy price tag, though, often costing the parties valuable time and resources.
Proposed Renewal Option Language
In order to save landlord and tenant time, as well as money and the potential headaches that may be associated with fair–market-value disputes at renewal, it is important for the parties to provide in detail the desired criteria and dispute resolution mechanism to be used in reaching a fair market rental figure. Below is a sample provision that represents a reasonable and effective compromise between landlord and tenant:
During each Extension Term, the Annual Rent Rate shall be 100% of the Prevailing Market Rate (as defined herein).
“Prevailing Market Rent” shall mean the fair market annual base or fixed rent payable from time to time for space comparable to the Premises in Comparable Buildings, taking into consideration all relevant factors including, without limitation, the creditworthiness of Tenant and the location, size, type and quality (including view corridor and visibility of building to major thoroughfares) of the Comparable Buildings, annual or other periodic rental escalations, brokerage commissions payable (or not payable) by Landlord, the applicable base year (and the applicable amount of any operating expenses and real estate taxes stops) for full service leases, the location of the premises within the building, the applicable rent commencement date and all applicable Market Concessions; provided, however, downtime will not be taken into consideration.
“Market Concessions” means such concessions (e.g., free rent and improvement allowances) as are being provided for transactions for comparable space in Comparable Buildings, taking into consideration all relevant factors with respect to such concessions; and
If within thirty (30) days following delivery of Tenant’s Extension Notice to Landlord, Landlord and Tenant have not (despite their good faith discussions) mutually agreed on the Prevailing Market Rent and Market Concessions, the Prevailing Market Rent and Market Concessions shall be determined as follows: Within ten (10) business days after the expiration of such thirty (30) day period, each party shall give written notice to the other setting forth the name and address of a Broker (hereinafter defined) selected by such party who has agreed to act in such capacity, to determine the Prevailing Market Rent and Market Concessions. If either party fails to timely select a Broker, the Prevailing Market Rent and Market Concessions shall be determined by the Broker selected by the other party. Each Broker shall thereupon independently make his or her determination of the Prevailing Market Rent and Market Concessions within twenty (20) days after the appointment of the second Broker. The two Brokers shall jointly appoint a third Broker within ten (10) days after the second of the two determinations described above has been rendered. In the event that the two (2) Brokers have failed to jointly appoint a third (3rd) Broker within such ten (10)-day period, either Landlord or Tenant shall have the right to have the third (3rd) Broker appointed by an arbitrator pursuant to the commercial arbitration rules of the American Arbitration Association in the jurisdiction wherein the Building is located. The third Broker shall independently make his/her determination of the Prevailing Market Rent and Market Concessions within twenty (20) days after his appointment and shall select either the determination of the Landlord’s Broker or the Tenant’s Broker that the third broker determines most closely approximates his or her determination of the Prevailing Market Rent and Market Concessions, and such determination shall be final and binding upon the parties. The third Broker shall have no right to propose a middle ground or any modification to either of the other two Broker’s proposed Prevailing Market Rent or Market Concessions determinations. For the purposes of this Section, “Broker” shall mean a real estate broker licensed in the State where the Building is located, who has been regularly engaged in such capacity in the business of commercial office leasing in the __________ market for at least ten (10) years immediately preceding such person’s appointment hereunder and not then representing Landlord or Tenant. Each party shall pay for the cost of its Broker and one-half of the cost of the third Broker.
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***** John G. Kelly, a member of the Board of Editors of Commerical Leasing Law & Strategy, is a shareholder of Arlington, VA-based law firm Bean, Kinney & Korman, P.C. He focuses his practice on all aspects of real property law and finance. Zack Andrews assisted with this article. Kellly can be contacted at email@example.com.
The views expressed in the article are those of the authors and not necessarily the views of their clients or other attorneys in their firm.