CRE Message: Arbitration, mediation, consternation? - by Donald Bouchard

Donald Bouchard, CRE

Having been in the real estate business for over 35 years, I have had the opportunity to read thousands of leases of all types. Sophisticated owners and tenants rely upon the efforts of high quality legal firms to craft these documents in order to protect the interests of their clients. Minute details are discussed as to term length, start date, rent commencement and changes, responsibilities of tenant and landlord, construction allowances, insurance, taxes, use clauses, defaults, utilities, trade fixtures, personal property, subordination, damages, casualty, eminent domain and the list goes on.

I am often impressed with the extraordinary detail in these documents. Unfortunately, I often encounter renewal clauses that are complex, poorly written and often abandon sound real estate principles related to market rent. I suspect that in the rush to sign the tenant to the initial term, the emphasis placed upon the lease extension language is secondary because it may be five, ten or more years into the future.

So assuming a tenant in occupancy for ten years provides proper notification to the landlord that it wishes to extend, a process is initiated that is most often directly focused on market rent. The problem is that the instructions for determining market rent are most likely not based upon the typical language in an appraisal textbook. It seems like it is never quite that simple.

The process is governed by the language in the lease and should define the relevant meaning of market rent and how it can be interpreted. Is the extension rent figure susceptible to the landlord’s opinion that the market rent for the space should now reflect a new highest and best use? Does the lease language mandate the consideration of market rent based solely upon the extension of the current use? What does the “Use Clause” allow? Extension language that is silent on this issue can produce wildly varying rent indications because each side is viewing the space from a very different point of view.

This is of course just the tip of the proverbial rent dispute iceberg that can create havoc if the lease is vague or conversely too prescriptive on the materials and information that can be brought to bear on the rent question. The issue of how to treat the impact of ten year old tenant improvements is always a tricky question that can result in huge rent differences. I have seen instances where the tenant takes the position that the improvements have been amortized in the initial term and the rent that the landlord is entitled to is the value of the space in “shell” condition. Funny thing…the landlords usually disagree.

Some leases actually mandate the specific buildings each party’s representative can employ leases from as evidence of market rent. Ten years out from the inception of the lease, it might seem like a bad idea in hindsight and could restrict the data pool to “a competitive set” that may have changed in a decade or so. In addition there are a great number of vaguely defined issues that often are subject to the interpretation of the respective parties. If the space exhibits wear and tear, does the tenant get the benefit of the condition in the renewal rent or should they not be allowed to benefit from their “hard use.” Regardless, you get the point.

Take this frequently encountered cauldron of uncertainty and then add to it the actual structure of the process. The variation here can be substantial. For example, side A and side B each get an appraiser or a broker and try to agree to a figure. When that fails, they select a third. In one instance my office was involved in, the lease language stated that the landlord and tenant representatives, as well as the jointly appointed third party must unanimously agree to a figure. What? Who came up with that brilliant idea and furthermore, who agreed with it and signed the lease? Regardless, this was a complete dead end for the process when the representative of one of the parties simply refused to agree to any compromise. It was likely doomed from the start. But have no fear. After nearly a year of acrimonious litigation, the parties finally agreed to accept the majority opinion to put the matter to rest.

The role of the third party is crucial because appointing this neutral participant is designed to deliver a solution. Sometimes the third has to develop an independent opinion in a manner similar to the landlord and tenant representatives. When they do, the lease language usually requires a majority decision. The third party conclusion alone may prevail as long as the findings are bracketed by the first two figures. In such instances, the consultants will most often deliver their conclusions simultaneously.

Conversely, the third party may simply be designated in the role of a true arbitrator where a “baseball” format mandates that he or she can only pick the figure of either the landlord or the tenant. No compromise is allowed. In my view, “baseball style” arbitration is often preferable because of the stakes. As one broker once noted, “it puts a collar on the behavior” of the parties because inevitably stretching for a figure that departs from the plausible reality of the market and the circumstances at hand will damage credibility and result in a 100% win for the opposing party.

When in doubt, read the lease. It will provide you with all of the answers. Or not.

Donald Bouchard, CRE, is the 2016 chair of the N.E. Chapter of the Counselors of Real Estate and senior VP of Lincoln Property Company, Boston.