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Devils in the Details—Defining “Fair Market Rent” in Commercial Lease Extension Option Provisions

In commercial leases, it is common for the tenant to be granted options to extend the term of the lease beyond the original term. At the time of lease execution, however, it is difficult or impossible to ascertain and negotiate the rental rate for the future extension term. While the rent for the initial term is negotiated within the known market conditions and going rental rates at the time of lease execution, the extension period usually will not commence until as many as five or ten years later, by which time market conditions, and going market rental rates, are likely to be significantly different. Accordingly, landlords and tenants will often agree to “punt” the issue for later determination, and provide in the lease that the fixed rent payable during the extension period will be the “fair market rent” in place at (or around) the time of the tenant’s exercise of the extension option.

...like many provisions in a commercial lease, the devil is in the details, and both landlords and tenants need to be attentive to these details to be sure that they do not get burned by hidden devils five years down the line when they are trying to establish the extension period rent.

For purposes of determining the “fair market rent” at that future time, the lease will typically include a provision setting forth standards and factors to be applied in the analysis and calculation of the extension term rent. But, like many provisions in a commercial lease, the devil is in the details, and both landlords and tenants need to be attentive to these details to be sure that they do not get burned by hidden devils five years down the line when they are trying to establish the extension period rent. The following is a brief discussion of a few common “devils” that each party would be well served to identify at the time of lease execution:

(i) Comparable Space. Typically, fair market rent will be based on the market rents then being charged for “comparable” space in comparable buildings in a defined market area. There is usually little dispute that the comparable space must (at least) be of equivalent size (in terms of the number of square feet) as the subject premises, but there are a host of other factors that play into whether the comparison space is actually “comparable.” For instance, the rents charged for comparably sized space can vary significantly based on variabilities in the fit and finish of the spaces, so if a landlord has (under the original lease) built out the tenant’s space with a host of special features and finishes, it will want to ensure that the fair market rent is not determined by reference to comparably sized space built out only to lower building standard finishes. Thus, the landlord should ensure that the definition of “fair market rent” refers to comparable space with “comparable fit and finish” to the subject premises.

Similarly, the location of the comparable space within the comparison building can affect the market rental value. If an office tenant’s space is on the second floor of a downtown office tower, the tenant certainly will not want its extension rent to be based on rents paid by otherwise comparably sized space on the penthouse level of the comparison office tower. Tenants should also ensure that the rents are comparable for “as is” space, since, four purposes of the extension term, the tenant usually takes its space its condition at the time of the extension. Thus, the tenant will not want its extension rent to be based on rents paid under leases the landlord is making (or giving the comparison tenants allowances for) substantial tenant improvements, as the costs of those improvements are usually built into the tenant’s rental structure (in terms of higher fixed rent) and amortized over the initial term of the comparison tenant’s lease.

(ii) Comparable Term. The fair market rent clause should also stipulate that fair market rent will be based on rents then being paid by tenants of comparable space with a comparable term. Fixed rental rates for longer term leases are ordinarily lower than fixed rents for shorter term leases, as landlords are often willing to exchange lower rent for a longer lease commitment by the tenant, which creates occupancy stability and rental income predictability for the landlord. Accordingly, in determining fair market rent for a hypothetical five-year extension term, the tenant should be attentive to ensure that the extension rent will not be based on higher rents then being paid by comparison tenants under three-year leases.

(iii) Comparable Buildings. Fair market rent clauses typically provide that the comparison space not only be comparable in size (and, if well drafted, also comparable in fit and finish, and location within the building, etc.), but also within comparable buildings. Tenants should be attentive to the details as to what may constitute a comparable building. For instance, many landlord forms provide that fair market rent will be based on comparable space in “other first class” buildings; if the subject building is not a first-class building (or if the issue is arguable), then obviously the tenant will not want its rent to be based on higher rents then commanded in first class buildings.

Also, if the subject premises are office space within an office building, the tenant should ensure that the lease defines fair market rent with reference to comparable space within comparable “office” buildings in the relevant market area. Rents for retail space are typically significantly higher than rents commanded for office space; accordingly, office tenants will want to ensure that their extension rents cannot be determined by reference to retail rents being paid by tenants of otherwise comparable spaces within retail buildings.

(iv) Relevant Market Area. The market area from which the comparable rents may be drawn is also very significant to the determination of fair market rent, and should always be carefully considered, narrowly tailored, and specifically identified. For instance, a lease that provides that fair market rent will be determined by reference to rents charged for comparable space “in the South Shore” leaves a lot of ambiguity and potential for abuse (or conflict). Rents commanded for space in North Quincy are likely to be significantly different than rents for comparable space in Rockland, and will give license to the landlord to draw upon data from the higher rent towns on the South Shore to establish the extension rent for space in lower rent towns. Indeed, major cities like Boston have many different sub markets within the city’s jurisdictional boundaries; a tenant of space in Brighton, for instance, would certainly not want its extension rent determined by reference to rents being paid in the Back Bay or on the Downtown waterfront. Accordingly, it is important to carefully identify the relevant market area at the time of lease execution, and to be sure that the lease language limits the relevant market area to that specifically defined area.

In summary, it is easy to simply gloss over the seemingly boilerplate extension rent provisions of the landlord’s lease form and assume that the broad references to “comparable” rent will be sufficient, years later, when it comes time to determine the rent payable during the extension term. But, attention to some of the finer details of the “fair market rent” definition in the lease can help remove ambiguities (and potential abuses), create a more clear and objective set of standards to guide the parties in determining the extension rent, and help the parties avoid (or reduce the likelihood of) disputes years in the future when the extension option is exercised.

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Should you have any questions, please do not hesitate to contact Tom Bhisitkul at 781-817-4900 or email tbhisitkul@lawmtm.com.

Tom Bhisitkul