By Scott Lippert, partner, Pashman Stein
In the commercial lease context, it can be difficult to reach an agreement concerning the methodology for arriving at the amount of base rent for any extensions of the term.
There are several different approaches: there can be a stated, fixed amount; an amount derived by formula (e.g. CPI increases); or an amount derived by an appraisal process, frequently referred to as “fair rental value”. Each method has its own virtues and vices.
Fixed, stated amounts provide certainty but are merely an educated guess and grow less likely to reflect actual market rent the further the extended term gets from lease execution. CPI increases are a hedge against inflation, but nothing more, and rents in the relevant market may have fluctuated wildly in the period between lease execution and the expiration of the initial term.
Re-establishing base rent by appraisal conducted as contemporaneously as possible with the commencement of the extended term would seem to be the fairest and most sensible approach to the problem.
Appraisals, of course, are only as good as the data and methodologies utilized, and the skill of the people who produce them. Consequently, a number of different approaches to the appraisal process have evolved.
Frequently, the language in the lease will require either that the landlord propose the new base rent during the extended term, or that the landlord obtain an appraisal report from a qualified appraiser, stating the proposed rent. The tenant would then be given the opportunity to dispute the landlord’s position with the tenant’s own appraisal. The point of contention then becomes how to resolve the difference, if any, between the respective positions of landlord and tenant.
Some clauses provide for an averaging of the two positions if they are within a certain range, perhaps within 5% or 10% of each other. If not within that range, or if the parties prefer not to provide for averaging, generally a third appraisal is then required, which will be binding upon the parties. The third appraiser may or may not be aware of the other appraisals.
To maintain some degree of control over the outcome, landlords will frequently require that the base rent during the extended term shall in no event be less than the base rent during the last year of the initial term. After all, an option to extend the term primarily benefits the tenant, not the landlord.
Conversely, tenants may seek to protect themselves with respect to the determination of fair rental value by asking for the right to withdraw the exercise of the option in the event of an adverse outcome. Landlords are understandably reluctant to go along with this concept, having spent time and money to get to a determination only to have the tenant unwind the whole process.
There is another approach, referred to as “baseball arbitration,” so-called because it was used originally in the arbitration of salary disputes between major league baseball players and ownership.
Baseball arbitration requires each party to submit its number to a neutral, and the neutral’s charge is to pick one number or the other. The neutral either comes up with her own figure, without knowing the figures of the parties, and the figure closer to the neutral’s figure will prevail (“night baseball arbitration”) or the neutral is made aware of each party’s figure and picks one or the other. There is no averaging, nothing in between.
The theory is that, out of fear that the other side’s number will be chosen, the parties will each submit a reasonable number, within the midrange of possible outcomes. There’s no point in submitting an outlier, since it is not likely to prevail, or at least so the thinking goes.
As in every contract negotiation, the parties are seeking to limit and allocate risk. Thus, it comes as a surprise that some landlords and tenants opt for baseball arbitration to resolve an impasse with respect to the determination of fair rental value.
It seems unlikely that implementation of any variation of the three appraisal process will lead to a result that is not within the range of reasonable outcomes. In contrast, with baseball arbitration, one of the parties could really get hurt.
Consider a scenario where the parties are spectacularly far apart in their pre-arbitration negotiations. Once they proceed to baseball arbitration, they may well be so invested and entrenched in their positions that they submit wildly divergent numbers to the arbitrator. If that happens, there will be one very unhappy landlord or tenant, which would not bode well for their relationship over the course of the extended term.
Baseball arbitration can be fun and exciting. Lease negotiations are generally not perceived as such, and for good reason. Minimizing risk for both landlord and tenant should be the order of the day.
