• Leasing Matters - Options to Renew
  • April 2, 2013
  • Law Firm: Singleton Urquhart LLP - Vancouver Office
  • When a landlord and a tenant conclude negotiations to settle the terms of a commercial lease, they may agree that the tenant will be granted an option to renew the initial term of the lease for a further term. A renewal clause will usually include the following language: “The landlord will, at the expiration of the original term, grant to the tenant a lease of the property for a further term of (an agreed number) years.”

    The clause typically goes on to state that, if the parties cannot resolve the fair rental value of the leased premises for the renewal term, an arbitrator will determine it. While this is a common and seemingly adequate consensus, there are a number of issues that the parties should identify, agree on and incorporate into the renewal clause of the lease.

    From the tenant’s perspective, an option is desirable, particularly if the tenant is not obliged to pay for the option by agreeing to, for example, an increase in basic rent or other concession. From the landlord’s perspective, if the leased premises form part of a building, granting an option limits the landlord’s ability to redevelop or possibly re-lease the building, particularly if a prospective tenant requires space that includes the leased premises subject to the option.

    Factors That May Preempt the Tenant’s Right to Renew

    There are some situations that may prevent a tenant from exercising its renewal option. These include:

    • A landlord may insist that the option is personal to the original tenant and will cease to exist if the tenant assigns its interest in the lease.
    • The landlord can also insist that the tenant may only exercise the option if the tenant has not been in default of its obligations contained in the lease during the initial term.

    A tenant should resist the inclusion of the second restriction as it would be inequitable to lose its option as a result of a trivial or technical default. One compromise is to provide that the tenant may only exercise its option if it is not in default of its obligations under the lease at the time that it gives notice exercising its option. Alternatively the relevant clause may state that the tenant must be in default of a “material” obligation contained in the lease to lose its option—although this alternative may result in a dispute as to what is “material”.

    When to Give Notice to Renew

    A lease should state when a tenant is obliged to give notice of its intention to exercise its option to renew the lease. A landlord will usually want at least six months’ notice so that it has sufficient time to find a new tenant if the tenant decides not to renew the lease. Conversely, a tenant will want as short a notice period as possible.

    Terms and Conditions of Leases for the Renewal Terms

    Except for basic rent, the renewal term of the lease is usually stated to be on the same terms and conditions as the initial term. Often, however, in order to rent the leased premises, a landlord will grant a tenant certain inducements, including a rent-free period and a tenant improvement allowance. When this is the case, the lease should clearly state that these inducements do not apply to the renewal term.

    Similarly, some tenants may initially have negotiated favourable lease terms that landlords will not want to have carried forward and applied to renewal terms. One such example is a “cap” on the increase of operating expenses.

    Somewhat perversely, some tenants may take the position that an option to renew be carried forward and incorporated into each renewal term. To avoid any misunderstanding in this regard, a lease should state that the option to renew is limited to one or more agreed number of options.

    Setting Fair Rental Value

    Most landlords insist that the basic rent for a renewal term will not be less than the basic rent for the initial term. In fact, the landlord’s lender may insist that such a provision is included in the lease. If, however, the fair market rent for the leased premises has declined since the commencement of the lease, the tenant will likely try to negotiate a new lease to reflect this fact instead of exercising its option to renew.

    From a tenant’s perspective, it is not fair for a landlord, when setting basic rent for the renewal period, to take into account the value of improvements to the leased premises made and paid for by the tenant. On the other hand, a landlord that has paid for leasehold improvements to induce a tenant to sign the original lease may reasonably maintain that the value of the improvements should be considered when determining the basic rent for the renewal term. If a lease is silent on this issue, the fair market rent for the renewal term will take into account the improvements made to the leased premises, regardless of who paid for them.

    A landlord may take the position that the basic rent for the renewal term should reflect the highest and best use for the leased premises and not the permitted use. But, as previously noted, the option-to-renew clause usually provides that the renewal term will be on the same terms and conditions contained in the lease for the initial term. If this is the case, the rent should reflect the permitted use contained in the lease, even though this may not be the highest and best use for the leased premises.

    Arbitration

    When landlords and tenants cannot agree on the fair rental value for the renewal term, they usually resort to arbitration. Some leases provide that the landlord appoints one arbitrator and the tenant another with those arbitrators appointing a third. This not only dramatically increases the cost of arbitration but finding dates for three arbitrators to meet for the arbitration, together with representatives of the landlord and tenant, becomes problematic. Except in extraordinary circumstances, it is advisable to appoint a single arbitrator.

    The Arbitration Process

    The renewal clause in a lease should set out a timeline for the appointment of an arbitrator, the arbitration itself, and the arbitration decision. This will ensure that the basic rent for the renewal term will be determined before the initial term ends. However, even with the best of intentions, it is not unusual for arbitration awards to be made after the start of a renewal term. Assuming the possibility of such a delay, a renewal clause should provide for the tenant to continue paying the same basic rent as it paid in the last lease year of the original term of the lease. Any underpayment made by the tenant becomes due and payable together with interest at an agreed rate after a stipulated period, usually fifteen days after the date of the arbitration award.

    Arbitrations to settle the basic rent for the renewal term can usually be concluded in one day. In most cases, the landlord and the tenant each submit an expert’s report; the arbitration involves the landlord’s representative examining the tenant’s expert and vice versa. For this reason, each party should select an expert who can not only prepare a well-researched report but defend it before the arbitrator.

    Both parties should bear in mind that the arbitrator only has a mandate to resolve those issues that are identified in the lease. Given this, the landlord and the tenant need to identify and document all issues that are relevant so that the arbitrator can make an award that is consistent with their expectations.