By Nate Bernstein, Esq.
We are all aware that at the end of a lease term, a commercial tenant frequently wants to extend the term of their stay based on rights pursuant to a lease option. A tenant may have built a successful business at the location with a loyal customer base, and has developed “goodwill” that may be lost if the tenant has to move to a different location. Tenants guard lease options like a treasure chest. The question is whether the option terms will be enforceable.
A commercial landlord who agrees to an option to renew or extend the lease will generally require the tenant to pay a higher amount of rent during the extended lease term. This is consistent with factors such as inflation, and increased business costs of the landlord. The tenant wants to have no increase or a very nominal increase. The tenant may argue that since the leasing market has collapsed due to the poor local and national economy, that an increase is not warranted. The fact of the matter is that commercial landlords can protect themselves from leasing market downturns by specific language in the option agreement that will assure rent option increases based on a specific standards and methods of calculation.
The landlord and tenant may agree in advance on a fixed increased amount, or agree to an adjustment based on a stated formula or standard. It is important not to leave the term of the amount of the rental increase open for disagreement- if you do this can lead to costly litigation about the enforceability and interpretation of the option. The Court will be placed in the awkward position of being asked to set the rent amount, evaluate the subjective intent of the parties, and will have to rely on appraiser’s opinions in any event. In any such costly litigation, the prevailing party can recover attorney’s fees if there is an attorneys fees clause in the lease agreement. Thus, the non-prevailing party is at risk for a large money judgment if the case goes to trial.
Whenever an option to renew or extend requires payment of an increased rent during the renewed or extended period, the specific amount or the formula or standard by which the amount of rent is to be determined must be included in the lease documents. See Ablett v. Clauson (1954) 43 Cal. 2d 280, 284-286, 272 P. 2d 753; Etco Corp. v. Hauer (1984) 161 Cal. App. 3d 1154, 1161, 208 Cal. Rptr. 118. A lease provision authorizing the lease’s renewal to be determined in the future is enforceable only if, absent agreement of the parties concerning the amount of that rent, the lease sets forth an ascertainable standard for the determination of the rent. Etco Corp. v. Hauer (1984) 161 Cal. App. 3d 1154, 1161, 208 Cal. Rptr. 1181.
In the case of Etco Corp. v. Hauer, Etco Corporation (the landlord) appealed from a declaratory judgment holding enforceable a provision of a lease, granting the lessee an option to renew the lease for five years “at a rent to be determined by mutual agreement of the parties at the time of exercise of the option.” The Court discussed that there was a division and split of authority in the appellate courts across the country as to the enforceability of a provision for the renewal or extension of a lease at a rental to be fixed by future agreement of the parties. The appeals court in Etco evaluated that split of authority and reversed the trial court in favor of the landlord, and concluded that the lease provision, which contains no method or standards for determining the rent, is unenforceable. The Court articulated, “We believe that this rule recognizes the reality that fluctuating market conditions will often preclude the determination of an appropriate rent for a renewal period at the time an initial lease is made, yet prevents the courts from being required to engage in the drafting of contracts for parties in the absence of guidelines for an objective determination of such rent.” See Etco Corp. at page 1161.
Aside from the legal holdings in the case law, simply stated, with careful drafting, commercial landlords and tenants can set an option rate at a stated fixed amount based on a rent increase percentage- for example base rent plus 5 % per annum increase.
Commercial landlords and tenants sometimes sign leases that set option rental rates at “market rent” or “market value as agreed on by the parties” at the time that the option can begin. This type of lease language is fraught with uncertainty because the landlord and tenant generally don’t agree on what the market price is, the lease comparables may not match the use or square footage that exists at the subject property, there are no definite appraisal or market guidelines, and there are lease comparable rates at both ends of the spectrum. Parties must rely on real estate leasing brokers and appraisers for opinions. In certain situations, the appraisers are to determine the “full cash market value” of the property, defined as the price a willing buyer would pay to a willing seller for the leased premises for the uses specified in the lease, regardless of the highest and best potential use of the premises. If the lease is silent on the issue of what uses are to be considered by the appraisers in determining a value for the property, a court may rule that the parties intended the property to be valued at its highest and best use, which could be considerably higher than the value of the property as used by the tenant. See Wu v. Interstate Consolidated Industries (1991) 226 Cal. App. 3d 1511, 1514-1517, 277 Cal. Rptr. 546. In short, relying on disagreeing and biased leasing brokers and appraisers to set forth a market option rate, is not a practical or efficient way to set the rent amount for the option term. This approach only causes delays in the landlord receiving the correct amount of rent, and increases costs of doing business.
If the landlord and tenant cannot fix the rent amount for the option period with a percentage increase, probably one of the better methods of stating the option terms is to rely on an increase based on changes in the consumer price index. This will help the landlord keep pace with inflation, and will help assure that the rental income stream of the investment property is “inflation protected.” One method is to increase the rent based on proportionate increases in national or local consumer price indices.
Probably the most common standard used is the Consumer Price Index published by the Bureau of Labor Statistics of the U.S. Department of Labor. If the parties agree to utilize the Consumer Price Index as the standard they must determine which index they will use. They may use the Consumer Price Index for Urban Wage Earners and Clerical Workers (also known as “CPI-W”) or the Consumer Price Index for All Urban Consumers (also known as “CPI-U.”) The parties must also decide whether to use the national index or the local index. The Department of Labor publishes local indexes for the main city areas. Although a local index may be more accurate, it may be necessary to provide an alternative index in case the index is modified, is discontinued, or makes for too drastic an increase. For a helpful website on local and national consumer price index standards please visit http://www.bls.gov/cpi.
Finally, the option language should set forth the base rent figure used to calculate the increase, and how often the rent will be adjusted throughout the term of the option. To protect the landlord from the minimum rent falling below a designated level through a CPI adjustment provided for in the lease, the lease generally should include a provision stating that the minimum rent, notwithstanding any adjustment, may not fall below either the minimum rent threshold during the last month period before the option starts.
In summary, it is worth the time and effort to negotiate and draft specific language that either fixes the amount of the increase, or provides a specific ascertainable standard for the option term rental increase. If the landlord wants the tenant to pay all or a portion of monthly expenses, the amount of the increase for expense can also be drafted specifically into the lease option agreement. If a commercial landlord does not draft the option language carefully, then the landlord may be at risk for being dragged into a lawsuit about the enforcement of carelessly drafted lease option clause.
The article is not intended as formal legal advice, and is only a general discussion of the selected topic. Each situation is fact specific, and the law may apply differently to each fact situation. No actual or implied attorney client relationship is intended between the reader and author.
THE AUTHOR, Nate Bernstein, ESQ.,, is the principal of Nate Bernstein & Associates, a law firm located in Encino, California which specializes in the areas of COMPLEX real estate litigation, commercial litigation, and bankruptcy matters. Mr. Bernstein can be reached at (818) 995-9475 and THE E-MAIL ADDRESS OF firstname.lastname@example.org.
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