When negotiating a new lease, both landlords and tenants should consider whether the tenant will have the right to extend or renew the lease beyond its initial term. Although this right is typically conditioned on the tenant not being in default under the lease at the time it exercises the renewal option and at the commencement of the renewal term, it remains a significant right for the tenant because the tenant has the right to force the landlord to extend the lease terms in accordance with the renewal option. The following is a summary of the main components of renewal option provisions to keep in mind when negotiating your lease.
- Number of renewal options and length of renewal terms. The number of renewal terms and length of each term vary greatly from lease to lease. As a tenant, it is important to consider your future business needs and how one or more renewal options may serve your goals. From a landlord’s perspective, the renewal terms should be more than one or two years – three- and five-year renewal terms are common – so the landlord is secure in the rental stream from the lease for a longer period of time if the tenant exercises the renewal option since it is foregoing the opportunity to enter into a long-term lease with a third party. Of note, a Pennsylvania lease with a term of 30 years or more is subject to real estate transfer tax; in determining the length of the term, renewal terms where the lease terms are set in the lease and not subject to later determination count toward calculating the length of the term, even if the tenant ultimately does not exercise its renewal option(s). Determining base rent during a renewal term based on the fair market rent just prior to the renewal term (as discussed below) would be an example of a lease term that is subject to later determination.
- Notice required for exercise of renewal option(s). Your lease should clearly state how much notice the tenant must give the landlord that it is exercising its renewal option under the lease. This time period typically ranges from three to 12 months (longer is customary for very large leases) prior to the expiration of the then-current term. Once the tenant has failed to timely renew, the landlord knows that it can freely market the space for relet following the expiration of the term. Larger spaces typically take longer to lease, so landlords want more notice. Similarly, tenants who are relocating large spaces will generally know that they are relocating well in advance of their lease expiration.
- Rent during renewal term(s). Typically all of the existing terms of a lease apply during a renewal term with the exception of base rent and tenant improvements (discussed below). Base rent is usually increased in some manner during a renewal term. The most straightforward way to accomplish this is for the parties to agree on an exact dollar amount increase to be stated in the lease. If, however, the initial term of the lease is fairly lengthy or there is uncertainty in the market or the overall economy, the parties may prefer to use a somewhat objective standard to determine the increase in base rent closer to the beginning of the renewal term. One way to accomplish this is to increase base rent by the corresponding increase in the Consumer Price Index. While this is a fair method, it can be cumbersome to calculate and the parties must be sure to specifically designate which Consumer Price Index will be used. Another alternative is for the base rent during the renewal term to be the fair market rent at the time of the commencement of the renewal term (or sometimes 90 percent or 95 percent of such fair market value), which will be determined through an appraisal or arbitration process. In this method, some number of independent appraisers or real estate brokers are designated to determine the fair market rent and both landlord and tenant are bound by this determination. It is helpful for the lease to provide a short period of time (15-30 days) after the tenant delivers its notice exercising the renewal option, during which the landlord and tenant can negotiate to determine the fair market rent on their own. If they are not able to agree, then usually each party would designate an appraiser or real estate broker to render an opinion as to the fair market rent – note that the lease can provide certain qualifications for the appraisers or brokers, such as someone who maintains certain appraisal credentials or has at least ten years’ experience leasing space in similar buildings in the same geographic area. Once both appraisers deliver their fair market rent determinations, the lease may provide that the fair market rent is the average of the two or, if the difference between the two exceeds a certain amount, a third appraiser may be chosen. In this case, the third appraiser may choose one of the fair market rent determinations of the first two appraisers or the third appraiser may make his or her own determination and the fair market rent may then be the average of the two determinations that are closest to one another. There are many valid ways to arrive at a determination, but it is most important that the lease clearly states the method the parties have agreed upon.
- Tenant Improvements. During a renewal term, landlords generally do not provide new tenant improvements or tenant improvement allowances comparable to those provided for the original term. Occasionally landlords will agree on a renewal provision to provide a "refurbishment allowance" designed to provide some minor improvements for the renewal term such as painting or new carpeting.
Also, remember that a landlord and tenant always have the option to negotiate an extension of the term of a lease, regardless of the renewal option set forth in the lease. Indeed, this is often what happens but even in these situations, the renewal option terms in the lease provide a starting point for negotiations and thus, should be carefully considered.