Your Expansion Space Is Dark and Full of Terrors
We are in July and fast approaching the dog days of August. So, naturally, “winter is coming”.
Yes, yes, I am all in. Game of Thrones Season Seven has started up, the HBO television adaptation of the George R.R. Martin books, A Song of Ice and Fire.
Leasing Illustrated receives more reader input for any G.O.T. themed edition than all our other issues combined. It must be that all that deceit, gore and back stabbing (and, of course, dragons) makes commercial leasing participants feel right at home.
Apparently, since so many popular characters have been killed off during the series, it has become a fan favorite as a new season begins to try to predict who will come to an untimely end.
Not surprising, seeing that at the end of last season Queen Cersei of House Lannister killed off half the cast in one giant explosion (Cersei used to be a landlord’s leasing counsel).
One of the show’s heartthrobs, Jon Snow, was even killed and brought back to life.
But big deal, you know nothing, Jon Snow. In commercial leasing, we regularly come back from the dead.
And no, I am not just talking about when we revive after passing out while reading an incomprehensible run-on sentence that constitutes most lease provisions.
I am referring to one of the methods used in commercial leases to determine the fair market rent for an expansion option.
We have talked in the past of expansion options, which generally consist of rights of first offer (ROFOs) on other space that becomes available in the building and options on particular space in the building scheduled to come available at particular times.
Leases often provide that when the tenant exercises these rights, the rent for such expansion space will be the then “fair market rental”.
Frequently, this fair market rental will be determined by arbitration and, as we have said in the past, a properly drafted arbitration provision is seldom invoked because most landlords and tenants want to avoid an arbitration proceeding and have an incentive to negotiate an outcome that works for both parties.
But there is another method to determine fair market rent for expansion space that can be beneficial for a tenant.
In this scenario, the landlord makes an offer to the tenant with the material economic terms that the landlord believes reflects the fair market rent. If the tenant accepts, then the parties have a deal. If the tenant does not accept, then the landlord can go into the market, but must come back to the tenant (i.e., bring the deal back to life) if it offers a substantially better deal to a third party.
The advantage to a tenant with this structure is that it will know the rent and material economic terms before being obligated to accept or reject such offer (as opposed to arbitration where, in most instances, the tenant is required to irrevocably exercise its option for the space prior to the determination of the rent and other material economic terms).
So, draw your long sword and brace yourself for determining fair market rent in this manner by following these seven suggestions:
- Require a detailed landlord offer. Whenever the applicable ROFO or expansion space becomes available, your landlord should be required to provide you with an offer detailing the material economic and business terms of such offer so that you can make an informed decision (e.g., the space being offered, fixed rent, escalations, dollar amount landlord will provide as a tenant allowance or work landlord will itself perform, free rent, etc.).
- Allow yourself time to respond. Your landlord will need a quick turnaround time on a “time of the essence” basis (i.e., you must timely respond or the offer will lapse). But you still must provide enough time (e.g., 10, 15 or 20 business days) for your organization to make a reasoned response.
- Memorialize any accepted offer. If you accept your landlord’s offer, or if the fair market rent is otherwise determined by negotiation, memorialize the agreement in a lease amendment. Make sure your lease indicates that failure to agree on the terms of such amendment will not nullify your acceptance of the offer or be deemed a default under your lease.
- Require landlord to re-offer if terms change. If you do not accept your landlord’s offer, your landlord will want the ability to lease to a third party upon any terms and conditions that it can negotiate. Some leases say no more on the subject but this is not acceptable (your landlord could then offer you unreasonable terms and thereafter lease to a third party on market terms). If there is a change in the offered terms of any significance, your landlord should be obligated to re-offer the space to you before moving forward with a third-party.
- Define significant change. Generally, if the “net economic terms” vary by more than an agreed upon amount (e.g., 5%, 7.5%, 10%), this is a significant change that requires a re-offer to the tenant. Remember, the economic terms of a lease are fungible so you cannot accurately compare two offers solely by comparing the fixed rent. The other variables discussed above, such as the amount of free rent, tenant allowance, etc., all play into the net economic terms and must be calculated in order to make a true “apples to apples” comparison.
- Provide example of the calculation of net economic terms. In order to avoid later disagreements, some leases will clearly define the net economic terms and provide a specific example of its calculation, e.g., if your landlord offered expansion space for a term of 10 years, at a fixed rent of $100.00 per rentable square foot (rsf), with a work allowance of $50.00 per rsf, and 12 months free rent, then the net economic terms would be $85.00 per rsf (not factoring in the time value of money).
- Require landlord to re-offer over time. Even if the net economic terms have not substantially changed, if after you have rejected an offer your landlord has not consummated a lease within an agreed upon period (e.g., 6, 9 or 12 months), then your landlord should re-offer the space to you under your lease’s offering conditions. You should remain the primary party entitled to the space if your landlord does not consummate a deal in a reasonable period after your initial rejection; remember, your needs and the market may have changed during such time.
I cannot tell you who will bite the dust in this G.O.T. season, although my money is on the guy who cannot die (Jon Snow) and the lady with the dragons (Daenerys Targaryen). As I always say, better to have dragons than not have dragons. Follow the seven fire-breathing suggestions above and your expansion options will live a long and happy life.