By: Ben Hanuka, Law Works
Editor: Rebecca Colley, Law Works
In our practice, we often represent landlords and tenants in commercial lease renewal disputes. It is important for parties to a commercial lease agreement to understand, first, whether there is a valid lease renewal option that is legally enforceable and, if so, whether the tenant has properly exercised that renewal option. Second, the parties will need to retain a qualified expert appraiser or broker to provide a professional appraisal report to be used in negotiations or in the arbitration or court case.
Does the lease contain an enforceable renewal option?
The renewal option in many commercial leases is frequently legally unenforceable. The key legal requirement for a legally enforceable renewal option is to have an objectively ascertainable renewal rent.
Many renewal options do contain a valid mechanism. For example, it is acceptable for a renewal option to state that the renewal rent will be the prevailing market rent for comparable properties at the time of the renewal. Even if the parties are in dispute about what that prevailing market rent is, a judge or arbitrator can decide what the prevailing market rent is based on evidence from the parties, including expert unbiased evidence from appraisers or real estate brokers.
At the same time, many renewal options contain a legally unenforceable renewal mechanism – they fail to specify what the renewal rate will be on an objectively verifiable basis. For example, a common unenforceable renewal option that we see is legally called “an agreement to agree”, which is legally invalid. It basically states that the parties have an obligation to agree on the renewal rent at the time of renewal. For instance, the renewal option states that “the parties will negotiate and agree upon the renewal rate”.
This type of option fails to provide an objectively verifiable way to determine what the renewal rent should be. Legally, an obligation to come to an agreement is unenforceable. This type of a clause is thus legally unenforceable.
Delivering notice of renewal on time
It is important for the tenant to deliver a notice of renewal within the deadline set out in the renewal option, which can be between six and nine months before the expiry of the current lease term.
Tenants often fail to deliver a written renewal notice in time. Failure of the tenant to deliver a valid lease renewal notice within the deadline required in the lease agreement can result in the tenant having failed to exercise its renewal option and, thus, invalidating the renewal option.
Consequences of no valid renewal option
In instances where the lease contains a legally invalid renewal option, the lease renewal notice was not given on time or where there is no renewal option at all (all have the same effect – no valid renewal option), the tenant will be at a significant disadvantage if it wants to continue operating its business from that location.
In these instances, the landlord has significant negotiating leverage: it has no legal obligation to negotiate a renewal with the tenant. The landlord can impose any rate it sees fit on a new lease extension, even if the rent that the landlord is seeking is over the prevailing market rate.
The landlord can also lease the space to a new tenant without consulting with the current tenant.
If the landlord chooses to impose a hefty increase to the base rent as a condition of agreeing to an extension of the lease, the tenant will be at a significant disadvantage if it has major investment in the fixtures and leaseholds of the business. The cost of relocating and building a new operation from scratch is substantial and can thus put the tenant in significant negotiating disadvantage.
For the landlord, this can pose a windfall by taking over a location with significant fixtures and leasehold improvements.
Disputes over the fair market renewal rate
If the tenant has a valid renewal option in the lease and has exercised it by delivering a valid renewal notice, disputes frequently arise about the prevailing market rate of the premises.
One option is for both sides to jointly hire one appraiser to prepare a report and for the parties to be bound by the appraiser’s opinion. Sometimes that is the prescribed method in the lease of determining the lease renewal rate. Even if that is not the prescribed method, the parties may mutually agree to follow this method.
Other times, the lease will require that the dispute be resolved by binding arbitration or court application. Typically, each party will need to retain it own appraiser or qualifying broker to prepare a report, and if necessary, testify at the hearing of the case at the arbitration or in court.
Typical steps in the litigation
The first procedural step in the litigation is the commencement of the proceeding – notice of arbitration (where the lease agreement requires that lease renewal disputes be resolved by arbitration) or claim (where the lease does not contain an arbitration requirement).
In an arbitration, the lawyers for the parties will need to come to an agreement on the most effective procedure for the case and the steps before the hearing, which typically include the following steps:
- discovery of documents (exchange of all relevant documents by the two sides);
- exchange of expert appraisal reports by each party;
- exchange of a responding expert appraisal report to the other side’s report;
- preparations for the hearing and hearing.
Role of the expert appraisal report
Each party’s expert appraisal report will serve as a key tool to try to negotiate an amicable resolution to the lease renewal dispute. For an expert appraisal report to be legally admissible at the hearing of the case, and for it to be useful as a negotiating tool, it must be prepared professionally by a person with expertise in preparing appraisal reports and it must be unbiased.
The expert that a party hires should either be a qualified appraiser or otherwise have demonstrated significant experience in dealing with similar properties in the vicinity where the property is located.
The opinion of the appraiser or broker will generally focus on the following factors, subject of course to any other unique elements about the property:
- type of property (e.g., office, industrial, retail);
- size of the property;
- length of the lease renewal option;
- age of the property;
- location (e.g., area, highway access, traffic volume, competition in the area);
- unique features of the property (such as a drive-thru, parking spaces, access to the building) and whether the property is truly comparable to others in the vicinity or distinguishable from them, and if so, the value of the unique elements of the property.
Identifying genuinely comparable properties in a way that withstands challenge from the other side is not always easy. Questionable comparables can be challenged or discredited by the other side at the hearing by cross-examining the expert witness.
Further, appraisal reports cannot rely on listing prices on the MLS, but rather must rely on actual listing prices – actual rent that properties were ultimately rented for. That information is not always publicly available and so it may be of assistance to hire an appraiser or experienced broker with access to that kind of information in the area.
It is important to verify whether the tenant has a valid lease renewal option and, if so, whether the tenant has properly exercised the renewal option. Where there is no valid lease renewal option, the tenant will be at a significant disadvantage and the landlord will have significant power to impose new lease rates.
Where the tenant has a valid lease renewal option and has exercised it properly, parties may disagree on the renewal rent. If a legal process is required, arbitration or court, parties should carefully select a qualified and experienced appraiser or broker to provide a professional and unbiased expert appraisal report for use in the legal process and in negotiations.