In the Spotlight: Confronting the Vagaries of 'Fair Market Rent'

When negotiating an option in favor of the tenant to extend the term or expand the leased premises at a later date, the issue of how to determine the economic terms of that extension or expansion can be a contentious one. Leasing markets are subject to quick and violent volatility, and landlords and tenants now more than ever are reticent to lock themselves into long-term fixed rental. But without a fixed rent schedule for an extended term or expansion premises, how can the parties agree on a method of determining market rent in a fair and reasonable way? What are the criteria for arriving at what is “fair,” and who ultimately decides?

Background

Historically, parties to commercial leases commonly tied a future calculation of market rent to the Consumer Price Index or similar mechanism promulgated by the federal government, or a generally accepted index by a financial services firm like Standard & Poor's, to reduce the effects of inflation and consumer prices to a general formula. In a strong leasing market, parties generally found methods like these adequate, and likely to produce impartial results.

Alternatively, if an index was not cited, leases often stipulated that the fair market rent would be determined in the landlord's discretion (reasonable or otherwise), which provision was accompanied by an option of the tenant to rescind its election to renew or expand. These provisions, together with various other forms of “agreements to agree” on the fair market rental, have the effect of nullifying the option in question, as a landlord desiring a new tenant or an alternative user for the expansion space has the flexibility of pricing the tenant out of the transaction.

Recent market conditions have prompted attorneys for commercial landlords and tenants to toil to create and refine a concept of “fair market rent” that distills, to the greatest extent possible, criteria specific to the lease, the space and the parties in question. This article summarizes the considerations of the parties in negotiating such a provision, and the mechanisms by which the parties will most likely be assured of a just result.

Criteria

The criteria for determining fair market rent are at least as important as the mechanisms and timing of that calculation. The definition of the term “fair market rent” may be as simple as “the then-current fair market rental for leases of comparable space in the market where the premises are located.” But, depending on who ultimately determines the rent in question, both parties should be careful to denote which particular aspects of the occupancy are eligible, if not mandatory, elements of that calculation. The goal is to give the parties a tool for identifying a set of comparable transactions upon which to base the rental when the lease calls for the fair market rent.

The three basic considerations in identifying such “market” transactions are the tenant, the space and the lease in question. First, the business, size and credit of the tenant should be considered. A multi-billion dollar multinational office tenant is not in a comparable market with a family-owned nail salon in a strip center. The location, quality and features of the property are important, as well as the size of the leased premises in question and the location of those premises within the building or shopping center. Class A office buildings in a central business district may command markedly different users and demands from Class C suburban properties. Ideally, the parties will incorporate into the analysis comparable leases of comparable space within the building in question; however, such leases might not always be available for consideration. Finally, the terms of the lease itself must be considered, including the term, options and concessions. Market conditions drive these features, including rent abatement and tenant improvement allowances, and the parties must limit their consideration to leases containing similar economic terms.

Negotiation

In any negotiation of a fair market rent provision, a tenant will be inclined to emphasize the value of all tenant concessions, as they will likely have the ultimate effect of reducing the market rent. In addition, in the context of an extension, a tenant will frequently demand that improvements to the premises constructed for the tenant wholly or partially at the tenant's expense should be excluded from any fair market rent calculation. This demand is supported by the notion that if the improvements become the property of the landlord at the expiration of the term, the tenant should not have to pay twice for them and the landlord should not be entitled to a windfall in the extension term.

An agreement by the parties of the criteria behind a fair market rent calculation will only resolve a fraction of the issues inherent in the process of that calculation. General references to aspects of the tenant credit and economic terms of the lease still call for a subjective analysis, and covenants of good faith and commercial reasonableness and diligence are far from cure-alls. But if the landlord and the tenant cannot agree on the fair market rent, who will be charged with resolving the dispute?

Upon the receipt of notice of a tenant's exercise of a renewal or expansion option calling for fair market rent, a landlord will often have a period of time to calculate and deliver notice to the tenant of that rental. Following receipt of the landlord's determination, the tenant will have a period of time either to accept the landlord's stated rental or reject it. If the tenant rejects the landlord's determination, it usually will have the choice either to rescind the exercise of the renewal or expansion option or enter into further negotiation with the landlord as to the fair market rent. If the tenant makes the latter election, the parties will customarily have a fixed period in which to enter into good-faith negotiation of the fair market rent.

If, upon the expiration of all applicable negotiation periods, the landlord and the tenant are unable to agree on the fair market rent, the lease will often call for an arbitration process, the first step in which the parties are to designate (jointly or severally) one or more third-party professionals to choose which party's determination is correct, or to make an independent determination of fair market rent, using the criteria stated in the lease. Following the presentation of the third-party results, the mechanisms by which the parties arrive at an agreed rental have numerous iterations. For example, the lease may require the parties to agree to an average of the competing third-party calculations, or it may require “baseball arbitration,” whereby the two appointed professionals jointly designate a third professional, who must choose between the calculations already provided.

Licensed Brokers or Qualified Appraisers

An increasingly common issue in this area is whether the parties should be required to designate licensed brokers or qualified appraisers. While there is much variance as to the interests of the parties from one market to another, the designation of the arbitrator is critical in the process. Advocates of brokers in this role argue that a broker is active in all aspects of a lease transaction and may have greater experience negotiating leases and increased familiarity with prevailing market rates. Those who prefer appraisers point to the reliability of the more scientific approach in appraisal work.

Whichever professional is called for, the parties should be clear that any designated professionals be licensed in their respective profession and have significant experience working in the submarket and type of space in question.

Other Considerations

Competing assertions of fair market rent are not always dramatically different. Therefore, an efficient approach to resolving a less substantial dispute is for the parties to agree to an automatic and binding resolution. If, initially or following any step in an arbitration process, the determinations presented by the parties themselves or by the designated professionals are very close (for example, less than 10% apart), the lease may provide that the parties are deemed to agree to an average of the two figures.

One other important provision in this area, particularly where a third-party arbitrator has been retained, is an express prohibition against the arbitrator “splitting the difference,” or deciding that neither of the two prior determinations is correct and thereby arriving at an average of the two numbers. This ensures that the third professional will take an active approach to resolving the dispute and that the parties will receive value for the fees paid and time spent.

Finally, if the tenant has substantial bargaining power, it may want to include an option to reject even the post-arbitration calculation of fair market rent and rescind its exercise of the renewal or expansion option. The landlord will resist this of course, but if it agrees to the concept the tenant should be required to reimburse the landlord for its arbitration expenses.

Conclusion

While in its essence a straightforward concept, fair market rent is rife with legal and economic hazards, and parties to a lease are wise to take caution in arriving at an agreed method of calculation.

David P. Resnick, a member of this newsletter's Board of Editors, is an attorney with the Chicago office of Edwards Wildman Palmer LLP. He can be reached at [email protected], or 312-201-2844.

When negotiating an option in favor of the tenant to extend the term or expand the leased premises at a later date, the issue of how to determine the economic terms of that extension or expansion can be a contentious one. Leasing markets are subject to quick and violent volatility, and landlords and tenants now more than ever are reticent to lock themselves into long-term fixed rental. But without a fixed rent schedule for an extended term or expansion premises, how can the parties agree on a method of determining market rent in a fair and reasonable way? What are the criteria for arriving at what is “fair,” and who ultimately decides?

Background

Historically, parties to commercial leases commonly tied a future calculation of market rent to the Consumer Price Index or similar mechanism promulgated by the federal government, or a generally accepted index by a financial services firm like Standard & Poor's, to reduce the effects of inflation and consumer prices to a general formula. In a strong leasing market, parties generally found methods like these adequate, and likely to produce impartial results.

Alternatively, if an index was not cited, leases often stipulated that the fair market rent would be determined in the landlord's discretion (reasonable or otherwise), which provision was accompanied by an option of the tenant to rescind its election to renew or expand. These provisions, together with various other forms of “agreements to agree” on the fair market rental, have the effect of nullifying the option in question, as a landlord desiring a new tenant or an alternative user for the expansion space has the flexibility of pricing the tenant out of the transaction.

Recent market conditions have prompted attorneys for commercial landlords and tenants to toil to create and refine a concept of “fair market rent” that distills, to the greatest extent possible, criteria specific to the lease, the space and the parties in question. This article summarizes the considerations of the parties in negotiating such a provision, and the mechanisms by which the parties will most likely be assured of a just result.

Criteria

The criteria for determining fair market rent are at least as important as the mechanisms and timing of that calculation. The definition of the term “fair market rent” may be as simple as “the then-current fair market rental for leases of comparable space in the market where the premises are located.” But, depending on who ultimately determines the rent in question, both parties should be careful to denote which particular aspects of the occupancy are eligible, if not mandatory, elements of that calculation. The goal is to give the parties a tool for identifying a set of comparable transactions upon which to base the rental when the lease calls for the fair market rent.

The three basic considerations in identifying such “market” transactions are the tenant, the space and the lease in question. First, the business, size and credit of the tenant should be considered. A multi-billion dollar multinational office tenant is not in a comparable market with a family-owned nail salon in a strip center. The location, quality and features of the property are important, as well as the size of the leased premises in question and the location of those premises within the building or shopping center. Class A office buildings in a central business district may command markedly different users and demands from Class C suburban properties. Ideally, the parties will incorporate into the analysis comparable leases of comparable space within the building in question; however, such leases might not always be available for consideration. Finally, the terms of the lease itself must be considered, including the term, options and concessions. Market conditions drive these features, including rent abatement and tenant improvement allowances, and the parties must limit their consideration to leases containing similar economic terms.

Negotiation

In any negotiation of a fair market rent provision, a tenant will be inclined to emphasize the value of all tenant concessions, as they will likely have the ultimate effect of reducing the market rent. In addition, in the context of an extension, a tenant will frequently demand that improvements to the premises constructed for the tenant wholly or partially at the tenant's expense should be excluded from any fair market rent calculation. This demand is supported by the notion that if the improvements become the property of the landlord at the expiration of the term, the tenant should not have to pay twice for them and the landlord should not be entitled to a windfall in the extension term.

An agreement by the parties of the criteria behind a fair market rent calculation will only resolve a fraction of the issues inherent in the process of that calculation. General references to aspects of the tenant credit and economic terms of the lease still call for a subjective analysis, and covenants of good faith and commercial reasonableness and diligence are far from cure-alls. But if the landlord and the tenant cannot agree on the fair market rent, who will be charged with resolving the dispute?

Upon the receipt of notice of a tenant's exercise of a renewal or expansion option calling for fair market rent, a landlord will often have a period of time to calculate and deliver notice to the tenant of that rental. Following receipt of the landlord's determination, the tenant will have a period of time either to accept the landlord's stated rental or reject it. If the tenant rejects the landlord's determination, it usually will have the choice either to rescind the exercise of the renewal or expansion option or enter into further negotiation with the landlord as to the fair market rent. If the tenant makes the latter election, the parties will customarily have a fixed period in which to enter into good-faith negotiation of the fair market rent.

If, upon the expiration of all applicable negotiation periods, the landlord and the tenant are unable to agree on the fair market rent, the lease will often call for an arbitration process, the first step in which the parties are to designate (jointly or severally) one or more third-party professionals to choose which party's determination is correct, or to make an independent determination of fair market rent, using the criteria stated in the lease. Following the presentation of the third-party results, the mechanisms by which the parties arrive at an agreed rental have numerous iterations. For example, the lease may require the parties to agree to an average of the competing third-party calculations, or it may require “baseball arbitration,” whereby the two appointed professionals jointly designate a third professional, who must choose between the calculations already provided.

Licensed Brokers or Qualified Appraisers

An increasingly common issue in this area is whether the parties should be required to designate licensed brokers or qualified appraisers. While there is much variance as to the interests of the parties from one market to another, the designation of the arbitrator is critical in the process. Advocates of brokers in this role argue that a broker is active in all aspects of a lease transaction and may have greater experience negotiating leases and increased familiarity with prevailing market rates. Those who prefer appraisers point to the reliability of the more scientific approach in appraisal work.

Whichever professional is called for, the parties should be clear that any designated professionals be licensed in their respective profession and have significant experience working in the submarket and type of space in question.

Other Considerations

Competing assertions of fair market rent are not always dramatically different. Therefore, an efficient approach to resolving a less substantial dispute is for the parties to agree to an automatic and binding resolution. If, initially or following any step in an arbitration process, the determinations presented by the parties themselves or by the designated professionals are very close (for example, less than 10% apart), the lease may provide that the parties are deemed to agree to an average of the two figures.

One other important provision in this area, particularly where a third-party arbitrator has been retained, is an express prohibition against the arbitrator “splitting the difference,” or deciding that neither of the two prior determinations is correct and thereby arriving at an average of the two numbers. This ensures that the third professional will take an active approach to resolving the dispute and that the parties will receive value for the fees paid and time spent.

Finally, if the tenant has substantial bargaining power, it may want to include an option to reject even the post-arbitration calculation of fair market rent and rescind its exercise of the renewal or expansion option. The landlord will resist this of course, but if it agrees to the concept the tenant should be required to reimburse the landlord for its arbitration expenses.

Conclusion

While in its essence a straightforward concept, fair market rent is rife with legal and economic hazards, and parties to a lease are wise to take caution in arriving at an agreed method of calculation.

David P. Resnick, a member of this newsletter's Board of Editors, is an attorney with the Chicago office of Edwards Wildman Palmer LLP. He can be reached at [email protected], or 312-201-2844.