Renewal Options: Negotiating and Preparing a Letter of Intent (“LOI”)
A compelling and convincing argument can be made that the inclusion of a renewal option very well may be one of the only clauses contained within a commercial lease which is pro-tenant. With that said, when wearing a landlord advocate hat, unless the context of the market and the transaction dictate otherwise, please know that as a landlord broker and/or attorney, wherever possible it is incumbent upon you to create as many rules and restrictions relative to the exercise of the option. Conversely, as you will soon see, it is the role of a tenant advocate to be as detailed as possible during the LOI stage as to the myriad of renewal option exercise rights your client should be entitled to. Short of that, be forewarned.
That said, before getting to the down and dirty of a renewal option LOI provision, I would like to break out a few oldies but goodies that I have touched upon before in my prior leasing “Rants & Raves Jam Sessions,” namely that:
- landlords need to channel the title of a song by Jazz great George Benson if faced with the potential departure of a long term and timely-paying tenant, by adopting a mantra of “Never Give Up On A Good Thing”; and
- given the loss of revenue and costs associated with a tenant relocating to another building (such as roughly $1,200,000.00 incurred on a 10,000 square foot office deal renting at $60 psf with a six (6) month free rent concession, a $60 tenant improvement allowance and brokers on both sides of the table, landlords need to ponder my take on what I like to call (with props out to Crosby, Stills & Nash, Sting and Led Zeppelin aside) my “Love The One Your With-Whole Lotta Love-So Lonely Drive-In Movie Theory!”
Stated another way, subject to compliance by the tenant with a myriad of terms and conditions to be contained in the lease, in most cases it is nonsensical for a landlord to not show its tenant (and channel the Led Zeppelin classic) a “Whole Lotta Love” by agreeing to a renewal option while negotiating the LOI, as I consider having vacant space the equivalent of going to an old drive-in movie by yourself, in a cab, with the meter running, while paying for a babysitter for the kids at home … yes, it makes no sense, especially in light of the fact that (a) loss of revenue is a byproduct of a tenant relocating to another building and (b) when it comes to a tenant paying its rent to a landlord other than themselves, like the song by The Police goes, landlords “Can’t Stand Losing You.”
The Make it Personal-Friends With Benefits Conundrum Theory
Landlord Advocate Perspective: Employing the “I giveth and taketh away” mantra of the fist prong of the aforesaid theory, the LOI should limit the ability to exercise the renewal option right, so that it is personal to that of the tenant only.
Tenant Advocate Perspective: As to the “friends with benefits” prong of the conundrum, given that in the majority of leases – especially those of a retail nature – the existence of a renewal option makes the value of that lease significantly stronger, having the right to exercise the renewal option not only by the named tenant, but also by any parent, affiliate, subsidiary or permitted assignee of the named tenant is imperative. By way of example, if a retail tenant is looking to sell its business or, if the use and assignment and subletting clauses have not been well drafted by the landlord, if a tenant wants to monetize its below market lease as a way of securing a substantial amount of key money for it, the existence of the renewal option is a conduit to doing so.
Loss of Renewal Rights
Many leases subtly, yet effectively, strip a tenant of its renewal rights if it has “ever been in default during the lease term” or if it has “not been timely” in its payment of rent to landlord. Although the “default ask” by the landlord is both essential and fair, at the same time, the existence of the word “ever” and phrase “not been timely” is not, so when wearing the tenant advocate hat, make sure that (1) “not been timely” is stricken and (2) “ever” is either stricken from the LOI (or at least changed to “then in default”). As a word of caution to landlords, as tenants have less negotiating leverage during lease negotiations, I suggest holding off on including the “ever in default” and “not timely” concepts until the lease negotiation stage.
As to the word “default,” whenever a tenant advocate sees the word all by its lonesome, consider it to be the equivalent of having the displeasure of watching me run naked through Central Park. Consequently, to combat that impact, at a minimum, add the language “beyond the expiration of any applicable notice and cure period” after the word “default.”
Timing is Everything
From a landlord’s perspective during the LOI stage, more often than not it is best to remain silent and leave it to the lease negotiation stage as to when you drop the Rolling Stones “Time Is On My Side” bombshell that the landlord requires between 12 and 18 months’ prior written notice as to when the tenant must exercise the option. If the renewal term rental is tied into fair market value, given the time it takes to negotiate the renewal terms, for a tenant – although 9 to 12 months would be preferred – that might not be such a bad thing. But if you have a clause providing a pre-established rent for the option period, such as 105% greater than year 10 rental, it would be best to insert language during the LOI stage that the tenant has 6 to 9 months prior to lease expiration to exercise the right
Allow Me to Freshen Up
For leases where the rent will be pre-established for the renewal term, tenants should attempt to have the landlord provide a tenant improvement allowance at lease renewal of roughly $5 to $15 PSF to allow the tenant to paint, carpet or otherwise improve its then “tired space.” Also ask that 15% or so of it can be used for “soft costs,” such as an architect in the event a tenant might need to reconfigure its space before or during the renewal term.
It needs to be said that more often than not, as written, it is my belief that most renewal option provisions are not exercised by tenants who very well fought long and hard to secure them. Nonetheless, if the context of the deal allows for the inclusion of a renewal option, it is imperative that as a tenant advocate you create alternatives, opportunities and leverage for your client; securing the inclusion of a renewal option with a healthy dose of pro-tenant bells and whistles is certainly a prime example! As I have stated previously in another segment, in any world, leverage (along with knowledge) is power, and as the title of the Red Hot Chili Peppers’ song goes, leverage brings “The Power of Equality” to those possessing it!
The Upside Down-Spit Out the Bone-Dancing on the Ceiling Fixed vs. FMV Renewal Rent Conundrum
Tenant Advocates: In a tenant’s ideal, fantasy world, for the renewal term the rent will be fixed and not based on FMV. With props out to Diana Ross of Motown legends The Supremes, as to the first prong of my “Upside Down”–“Spit Out the Bone”–“Dancing on the Ceiling” Fixed vs. FMV Renewal Rent Conundrum, as a consequence of a landlord agreeing to a fixed rent for the renewal term, the tenant essentially only has “upside” and the landlord “downside” in that it has created a “ceiling”on its revenue upside if market rent at the expiration date of the initial lease term is higher than that which they agreed to in the LOI stage. I view the foregoing strategy as “all good” if you are a tenant, and as the title of the song by George Thorogood and the Destroyers goes, “Bad to the Bone” for a landlord. I feel this way not only for the reasons stated previously, but also as a consequence of the scenario when market rent is, a few months prior to the time the option is to be exercised, below that of the pre-establish fixed rent agreed to in the lease for the renewal term – because simply put any well represented or educated tenant will (or should) begin to negotiate a lower renewal rent for itself.
One last point here as to throwing the landlord a bone when it comes to a tenant advocate’s attempt to have a landlord accept a fixed rent for the renewal term. The second prong of the conundrum, inspired by Metallica’s song “Spit Out the Bone,” in relatively simple English equates to a tenant agent’s attempt to seduce the landlord into accepting a fixed rent renewal with bone in the form of a 105% to 107% or so add on factor to the last year’s rental amount.
Landlord Advocates: For those on the landlord side of the table, not only should you insist that the renewal term rental will be 100% of the fair market value but, in line with the “Dancing on the Ceiling” prong of the aforesaid theory inspired by Lionel Richie, landlord advocates need to break-dance their way over and above the ceiling without limits by creating a floor on such FMV by providing that the renewal rent shall be no lower than the net effective rental at lease expiration plus 3% to 5%.
Tenant Advocates: On the tenant side, not only do you want to take a surgical machete to the aforesaid floor and percentage bumps applied thereto, but furthermore, you want:
- the renewal term rental to be 90 to 95% of fair market value; and
- the fair market value to be based upon all “relevant market factors.”
For those who care to feast on a buffet of pro-tenant renewal option appetizers, I’ll conclude this segment with a hybrid example of what, on occasion, we have been successful in negotiating with a “market or advocate challenged” landlord:
“Tenant or Tenant’s parent, affiliate, subsidiary or permitted assignee or subtenant shall have the right to renew this Lease (“Renewal Option”) at its option for two (2) additional terms of five (5) years each (“First Renewal Term” and “Second Renewal Term”, respectively). Such Renewal Options shall be exercised by Tenant no later than nine (9) months prior to the term expiration date of the Lease. The Base Rent for the First Renewal Term (“First Renewal Rent”) shall be subject to a 5% rental escalation from Year 10, and the Base Rent for the Second Renewal Rent shall be at 95% of FMV. Years 12 through 15 and Years 17 through 20 shall be subject to annual 2.5% increases. FMV to be determined based upon all relevant market conditions. For the First Renewal Term, landlord in the form of a free fixed rent credit, shall provide tenant with a $15 psf tenant improvement allowance for paint, flooring and other decorative purposes. As to making its determination of the FMV of the Premises, the appraisers shall take into account “relevant market factors” by taking into account all then-relevant market conditions, including the then-current rentals and/or licenses of comparable space and similar properties in the local rental market as of the appraisal date, as well as other relevant market conditions (e.g., what a willing non-sublease tenant would pay and a willing landlord would accept on a non-sublease, non-renewal basis, for unencumbered space comparable to the Premises giving appropriate consideration to market concessions and to all economic terms, including length of lease term, size and location of premises, and whether tenant improvements or allowance are or are not being provided for such comparable space and whether or not brokerage commissions and free rent concessions are being paid and/or granted, respectively).”
In closing, I’m hopeful that the foregoing was able to enlighten yet educate advocates on all sides of the bargaining table when it comes to – as the song titles of both Pitbull and The Black Eyed Peas go, a landlord and tenant’s mantra of “Don’t Stop the Party” that is the potential extension of their lease term. Until the next segment of “Time for a Leasing Intervention?,” be well my friends, and may your Leasing REality be a fruitful one!