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Office tenants, while negotiating their lease, often bargain for and receive a right to extend the term of their lease. These renewal rights are very valuable to tenants. After all, if a tenant has to move to a different location when a lease term ends, it can face costly executive downtime, out-of-pocket expenses, and interruption to business. In addition, a new lease may mean the tenant has to pay a rental rate that’s higher than the market rate. In tightening urban markets such as Washington, D.C., where rental rates are rising and the creation of additional supply is restricted, renewal rights can give tenants some leverage. Without a guaranteed right to extend the lease term, landlords could drive a much harder deal on the terms and conditions of a renewal. But what belongs in a renewal clause? Renewal clauses focus on the formula used to calculate a fair-market renewal rental rate and then the determination of a rental rate based on that formula. But even with that system, a tenant looking for a good deal needs to understand a number of issues. The most important issue is the process used to determine the rental rate that will be applicable to the tenant’s lease (called the “option rental rate”). Because fair-market rental rates for office leases are seldom based on a set rental rate or a set inflation index (such as the consumer price index), the parties must agree upon, and put into the lease, a process for determining the fair-market rental rate. WHAT’S FAIR? Several issues come up when a process for determining the fair-market rental rate is put into a lease. The first one concerns the deadline by which the tenant must exercise its option. That deadline depends on many factors. The landlord needs to know well in advance if the tenant is going to exercise a renewal option. This allows the landlord time to find a third party to lease the space if the tenant doesn’t use its option. The amount of time depends on the size, type, and location of the space. The general rule of thumb is, the larger the space the more notice the landlord will require. For example, a landlord will probably require between 9 and 12 months’ prior notice for smaller spaces (between 5,000 and 20,000 square feet), between 12 and 15 months’ prior notice for somewhat larger spaces (20,000 to 60,000 square feet), and between 15 and 18 months’ advance notice for spaces of more than 60,000 square feet. If the tenant doesn’t exercise the right within the required time frame, the right will end and the landlord will be free to lease the space to a different tenant. The second issue involves the extent of each party’s obligation to negotiate for a set period of time to try to agree upon the fair-market rental rate. Once the tenant has used its renewal option, the landlord and tenant should meet to discuss and, if possible, come to agreement on the fair-market rental rate for the space. There are several questions to ask at this point. Does the tenant have to exercise its renewal-right option before the landlord is obligated to meet and discuss fair-market rental rates? If the landlord is required to discuss the fair-market rental rates with the tenant at any time, should he be obligated to provide the tenant with backup documentation about his determination of the fair-market rental rate (such as a summary of the landlord’s recent leasing activity in the building or project)? And what happens if the landlord and tenant are unable to agree upon the fair-market rental rate? The landlord will often agree to meet and discuss the fair-market rental rate before the tenant’s renewal option has expired. This allows the tenant to have an idea of what the landlord believes the fair-market rental rate to be before the tenant must exercise its option. With backup documentation, landlords generally consider the economic terms of other leases in the building or project to be confidential and, therefore, will be very reluctant to turn over that information to the tenant. As a result, tenants are expected to rely upon their own sources (through a broker or otherwise) to determine the fair-market rental rate. Finally, if the parties are unable to agree upon the fair-market rental rate within a set time period, say, 30 days, the lease must provide some mechanism for resolving the dispute. Dispute resolution is the third issue to consider in a renewal clause. Landlords almost always require that the tenant must have irrevocably exercised its renewal option before proceeding to any type of dispute resolution. This is because landlords do not want to be forced to spend time and money in dispute resolution only to have the tenant decide that it doesn’t like the result and then rescind its option. The most common method of resolving a fair-market-rental-rate dispute is for each party to submit a final, binding fair-market-rental-rate determination to arbitration. Arbitration requires a series of steps. To arbitrate the fair-market rental rate, the landlord and tenant must first agree upon an arbitrator. Both the landlord and tenant select an arbitrator (called an “advocate arbitrator”). That person is generally required to be a real estate broker, appraiser, or attorney with at least five years of real estate experience in the region. Many landlords and tenants tend to believe that appraisers or brokers are best suited to determine the fair-market rental rate. But the job involves gathering and interpreting large amounts of data, interpreting lease language, and effectively advocating a position to the neutral arbitrator, and often attorneys (who rely on consultants, including appraisers or brokers, to determine the fair-market rental rate) are best suited to the job. In addition, in markets such as Washington, the parties have, at some point in the past, worked with most, if not all, of the top appraisers and brokers in the area. As a result, selecting a qualified broker or appraiser who does not have a conflict could be problematic. But selecting a qualified attorney to serve as the neutral arbitrator would be easier, since there is a much larger pool of qualified attorneys to select from. Once the two advocate arbitrators have been selected, they should meet and select a third, independent arbitrator (called the “neutral arbitrator”). The neutral arbitrator will actually be responsible for determining the fair-market rental rate. The fourth issue involves figuring out how to handle arbitration. A good system is commonly known as “baseball” arbitration because it was originally developed by professional baseball to resolve salary disputes between owners and players. In baseball arbitration the neutral arbitrator must select the fair-market rental rate from either the landlord or tenant, but cannot select an alternative determination. The good thing about this approach is that it eliminates a common result called “splitting the baby,” in which the neutral arbitrator simply selects a rental rate midway between the suggested rates of the landlord and tenant. It also allows the landlord and tenant more flexibility in reaching a compromise. Each party knows that if its submitted rental rate is not closer to the rental rate that the neutral arbitrator believes to be the actual rental rate, then the neutral arbitrator will select the other party’s rate. At its best, baseball arbitration forces both sides to be realistic about their submitted rental rate, and the process often results in an agreement about the fair-market rental rate before the parties have to resort to arbitration. That, of course, saves everyone considerable time and money. In today’s marketplace, tenants often negotiate for and receive valuable renewal rights at the fair-market rental rate. To make these rights easy to understand, both landlords and tenants should make sure the lease includes a precise process for determining the fair-market rental rate.
Anton N. Natsis is a name partner and Michael E. McFadden is an associate in the Century City, Calif., office of Allen Matkins Leck Gamble Mallory & Natsis. Both Natsis and McFadden specialize in real estate law with an emphasis on development, leasing, asset management, and purchase and sale.

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