Many contracts and leases leave the parties to determine a future purchase price or rent between themselves as set by the then “Fair Market Value” (FMV). The crafty draftsperson will often try to sneak in language “as determined by seller (or landlord)”. But smart buyers and tenants won’t stand for that unilateral determination. A more concrete method of determining the FMV needs to be added to the document to set the future purchase price, option price or renewal rent. FMV is then usually determined by an appraisal. Sometimes the seller or landlord will obtain the initial appraisal, with the buyer/tenant having the right to challenge the initial appraisal by obtaining its own appraisal. If the 2 appraisals don’t agree, the appraisers choose a 3rd appraiser whose appraisal would then be binding. This process can be time consuming and costly. Other times, the buyer and seller or landlord and tenant agree in advance as to who the appraiser will be and jointly pay for the appraisal prior to the time the purchase price, option price or rent is to be set. The appraiser’s determination of FMV would be binding and the purchase price or rent is set based on such determination.

It is important to understand what you are getting when you add this appraisal language to a contract or lease. Otherwise, when the time comes, the appraisal you obtain might not fit your needs and the FMV could cause you to overpay, as tenant or buyer, or receive, as seller or landlord, less than FMV.

The Uniform Standards of Professional Appraisal Practice, as developed by the
Appraisal Standards Board of the Appraisal Foundation, has 3 approaches in determining a property’s value:

  1. Cost Approach: Under this approach, a property’s value is determined by adding the estimated value of the land to the current cost of construction of the replacement for the improvements on the land and subtracting depreciation (land value + construction cost – depreciation). The appraiser must obtain cost estimates from builders and contractors. Appraisers must do research as to depreciation. Land value is established separately.
  2. Sales Comparison Approach: this approach is useful when several similar properties have sold or are for sale in the subject market. The value of the subject property is determined by comparing comparable sale and a price range is given.
  3. Income Capitalization Approach: Value under this approach is reached as the present value of future benefits of property ownership. There are 2 methods, direct capitalization and yield capitalization. Direct capitalization is the relationship between 1 year’s income and the value of the property that equals a cap rate or income multiplier. Yield capitalization is the relationship between several years of stabilized income and a reversionary value at the end of a defined term.

 

Most appraisals determine value using at least 2 of the methods. Income producing property will almost always use an Income Capitalization Approach. Where 2 of the approaches conclude virtually the same value, it is safe to assume that the appraisal is fairly accurate. However, it is important to review the appraiser’s assumption. How old are the comps used? What is the supply of like properties currently for sale? What is the absorption rate? What are area cap rates? What is the condition of the subject property and what was the condition of the comps? What is the vacancy rate and what vacancy rates were used? There are many other assumptions to consider that could affect the appraiser’s conclusions as to FMV.

At contract/lease drafting time, sellers and landlords want as much flexibility as possible to raise the purchase price or rent in the future. At this point, FMV is a very loose term. Buyers and tenants want caps. Efforts to cap an increase are sometimes futile, especially following a lengthy initial lease term with small rent increases. That is why it is essential that the parties work to ensure that FMV actually be fair at the adjustment time.

Tenants don’t often spend a lot of time on the renewal option provisions of commercial leases during negotiations. Though these provisions are seem to be for the tenants’ benefit, many tenants are satisfied that the lease provides for the agreed upon option with out giving much thought as to what their choices will be at the end of the lease term.  I suppose this short term thinking comes from the fact that people generally don’t like change and to move your business is very unappealing and disruptive.  However, if a tenant is careful and able to get some favorable language in the renewal provisions, as the expiration of the initial term approaches, the tenant will have time to properly evaluate whether to extend the lease or to sign a lease for space at another property.

The first thing to watch for relating to the renewal option is the time to exercise the right. Landlords generally look for a short window to exercise, about a year prior to the end of the term.  The window itself should not be that important to tenant as long that tenant properly calendars the dates and begins to research options far enough in advance of the notice period to make an educated decision and complete negotiations with a new landlord or the current landlord.  However, tenants should strive to negotiate for the window to exercise the renewal option to be at least 6 months long.  The time to exercise the option is usually around a year prior to the end of the term and the window falls around the 1-year mark.

Rent during the renewal term is the next key point. Landlords don’t like to lock themselves in here. While rent during the initial term usually increases a fixed amount year to year or on fixed dates or intervals, landlords like to reset rent at the beginning of the renewal term.  Sometimes lease drafts have language saying that rent will be determined at the start of the renewal term.  Tenants should never agree to this clause.  That is a blank check for the landlord.  A more common clause is to reset rent a fair market value (FMV).  This could be a blank check as well if FMV is not carefully defined or capped.  There is no right answer as to the definition of FMV.  Sometimes appraisers or brokers’ professional opinions (BPO’s) are used.  Still, you need to define what geographical area, class of property, rent incentives and other factors can be included in the determination of FMV.  Many landlords put a floor on rent, i.e., rent at the beginning of the renewal term can not be lower than rent for the last year of the initial term.  Whenever a FMV provision is included, I try to place a cap on the reset.  Sometimes, I try to convince the landlord to move away from FMV and instead, change the first year renewal rent to the increase in CPI from the last year of the initial term.  You also need to look at rent for the remainder of the renewal term and make sure that the reset does not happen every year.  I have encountered this on more than 1 occasion.

CAM increases during renewals need to be addressed. The base year for CAM increases should be re-set to the 1st year of the renewal term.

Tenants should pay attention to the renewal option language in the lease prior to signing. Planning for the future should begin immediately.  A poorly drafted renewal option provision could limit a tenant’s choices years down the road.  Thinking ahead could give a tenant leverage.

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