In lease transactions that include extension options, landlords and tenants will often agree that the rent during such options will be based on “fair market rent.” But what does that mean? Definitions of “fair market rent” vary from deal to deal, depending on many factors. Each party seeks to include provisions in the definition that will result not in a rent that is necessarily “fair,” but rather in a rent that is advantageous to its side. With that in mind, here are some of the factors that are often negotiated in fair market rent definitions.
A landlord will want to base the fair market rent on the highest and best use of the property, even if the existing tenant is using the property for a different, lower-rent-generating use. For example, a tenant may use the space for office purposes even though it is possible to use the same space for retail purposes (which often command a higher rent). Tenants, on the other hand, will want the rent to correspond to the actual use of the property.
Some landlords who feel they operate a higher quality of property than their neighboring landlords will try to define the fair market rent based on the rents that the landlord is receiving in that particular property versus the rents being collected by other landlords in the local marketplace. For example, the landlord of a building that is better managed or is newer will usually receive a higher rent for that building than the landlord of another building that is less well managed or is older will obtain, even if the other building is just across the street. Conversely, a tenant will often want to broaden the marketplace of comparable buildings used in determining what the fair market rent is.
A tenant will want the fair market rent amount to take into account some of the savings that a landlord will gain by having the existing tenant stay in the premises as opposed to the landlord needing to find a new tenant. If the landlord has to find a new tenant, the argument goes, then the landlord will have to pay a broker commission and possibly a tenant improvement allowance, and will suffer down time when the space isn’t generating any rental income. Another common sticking point is whether the definition of fair market rent should include a “rent floor” equal to the same rent that the tenant was paying during the last year of the original term of the lease. Many landlords insist that the rent should never go down, and in fact, should increase by at least the same percentage increase that the tenant’s rent had increased during the original term. But tenants argue that fair market rent should ignore the prior rent owed by the tenant because the spirit behind the concept is to base the rent on the market as of the time of the option. Therefore, if the market has changed and rents have dropped, then the fair market rent should reflect that drop.
To avoid a lot of the negotiation (and often dense, lengthy language) over such definitions, some parties simply agree to define fair market rent as the rent that parties would agree upon in an arm’s length transaction, “relying on all relevant factors.” With this broad definition, in the event of a dispute, a neutral expert appraiser or broker will be able to consider those factors the expert considers to be relevant in determining the fair market rent, without pre-established limitations.