Option to Extend May be a Mirage
Option to Extend May be a Mirage
By Bryan Mashian, Esq.
When negotiating a lease extension option, parties may be uncomfortable agreeing on a specific rent amount for the option period, especially in a lease with a long original term where the option term starts far in the future. The parties sometimes want to defer establishing the rent amount until the option term rolls around and avoid bearing the risk of interim fluctuations in market rent. But how the parties express this intent is very critical since merely stating that they agree to agree on the rent amount at a later date may be fatal. If the lease does not provide an ascertainable standard for determining the future rent, the option may be unenforceable.
Commercial tenants routinely request one or more options to extend the lease term to be sure they can continue their business at a particular location. Likewise, landlords benefit from retaining tenants by avoiding costs of a turn over, such as paying brokerage commissions for a new lease, paying for new improvements, providing free rent to the new tenant, and avoiding a vacant building. If the parties establish a specific rent for the option period and this rent ends up being higher than the market rent, the tenant simply will not exercise the option, and will either renegotiate or relocate. But, if the agreed upon option rent turns out to be lower than market rent, the tenant is more likely to exercise the option. A below market option to extend is a valuable right for the tenant, which conversely reduces the value of the landlord’s property.
The parties can legally decide to defer setting the rent amount until the option term is exercised, but for such an option to be enforceable, the lease must provide its essential terms. Typically, the option is part of the lease which provides that if the option term is exercised, then terms and conditions of the original lease apply. So, the original lease agreement supplies most of the material terms, but not the actual rent amount.
An option at a rent “to be mutually agreed upon,” however, is usually too uncertain for enforcement, although there is a split of authority on this issue. The traditional rule in California with regards to agreements to be made in the future is that if an essential element is reserved for the future agreement of both parties, the option does not create a legal obligation until the parties in fact do reach such agreement. Courts have noted that “Since either party by the terms of the promise may refuse to agree to anything to which the other party will agree, it is impossible for the law to affix any obligation to such a promise.”
In a California case, a lease provided for an option to renew the term of the lease on the same terms and conditions as the original lease, except that the rent would “be determined by mutual agreement.” The court held that the renewal option was unenforceable because there was no standard of measurement in the lease for determining the rent to be charged during the renewal term. It concluded that a provision for renewal of a lease at a rent to be determined in the future is not enforceable unless there is an ascertainable standard for determining the rent.
In contrast, another court enforced a renewal on terms “to be mutually agreed upon.” In this case, tenant leased an unimproved lot for five years, and had a right of first refusal for an additional term, with rent and terms to be mutually agreed upon at that time. The tenant spent tenant’s own money to turn the lot into a trailer park. The lease provided that upon termination, the landlord would have the option to purchase these improvements at 50% of their salvage price, or the tenant would be responsible for the removing these improvements.
When the tenant exercised the extension option, the landlord refused to negotiate and stated that she wanted her son to take over and run the trailer park. In this case, the court held that the renewal option was enforceable and reasoned that it was not making a new contract for the parties but merely compelling the parties to do what they contemplated at the time they initially contracted. This decision has been heavily criticized, however, and may have been motivated by unique facts. In this case, the court noted that if the lease term was not extended, the tenant would be required to remove the improvements, the cost of which was “prohibitive,” while the salvage value of these same improvements was “nominal.”
In conclusion, to ensure that a renewal option is enforceable, the lease should provide a an ascertainable standard for setting the future rent. These standards can be fair market rent to be determined by arbitration or appraisal, or by reference to similar properties at the time of establishment of the future rent. Although there is a split of authority in California, prudent parties would include in the lease an ascertainable standard to ensure that the option would be enforceable.