Okay, now that we have your attention, you’re probably wondering what Jacuzzi tubs, fondue sets and lease renewal options have in common, right? Well, the fact is, everybody seems to want them, but people rarely actually use them. They all sound wonderful in theory, but, in the end, they are difficult to use and often not worth the effort.
Lease renewal rights are often hashed out at great length in the lease negotiations. Tenants want the ability to remain in premises on favorable economic terms when the original lease comes to an end. Landlords, on the other hand, fight them claiming they are one way options which only benefit tenants. Typically, the negotiations focus on things like the term of the option, the rate, whether the rate will be fixed or “market” and, if the latter, how it will be determined. Parties also battle over whether the tenant must commit to the renewal before knowing the actual rate or whether it can wait to exercise the option (or revoke its exercise of the option) after the rate is determined.
With all the time and energy we put into these provisions, in all of our collective years of real estate practice, we can count on a few hands the number of times a meaningful sized tenant has actually exercised its renewal option. More typically, renewal deals are hammered out through a new negotiation with the landlord outside of the contractual renewal language in the lease. However, that does NOT mean the contractual right is irrelevant and should be ignored, waived or treated lightly. Often times, the strength of a well structured and drafted renewal right in the lease can provide important leverage for the tenant in the ultimate negotiation of the renewal deal with the landlord.
Why are renewal rights rarely exercised? There are two basic forms of renewal rights:
1. The Pre-Negotiated Renewal Rate. The first provides for a stipulated rental rate that will apply after the original lease term expires. Because the landlord is committing to lease space in the future at the tenant’s election, landlords are usually only willing to provide a very rich rate for the renewal term. While it is possible that this may still turn out to be a very favorable rate down the road if the market heats up beyond expectation, this has rarely been the case in the Delaware Valley where we have seen relatively flat or declining rents over the past 20 years. It has been more likely than not that an escalated renewal rate stated in the lease for a renewal term 10 years or more in the future will be well above what a new tenant is obtaining when going through a competitive procurement process.
2. The “To Be Determined” Market Rate. The second type of renewal provision is one where the renewal rate is based on some concept of “market” rate as determined in the future. Typically, the landlord will quote a rate at the time the tenant exercises its option. The tenant can either accept the rate or dispute it, in which case the parties will initially try to agree on market and then submit it to binding arbitration if they cannot reach agreement. On its face, this type of deal seems pretty fair and straightforward. Who could object to a “market” deal? The problem is that defining “market” is not an exact science. In fact, we have seen landlords and tenants in the region be $7-$10 apart in what they and their respective experts believe market to be for a given building. Why? Because the “market” is made up of and defined by all kinds of deals which are cut under all different types of facts and circumstances. One tenant may have recently negotiated its own renewal deal in the building without competing it and without focusing on cash and other concessions which impact overall deal economics. Another Tenant may have paid a premium for a short term deal or simply been poorly represented by a broker who did a lot of business with the landlord. Landlords will emphasize these “comparable” deals in defining the market. On the other hand, a major tenant in a neighboring building may have recently secured a very aggressive deal because the landlord needed that tenant to ensure it could sell or refinance its asset. Tenants will emphasize these types of deals in arguing “market”.
In the end, however, tenants rarely exercise these types of market renewal rights because of the uncertainty involved. Few tenants are willing to commit to a renewal term without knowing up front the rent to which they are committing. Imagine the CEO who asks his or her Board to approve a 5 year lease commitment without being able to tell them what the rent is. That’s a very hard sell more often than not. In fact, in the handful of deals where these types of options have actually been exercised in our region, it is often the case that the building is in distress, negotiations have broken down (along with the landlord/tenant relationship) and the tenant rarely remains in the building after that renewal term expires.
So, if options with fixed rental rates are rarely favorable to tenants and those with “market” rates are too risky, why are renewal options important? Landlords will often argue that for these very reasons they are not important and, therefore, should be shelved or eliminated. If the renewal option is a weak one, the landlord is probably correct. However, a well thought out option can be a key element to the tenant’s renewal strategy down the road.
Small Tenants. For smaller tenants, especially those who are investing meaningful amounts of money in their space, the ability to renew, even at a premium price, can be important. Smaller tenants can become collateral damage of bigger lease deals if they don’t plan ahead and protect their interests. A large, growing tenant in the building may need that tenant’s space down the road and the landlord will gladly sacrifice the needs of the smaller tenant to accommodate a larger one. Likewise, a landlord may need to aggregate a number of smaller suites to be able to attract a larger tenant who is interested in the building. By ensuring that it has the right to renew its lease, the tenant can protect against these types of scenarios and also enhance its leverage with a landlord who may want to move the tenant to accommodate the bigger deal.
Larger tenants. As we have detailed in many blog posts in the past, landlords make almost all of their profits on lease renewals. They avoid vacancy periods, often involve less capital than a new lease deal and, in some cases, are not competed by the tenant (or are poorly competed). In fact, the profit to a landlord on a renewal deal can often be three to five times its profit on a new lease. As a result, in most renewal provisions, landlords try to limit the definition of “market” to renewal deals that have recently occurred in the building or comparable buildings and exclude any new deals. This can artificially skew the true “market rate” for the space and enrich the landlord’s position. “Market” is typically defined as what a willing landlord would accept from a willing tenant in the market when not compelled to act. With this in mind, new lease deals are more likely to reflect an openly competed transaction with more aggressive rates and healthier concessions and, therefore, reflect a truer “market”. A tenant who has many options in the market is more akin to a “willing buyer” than a tenant who is essentially captive to its existing space when it agrees to a renewal. By ensuring that “market” reflects new lease deals as well as the cash concessions that come with these deals, the “renewal premium” that landlords depend on is minimized and tenants will get a rate that is more aggressive. With the potential for a more aggressive market rate determination, landlords have more incentive to work with tenants on a negotiated renewal rate. If, on the other hand, the tenant has no renewal rights or its rights are watered down or at a premium, the tenant may be at the mercy of the landlord if it really wants to remain in the space.
While lease renewal options are rarely exercised, they are still important provisions. For smaller tenants, they can provide a defense against larger, more valuable tenants who want their space in the future. For larger tenants, they can provide some certainty for the future as well as leverage in the ultimate negotiations with the landlord that typically define the renewal terms. In sum, the only thing more comforting than a soak in the Jacuzzi after a delicious fondue dinner might be the feeling you get when sitting at the negotiating table with your landlord armed with a solid renewal right.
For more information contact Glenn Blumenfeld