When a tenant is leasing commercial space, it may wish to reserve the right to secure its tenure beyond the initial term of the lease. Typically, this is achieved by the landlord providing the tenant with an option to renew or extend the lease ("Renewal Option").
Enforceability of Renewal Options
For a Renewal Option to be enforceable, it must provide for all essential terms being:
(ii) the length of the term ("Renewal Term");
(iv) rent ("Renewal Rent"); and
(v) any other essential terms.
Failing agreement on those elements, the Renewal Option would be an "agreement to agree" and not enforceable.
Accordingly, to be enforceable, the Renewal Rent must be fixed or objectively ascertainable. To be ascertainable, it is common that the Renewal Rent, if not fixed, be based upon "fair market rent for comparable premises in the same market area as the leased premises to be agreed upon between the parties." Note there are two elements, being (i) the "fair market rent"; and (ii) to be agreed upon between the parties.
Typically, such a Renewal Option provides that the lease would be renewed for a fixed term on the same terms as the lease (which would satisfy all of the requirements listed above except for the Renewal Rent).
If Renewal Rent is not fixed or objectively ascertainable, there is not an enforceable Renewal Option. An uncertain Renewal Option will not give the tenant an enforceable right to renew/extend the lease, and will merely create the obligation on the landlord to negotiate a renewal/extension with the tenant in good faith.1
In addition to agreeing on the basis for ascertaining the amount of the Renewal Rent, what happens if the parties fail to agree on the amount of the Renewal Rent? Frequently, in cases where the Renewal Rent is not fixed, Renewal Options provide for the Renewal Rent to be determined by arbitration. Arbitration is time-consuming and costly. An alternative for relatively small premises is to have the Renewal Rent decided by an independent, third-party expert.
Elements for Establishing Renewal Rent
There are two elements for establishing the Renewal Rent, being (i) the basis for determining the amount (e.g., market rate); and (ii) the method of determining such amount if the parties do not agree (e.g., arbitrator).
As an example, say that the parties agreed that the rent in the extension term will be fair market rent at the start of the extension term. But what is "fair market rent"? The landlord may claim $20.00 per square foot is fair market rent and the tenant may claim, with competitive analysis, rent in similar space is $5.00 per square foot. Ideally, they will meet somewhere in the middle before the term ends. However, sometimes they cannot reach an agreement on what price is fair market rent. If they cannot agree, they need to agree on who will set that price, such as a third-party expert. As long as the parties have agreed upon the basis for establishing the Renewal Rent but have failed to agree upon the method of determining the same (such as arbitration or expert), it was, until recently, unclear as to how the Renewal Rent would be set. This called into question the enforceability of the Renewal Option.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.