Path of “Least Resistance”: To Exercise a Renewal Option or
Not?
[Conclusion: In our opinion, the entire process is a lose...
Path of “Least Resistance”: To Exercise a Renewal Option or Not?
By Dan Mihalovich, President, MIHALOVICH PARTNERS
March, ...
Path of “Least Resistance”: To Exercise a Renewal Option or Not?
By Dan Mihalovich, President, MIHALOVICH PARTNERS
March, ...
Path of “Least Resistance”: To Exercise a Renewal Option or Not?
By Dan Mihalovich, President, MIHALOVICH PARTNERS
March, ...
Path of “Least Resistance”: To Exercise a Renewal Option or Not?
By Dan Mihalovich, President, MIHALOVICH PARTNERS
March, ...
Path of “Least Resistance”: To Exercise a Renewal Option or Not?
By Dan Mihalovich, President, MIHALOVICH PARTNERS
March, ...
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Path Of Least Resistance To Renew An Option Or Not

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Path Of Least Resistance To Renew An Option Or Not

  1. 1. Path of “Least Resistance”: To Exercise a Renewal Option or Not? [Conclusion: In our opinion, the entire process is a loser. This type of gambling does not constitute astute fiduciary duty to one’s shareholders. Our clients enjoy their financial stature resulting from years of hard, smart work and planning. In an open market transaction, we can negotiate an outcome to a renewal transaction of far higher quality than through the typically contrived and manipulated “Fair Market Rent” renewal option provisions and arbitration process. Our clients have leverage and we know how to use it. Exercising renewal options simply leaves a lot of money---and time---on the table. And we hate leaving money on the table.] Face it. Landlords hate giving tenants options of any kind. Whether options to renew; to expand or contract; to terminate one’s lease; to assign one’s options to another tenant, etc. However, a tenant with some leverage will command enough respect to lock in some options---unilateral options. The question is whether or not a tenant is well served by exercising some of those options- --versus negotiating around the options in new, arms-length, open discussions with the landlord. Few tenants exercise these options. And for good reason. As tenant-representation specialists, we pride ourselves in creating as much flexibility for our clients as possible…taking careful note of our client’s needs at the formulative space programming stage of strategic planning. For discussion purposes, we’ll focus here on Renewal Options…the criteria which leads to exercising a renewal option; the viability of those options; and the practical reality of exercising a potentially irrevocable option. • At the inception of a lease, why do tenants bother negotiating renewal options? We expect longevity in our businesses, certainly beyond the initial “fixed” term of the lease. So, we want to encumber the Premises for some additional period or periods. The underlying assumption is that without an option to renew, the landlord will either lease your space to another party without any obligation to you whatsoever; or potentially option your space to another party….putting you into 2nd place (or worse) for a crack at leasing your own space! In either case, a lack of trust in the landlord drives the requirement for a renewal option---even though it would likely be in the landlord’s best interest to extend your coveted tenancy anyway! One simply can’t count on the landlord to do the “right thing”. But these renewal options are VERY complex, to the point that the tenant, landlord, brokers and real estate lawyers work arduously to craft “Fair Market Value” or “Fair Market Rent” terms in the final lease
  2. 2. Path of “Least Resistance”: To Exercise a Renewal Option or Not? By Dan Mihalovich, President, MIHALOVICH PARTNERS March, 2008 Page 2 document. In spite of all the efforts, are these renewal clauses ever perfect? Far from it. • During the negotiation of general business terms of the Letter of Intent, Tenant and Landlord strike an agreement for a renewal option---with myriad conditions and complexities. On the face of it, the notion that--- once exercised---the tenant’s renewal lease term will continue at “Fair Market Rent” for comparable space in comparable buildings. And, if the parties can’t amicably agree to the new rate within a reasonable period of time, a “baseball-style” arbitration ensues. This sounds easy enough, but let the buyer (that’s YOU, tenants!) beware: (a) Once you’ve exercised your renewal option, the normally advantageous leverage of open negotiations evaporates. The parties are relegated to interpreting imperfect language of the lease to determine what’s “fair”. (b) The artificial timeline described in the renewal option sets both parties to a schedule to reach an agreement, yet this timeline most often serves one side or the other with unfair advantage. Tenants must give written notice to exercise, frequently 12-15 months in advance of the renewal term commencement date. Unfortunately, this timing for a final and binding decision by a tenant usually coincides with the beginning of most tenant’s drive into the marketplace to determine the value of their tenancy to a small field of landlords. Most tenants are ill-prepared to make such an enormous commitment to a renewal so far in advance of the new term. And, not surprisingly, prospective outside landlords are rarely prepared to offer aggressive concessions to all but the largest tenants so far in advance. If a tenant must exercise a renewal option 12-15 months in advance, then to consider relocation alternatives instead, a tenant would likely have to receive binding commitments from an outside landlord 16-18 months ahead. Unlikely to occur. (c) Many other challenges dilute the effectiveness of the renewal option. Once the tenant submits its notice to renew, the renewal clause will have offered the landlord a period during which they will formulate their “reasonable” opinion of “fair” rent. After all, it’s so far in advance of the new term, the landlord needs some time to contrive the most hideous of lease comparables---those recently completed transactions---which in the landlord’s view are fitting with the definition of “fair” in the lease. We cannot describe in this writing, without volumes, how manipulative the “comps” data
  3. 3. Path of “Least Resistance”: To Exercise a Renewal Option or Not? By Dan Mihalovich, President, MIHALOVICH PARTNERS March, 2008 Page 3 becomes. Remember that lease transactions are NOT recorded, publicly. Lease transaction data is often shared between landlords, landlord-brokers and tenant-brokers---but nevertheless the data is founded on heresay and is often reported incorrectly. Does the landlord have an obligation to share its data and substantiate its claim of “fair” rent? Most frequently, not. The standards of the lease, however, are founded on the spirit of good faith and fair dealing. Is the door open for the parties to “cook” the “Fair Market Rent” clause? Absolutely. Isn’t there great risk to the tenant, to our clients, subjecting oneself to such a process? Absolutely. (d) At the time both Tenant and Landlord strike the initial lease deal, in all likelihood market conditions will be quite different than when the renewal option is exercised. Yet the “standard” for renewal options bases “Fair Market Rent” on an “as-is” renewal for the period. No tenant improvement allowance is offered; nor downtime for construction; no allowances for architectural fees or moving expenses related to any phased renovations of your space; oftentimes brokerage fees are excluded. But the lease language may suggest that “fair” rent will take into account some or all of these concessions, if granted in the comparable transactions in comparable buildings. By this juncture, however, the leverage that a tenant would otherwise maintain to negotiate such allowances for a renovation---or lack of renovation---is severely diminished. Your ability to secure offsets from your current landlords becomes a function of concessions given to other tenants…in deals negotiated by other brokers. (e) We must underscore the likely pitfalls of subjecting one’s financial future to outside “comps” at all. Not only are there authorship issues, insofar as we are likely to negotiate better terms for our clients than other tenant-representation brokers; but the notion that a tenant MUST rely on deals already completed signals a locked-in loss for tenants in a falling market. Why would a tenant voluntarily subject itself to setting a “fair” rent for the renewal 12-15 months hence (in a declining market) based on deals gone by?! Conversely, in a rising market, tenants should expect landlords to manipulate the comps to reflect only the most recent and most expensive comps…if there even exists an obligation for the parties to provide comps. Most renewal clauses are drafted in a manner which only obligates the landlord to propose “Fair Market Rent” in their reasonable discretion. In a rising market, if a single tenant in a single comparable building pays an
  4. 4. Path of “Least Resistance”: To Exercise a Renewal Option or Not? By Dan Mihalovich, President, MIHALOVICH PARTNERS March, 2008 Page 4 agregious amount of rent….you can expect to hear from your landlord that that is the “fair” amount. Is the process contrived? Yes! (f) For those of you, tenants, who were attracted to your current space because once upon a time your landlord was under pressure to rid itself of an extended vacancy; and/or due to an unusual configuration of the space, perhaps ineffieciency…….beware that the landlord’s view of the same space will change markedly during the determination of “Fair Market Rent” in a renewal! Once the tenant has locked into its renewal term by exercising its irrevocable option, the games have begun. All the reasons the space sat idly on the market for months or years before you signed on are forgotten. The concessions the landlord made to you at the outset of your lease, because no one else seriously considered that space….all forgotten. With 20/20 hindsight, one of the most masterful concessions to have secured in your renewal language would have been the tenant’s right to rescind its exercise of the renewal option---if and only if the landlord’s estimate of “Fair Market Rent” is unacceptable to you. Of course few landlords care to offer this option to rescind, since…in the landlord’s view…the tenant’s unilateral right to renew is deemed to be more than sufficient consideration given. (g) In the “devious” category: “Fair Market Rent” means fair market rent for whom? Is the issue, “What will the market bear for this space, given its as-is condition for the specified length of years, considering comparable space in comparable buildings?” In other words, is the issue, “What will any ready, willing and able tenant be willing to pay….?” Or is the issue, “What should THIS tenant pay for its specific use in this made-to-order space for THIS tenant?” The notion of “market” and fair determination of value must be determined by considering what a reasonable field of tenants would be willing to pay for such space. (h) How does one determine the value of an albatross? If a space is so unusual that its salvage value upon re-leasing to the open market is ZERO (ie. the space will necessarily have to be demolished and rebuilt in order to re-lease the space), then the utility of the space, or lack thereof, must be considered as “Fair Market Rent” is determined. But in the contrived world of renewal- option clauses, landlords may surprise and disappoint you with distorted interpretations of basic English. Generally speaking, if the
  5. 5. Path of “Least Resistance”: To Exercise a Renewal Option or Not? By Dan Mihalovich, President, MIHALOVICH PARTNERS March, 2008 Page 5 space looks and smells like a pig (you leased the space because it was a “steal”), it will be slaughtered once you vacate to another location. On the renewal, however, expect the landlord to perfume that pig. It’s in their interest to do so and you’ve just locked yourself into the renewal. Again, buyer beware. (i) The games continue, ad nauseam. Tenant exerices the renewal option. Landlord floats their initial “reasonable” rental rate. Shock sets in. Why? Because the landlord refused to entertain any discussion about forecasted rent prior to the tenant exercising its option. After all, the tenant controls the renewal term, not the landlord. The landlord offered to discuss renewal terms, but only after the expiration date for the tenant to exercise its renewal option. The landlord’s shocking salvo appears just at the time the parties are to enjoy one another’s company in a 30-day (or so) period of “negotiations”. If the parties can’t agree to terms, or simply don’t want to, this period will lapse without progress. Typically, what ensues is another debate----this time between representative- brokers or appraisers of Tenant and Landlord. Surely they will resolve the mess, or else! Or else what? Or else both parties risk turning over complete control to a 3rd broker or appraiser, whose qualifications are known but oftentimes little more as to how that person will actually resolve the dispute between the parties. Again, one must rely on the negotiated and imperfect language of the lease to spell out the role and process for the 3rd broker/appraiser. Even if the process were perfect, tenants, how can this contrived process result in a conservative and controlled determination of your company’s financial future? (j) The reliance upon “baseball arbitration” gives comfort to many a tenant and landlord. In the end, however, the parties resort to gambling---albeit “educated” gambling. In spite of any and all previous discussions, negotiations, offers or otherwise, each party resorts to putting a number into a sealed envelope and submits it to the 3rd broker/appraiser. Everyone second guesses the other, including second-guessing the 3rd broker/appraiser. Either the landlord or tenant loses; or both can lose, actually. In our opinion, the entire process is a loser. This type of gambling does not constitute astute fiduciary duty to one’s shareholders. Our clients enjoy their financial stature resulting from years of hard, smart work and planning. In an open market transaction, we can negotiate an outcome to a renewal transaction of far higher quality than through the typically contrived and manipulated “Fair Market Rent” renewal option
  6. 6. Path of “Least Resistance”: To Exercise a Renewal Option or Not? By Dan Mihalovich, President, MIHALOVICH PARTNERS March, 2008 Page 6 provisions and arbitration process. Our clients have leverage and we know how to use it. Exercising renewal options simply leaves a lot of money---and time---on the table. And we hate leaving money on the table. Dan Mihalovich President MIHALOVICH PARTNERS Tenant Leasing Services 655 Montgomery Street, Suite 810 San Francisco, CA 94111 T: 415-434-2820 C: 415-999-9244 F: 415-434-2830 E: dan@TheSpacePlace.net W: www.TheSpacePlace.net Mihalovich Partners, a San Francisco based tenant-representation firm, was formed in 1998 by Dan Mihalovich. Mr. Mihalovich brings to the firm 29 years of business experience, focusing on strategic and market analysis, negotiation skills and project management expertise. He has managed over 200 office-leasing assignments for many of San Francisco's most prestigious tenants, including The California Academy of Sciences; The Bar Association of San Francisco; and Wilson, Sonsini, Goodrich & Rosati. His career, and the focus of Mihalovich Partners, is solely driven to advocate the interests of San Francisco tenants in leasing negotiations of all types---renewals, relocations, renegotiations, and terminations. To avoid conflicts of interest, unlike most firms in the leasing brokerage business, Mihalovich Partners never represents landlords. Visit our website at www.TheSpacePlace.net to learn more.

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