Fair market rent

A Big Problem with Lease Renewal Options: Pegging “Fair Market Rent”

By Kenneth J. Abner

Every experienced commercial tenant prefers to have lease renewal options in a lease so that they don’t have to face this dilemma: Do I accept the above-market renewal rates the landlord is trying to impose upon me now that I am trying to renew the lease or do I move to a new space and incur all the cost and disruption to my business? Landlords usually don’t mind accommodating the tenant because it’s better than looking for a new tenant every five years. But who wants to lease property at rates that don’t reflect the market? As a result, landlords and tenants often enter into leases that give the tenant an option to renew, with the rent adjusted to whatever is “fair market rent” on the date the lease is renewed. Fair enough, or so it seems. Yet, in the real world, pegging “fair market rent” is much more difficult than it first appears. Too bad landlords and tenants don’t give this issue the attention it deserves.

No one has a crystal ball and can safely predict what rates will be 5, 10 or 15 years from now. The economy changes. Local markets change. This can make renewal options tricky. Because the exercise of the option is in the tenant’s discretion, landlords are especially uncomfortable agreeing to a rental rate years in advance that may prove to be far below market.

Because of this market uncertainty, landlords and tenants will often agree to renewal options at “fair market rent.” Often, these clauses have no explanation of how “fair market rent” will be determined. By using the “fair market rent renewal standard”, both parties think they have agreed to a rent that will be basically fair but “fair” is probably the most elusive concept in the law.

'Fair' is probably the most elusive concept in the law.

Thus, the words “fair market rent” may not be helpful years down the road when the two parties cannot agree on the standards for determining fair market rent. In fact, some courts have held that the language “fair market rent” alone does not provide an ascertainable standard and the whole renewal clause may be voided. The parties need to provide criteria to the fair market rent renewal standard. Tenants may want to base fair market rent on the present use of the premises (sometimes called “use-in-place criteria”). Landlords, however, often want to base fair market rent on the highest and best use of the premises (sometimes called “highest and best use criteria”). Comparisons to surrounding premises may also be acceptable criteria (sometimes called “comparability criteria”). Whatever standard is chosen, the parties need to agree to a more defined concept of “fair market rent” that is satisfactory to both parties.

One related note. From time to time we run across leases that may handle the determination of fair market rent in a sensible fashion but fail from a procedural perspective. In particular, tenants should be wary of provisions that require them to exercise their option to renew before fair market rent is determined. Tenants need to ensure that they have an escape clause so that they can revoke their exercise of the renewal option in case they disagree with the rent determination.