It is not uncommon for commercial real estate lease agreements to contain an option to extend the original lease term. Most of the time, the lease will include language that confirms that all terms and conditions of the lease remain the same during the extension term, except for the rent amount, which shall be adjusted to reflect the “Market Rent” based on a pre-determined formula described in the lease. Many leases provide that a landlord will submit a value for “Market Rent” to the tenant within some period of time prior to the expiration of the lease term, and the tenant has the right to either accept or reject the value. If the Tenant rejects the value, a well-drafted lease will describe the exact process the parties will use to determine Market Rent during the renewal term.
Traditionally, landlords and tenants resolved valuation disputes by using two or more “independent” appraisers or brokers to assess the market and make a determination regarding “Market Rent”. Other times, the parties might appoint an arbitrator to hear the facts and make a binding determination regarding Market Rent. The problem with both methodologies (and many others not discussed as part of this post) is there is little incentive for the parties to act reasonably in the process. The tenant appointed representative has an incentive to “low ball” the Market Rent and the landlord appointed representative has an incentive to “high ball” the Market Rent. This tendency can lead to disfavorable results.
In recent years, baseball arbitration has become an increasingly popular and effective alternative to traditional dispute resolution methods. Modeled after Major League Baseball arbitration rules for resolving salary disputes, the process is fairly simple to administer and extremely cost and time efficient. Here’s how it works: Each side picks a number. In this case, both the landlord and tenant pick the actual value of “Market Rent” that each believes to be fair, reasonable, and justifiable based on the circumstances and submit the values to an arbitrator for consideration. The arbitrator will review the relevant market factors (as should be designated in the lease), then pick one of the two submissions as the “Market Rent.” There is no middle ground or compromise—the arbitrator can only pick one result. The purpose is to force the parties to be reasonable. The potential downside of being too aggressive in the valuation process is that the arbitrator will pick the counterparty’s proposed value. This incentivizes both parties to pick a number as close to the actual “Market Rent” as possible and stay out of “left field,” which can have significant downside.
A few practice pointers to remember:
- Make sure the lease provision adequately describes how the arbitrator will be appointed and what qualifications the arbitrator must possess. For instance, the arbitrator must be experienced in commercial real estate matters, understand valuation/appraisal methods, and have a minimum number of years experience in the field. In the event the parties can’t agree on the arbitrator during some period of time, most leases will state that either the “local board of realtors” or the “American Arbitration Association” will appoint an arbitrator on behalf of the parties.
- Make sure the entire process, including all timelines, is spelled out in detail in the lease.
- The lease should provide what Market Rent will be charged during the pendency of the baseball arbitration process (if the lease term expires). Some leases will provide that the landlord’s submitted market rent will control until the arbitrator rules otherwise. If the arbitrator selects the tenant’s market rent, then the landlord will be required to refund any overpayment back to the tenant.
- The lease should expressly list the material factors that should be considered in determining Market Rent. For instance, the lease may say that vacancy rates, class of building, and use are the sole factors to be utilized in determining Market Rent.
- It’s a good idea to require all offers to be submitted simultaneously in writing and encourage negotiation up until the moment the arbitrator makes his or her determination. Another option to encourage reasonableness and compromise is requiring the “loser” to pay for all attorneys’ fees, appraisal fees, and arbitration fees, as opposed to splitting such costs.
Sample Baseball Arbitration Provisions:
- “Each party shall submit to the arbitrator and exchange with the other, in accordance with a procedure to be established by the arbitrator, its best offer. The arbitrator shall be limited to awarding only one or the other of the two positions submitted.”
- “The parties agree that they will exchange and provide to the arbitrator a copy of written proposals for the value of market rent. In rendering a decision, the arbitrator(s) shall be limited to selecting only one of the two proposals submitted by the parties.”