Lease Option Terms Are Worth Paying Attention To In Letters Of Intent

An experienced commercial real estate broker once asked me, “Is there really much to negotiate in these lease agreements other than the operating costs?” Of course, the answer is “yes,” but his point was not lost on me. To wit: “You lawyers should not screw up our deal with a bunch of wordsmithing and should focus on the items that have an actual monetary impact to the client.”

Our firm frequently negotiates leases for both landlords and tenants in various contexts and industries, and lately I have seen a few interesting trends in one of the most often overlooked provisions of a lease and the letter of intent—the renewal options, and specifically the methods for determining fair market rent for renewal terms.

Landlords have become more sophisticated in attempting to set the market in advance, so as to minimize negotiations and down-side risk when a renewal term strikes. Probably the best way for landlords to do this is to narrow the market of “comparable” properties. Some downtown Seattle landlords with low vacancy specifically define the Class A buildings that are a “comparable” property in the Central Business District (“CBD”). Obviously, the market has evolved over the last several years thanks to Amazon—there are now Class A buildings at the north end of the CBD; conversely, some buildings at the south end of the CBD are no longer considered Class A.

We have also seen this in retail or restaurant leases in certain Seattle neighborhoods—trying to define certain “hot” neighborhoods as the universe of comps, e.g., Ballard, Pike/Pine, or South Lake Union.

I even recently saw one industrial lease in Kent where the landlord confined the comparable market to his other buildings!

More alarming for tenants are limitations based on the term or nature of the lease. For example, landlords might limit the renewal comps to other recent renewals. This is usually a very narrow category, which likely does not reflect the market. When the renewal term rolls around in three to five years, the tenant will likely have choices of at least a few other properties on the market, and it is not a stretch to say that other new leases should be considered as comparables, i.e., what has happened recently in the market.

Landlords are also wise to limit the types of concessions that can be considered for purposes of analyzing market comps for renewal purposes. For example, exclude moving costs on the theory that the moving costs would not be a consideration if tenant renewed in the current space. This is probably a reasonable position.

Some landlords are increasingly refusing to consider free rent or tenant improvement allowance concessions in evaluating comparables, and are sticking only to the “face rent” as the only comparable factor. These factors, which yield the “net value” of the “total lease package,” are usually part of the market analysis when the tenant is considering whether to renew or move, and it does not seem appropriate to exclude them.

I rarely see increases based on the Consumer Price Index (“CPI”) anymore, given the sluggish economic growth. Now the parties are more content to simply go with a market analysis, with an arbitration provision to employ experienced appraisers or brokers to decide the fair market rent if the parties cannot agree. A fair compromise I often see with two option periods is to have 2-3% annual increases during the first 5-year option period, and to go with market rent during the second period. Again, this is where itemizing all of the factors to be considered in calculating the “fair market rent” becomes important.

Does this really matter to tenants? Not much in a tenant’s market, where there is significant vacancy and tenants have multiple other options in the market. A tenant can simply decline their option and then negotiate new terms with the landlord. If the market stays tight, however, this definitely makes a difference to the tenant, and there is no down side to the landlord if they can define or further narrow the market years in advance.

The moral of the story? The letter of intent is more important than many think, even if it always contains that “non-binding” legalese in the last paragraph. This does not mean every letter of intent now must be 10-15 pages and essentially replace the lease. The letter of intent should still be 3-5 pages, depending on the issues presented but it is worth some time for both sides to haggle over what will represent a true comp in an option renewal period 5-10 years in the future.