LEASE AGREEMENT REFERENCE GUIDE 1420: REFINING THE FAIR MARKET RENTAL RENEWAL OPTION $24.95
Can the Adjustable Renewal Option Help Cure Tenant Sticker Shock?
If you can’t remember what the market for office space was incredibly glutted, consider this. BCE Development Properties held an auction on March 7, 1987 in Denver to unload 200,000 square feet of unwanted high quality office space located in seven different Denver metro buildings. BCE had assumed leases for the space in the course of leasing 1.2 million square feet in its Republic Plaza office complex. Some of the unwanted space was slated to go to the highest bidder, no matter how low the bid. For other blocks of space, BCE would decide at the auction whether or not to accept the highest bid. BCE announced it would be present at the auction, prepared to assign or sublease blocks of the unwanted space to successful bidders.
In most cases, the highest bid wasn’t very high. Bids for various chunks of space ranged from a lofty $5.20 per square foot to a low of 10¢ per square foot. That’s right, 10¢ per square foot.
People familiar with the market weren’t particularly surprised. Quality office space—especially in downtown Denver where several large tenants had just vacated large blocks of space—was cheap. At the time, free rent in Denver was an ubiquitous feature in new leases with credit tenants, and the same thing was going on in lots of other markets, too. Prospective office tenants with strong financials—including those who could afford to pay decent rent—were demanding and getting between two and three years of free rent on a lease with a ten year initial term.
Time to Renew
The only trouble for the tenants who signed those leases is they are coming up for renewal, and times have changed. Vacancy rates are dropping, and rents are on the rise in lots of markets around the country. Some tenants are in for serious sticker shock when they find out what the landlord wants for rent to renew their formerly cheap leases. A healthy percentage of those tenants will no doubt move to different buildings to cut their rent bills. Others will reduce the size of their premises as a way to afford the higher rent.
What does all this mean to the landlords of this world, who are anxious to retain good tenants, and who have a clear burning memory of recent double digit vacancy rates? Rising rents and falling vacancy rates raise the question of what form the lease renewal option should take in landlord leases for the next ten years or so.
Fair Market Rent and Flexibility
Two factors in the lease renewal option whose importance will likely increase are:
CPI v. FMR
The renewal option with rent increased by the Consumer Price Index used to be the industry standard in commercial leases, but such clauses have fallen out of favor these days. That may have something to do with the fact that current Class A office rents are probably increasing something like 10% per year nationally, and the CPI is increasing 2 or 3% per annum. For the last several years, the CPI has been pretty much hibernating, and landlords have abandoned the device as a rent setting instrument in droves.
FMR renewals are much more in evidence, even though they involve some haggling between the landlord and the tenant about what exactly the FMR should be for the premises. Lots of that haggling can be avoided by taking time to negotiate a well drafted definition of FMR when the lease is signed, and by specifying exactly which factors will be used to compute FMR for the renewal term.