When working on the disposition of an asset, one of the first questions that comes up is,
“what type of renewal options do the tenants have?”
There are many reasons this is important for a potential buyer, not limited to:
- ability to redevelop,
- near or long-term upside,
- preferable language or tenant right,
- down side risk mitigation.
Unfortunately for a buyer, there is not much that can be done to alter existing language at the point they are getting involved. Any negatives or shortfalls in the existing renewal language that may limit or reduce a buyer’s interest is felt by the existing owner.
Renewal options can often be a significant point of negotiation at the forefront of any lease discussion. However, throughout the lease negotiation process, they can often take a back seat and fall down the list of priorities as groups pick through the balance of the document. Deal fatigue or apathy can set in and leave a landlord simply wanting to move on with the deal, capitulating to the terms of the renewal option language. Others may simply be of the belief they will own the asset “forever”, and are therefore okay with it. Current market conditions, either good or bad, may also lead one to the decision that the terms of the renewal are sufficient. Regardless of the reason, a lot can change over time and given the first time that the renewal language / clause will be dusted off is 5, 10, or sometimes even 20 years in the future, things will have inevitably changed. A one-time “forever” holder may be in a position where they turn to sellers given a multitude of circumstances; for instance, previously downtrodden leasing markets may now be experiencing significant activity, or a single-storey retail building may be turning into a prime mid/high-rise development site. The list goes on, but the point is that things will be different over time, and thus the reason why renewal options are so important. What is seemingly a 5 or 10 year agreement, can actually turn into a 20 to 30 year commitment.
Keeping this in mind, here are a few key items we would recommend considering when negotiating the renewal option language within a lease:
- Renewal options are truly only beneficial to a tenant. Landlords often treat renewal options favourably, as it seems the tenant is perhaps making a longer commitment than the initial term. It might be the case that the tenant does stay throughout their original term and renewal option periods, however they will only do so if it’s in their best interest. Renewal options give tenants control, and they will only exercise them when it’s to their benefit.
- Tenants suggest that the proposed renewal language is “our standard language and it’s in every lease”. Hopefully you’re already working with a qualified real estate advisor, however if not, this would be a good time to connect with one. Yes, AAA national tenants often have preferred language, however “standard” and “every” is likely a stretch. Provided it might take some nuancing, difficult language such as ceilings on rental rates, renewal notice periods, and determination of renewal rate can be amended from the tenant proposed language, even for the biggest of tenants.
- With regards to the last item above, namely determination of renewal rates, on a recent lease negotiation a tenant proposed renewal language wherein the landlord, 12 months prior to the expiration of the then-current term, was required to deliver to the tenant their thoughts on lease rates for the renewal period. The landlord would be providing this information prior to the tenant’s renewal exercise period of no sooner than 9 months and no later than 6 months. This is a non-starter. Landlords should not discuss renewal rates until after the tenant has formally exercised its option.
- Rent for renewal options should be worded as “not less than the rent payable in the preceding year”. Some tenants may get hung up on this, however as previously mentioned, options are for their benefit. If market rent is arguably below the previous year’s rent, they should simply not exercise the option and negotiate with the landlord outside of the renewal option (i.e. after the renewal option has lapsed).
- Ensure any termination options in favour of the tenant do not carry-on through renewal periods. Termination options in favour of the tenant are never well received, however we find them particularly bothersome when they continue through renewal options. You’ve just gone through the process of determining that they want to stay on and commit to an additional period of time, however given the presence of a termination option, they can then simply “pull the plug” following negotiation and agreement on a renewal. We recently saw this on chartered bank in the Cloverdale area of Surrey wherein the tenant negotiated a renewal, and three months after going through a rather lengthy process, pulled chute and terminated. Another example of this is an AAA covenant restaurant on Vancouver Island, where a termination option was included within the original lease and had significant penalties that were reduced overtime. At the end of the initial term, the penalty was reduced to a rather nominal fee. However, as the termination option was not eliminated during any renewal periods (to which the tenant had an additional three (3) five (5) year options), the tenant had control of the property for the next 15 years, though the landlord had no certainty they would have a tenant. When the owner of the property eventually found themselves looking to sell, the presence of the termination option greatly reduced the potential buyer pool and demand for the property.
- Penalize bullies. Smaller landlords may find themselves between a rock and a hard place when dealing with larger corporate tenants, as these tenants can use their financial capacity and ability to spread risk / cost through their larger regional or national operations; the tenant might be in a better position to play chicken with respect to the threat of arbitration. Arbitration can be very expensive, and for an owner that has limited holdings or a smaller centre, it can be very difficult to make a business case for going through arbitration even when there is a significant discrepancy between what the tenant is proposing and what is arguably fair market rent. One way to keep everyone honest is to include a mechanism that if arbitration is triggered due to inability to agree on rent, the losing party pays the cost of arbitration. I’ve also seen this concept worded wherein if the rent lands outside of 10% or 15% of what the losing party was suggesting, then they shall be responsible for the other party’s reasonable cost of arbitration.
Above are very limited examples of different scenarios, as well as things to consider and hone in on when negotiating renewal option language. There are a number of other factors and conditions one will want to be aware of and attempt to address as part of lease negotiations.
If you’re in the midst of negotiating a lease, working on a lease renewal or simply want a sounding board, please do not hesitate to contact us.
Curtis Leonhardt* / firstname.lastname@example.org / 604 638 1999