Magazine article Journal of Property Management

Clearing the Hurdle of Lease Renewal Options

Magazine article Journal of Property Management

Clearing the Hurdle of Lease Renewal Options

Article excerpt

Lease negotiations, more often than not, lead to a request from the lessee for renewal options. And, just as often, such options are given freely, without much thought or negotiation, by even the most sophisticated owners and managers. Yet, lease renewal options (LROs), like other kinds of options, raise some significant hurdles for the lessor.

A Winner for Lessees

It is very easy to understand the position of a lessee in asking for renewal options. A LRO is never a bad idea for a lessee, regardless of the terms of that option. There is no mandatory requirement that a lessee exercise a renewal option in order to renew a lease. If market conditions are beneficial, the lessee will exercise the option; if conditions are unfavorable, the lessee may opt to try and renegotiate better terms with the landlord. In all cases, a LRO is a "free ride" for the lessee, especially when, as is often the case, that option is given free of any charge.

Issues for the Lessor

LROs raise some serious questions from the viewpoint of the lessor. Each basic option formula has its own particular set of problems, but a common problem shared by all formulas is that the terms and conditions of the option provisions are, most probably, absolutely and irrevocably binding on the lessor while being binding to the lessee only if exercised. The exception might be a case in which the option is no more than an agreement to agree without remedy if an agreement cannot be reached. In many jurisdictions, options based on an agreement to agree are not enforceable.

This situation, in effect, transfers some of the future control of the property to the lessee. The fact that the lessee can choose to exercise or to renegotiate, within the time limits and restrictions included in the option, sets up an uneven playing field.

Differences in Options

Renewal options at pre-agreed rents present a problem when the market rents at the time of exercise are substantially higher than the agreed option rent. In this case, the lessee has every inducement to exercise the renewal option. But, in the event the market rents are lower than the agreed rent, there is every reason to believe that the lessee will choose to renegotiate the lease. However, a perceived benefit of options at a specified dollar rent amount is that they do not lead to controversy or dispute at the time of exercise.

LROs based on the percentage increase in the CPI or similar index have a similar problem. There is no true correlation between changes in the GPI and changes in market rents. Market rents are driven much more by the forces of supply and demand in a particular market than national inflation. For example, between 1996 and the present, the surge of demand for many types of space has pushed rents in many markets up by double digits while the CPI has been increasing at a very slow rate. Accordingly, it may be concluded that the probability of a CPI or other index tracking real estate rental markets is minuscule.

CPI or index rent adjustments during a lease term are theoretically different from options in that they are perceived to maintain a purchasing power parity for the rent dollar and are based on a fixed formula in which the inputs are factually established.

The failure of specified dollar options or index adjustments to parallel the actual rental market favor some type of market-rate renewal option over other alternatives. In theory, this is an excellent idea. No owner or manager should expect to get more rent than an existing, renewing lessee would have to pay for comparable space available in the marketplace.

The major difficulty with market-rate renewal options lies in implementing the process and procedures for determining market rent. The real problem for lessors usually lies in the option language, which, more often than not, lacks specificity. On the one hand, there is the practical difficulty of developing option language specific enough to eliminate any controversy on how market rent will be determined. …

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