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Determining fair market rental value

The value of a rental space can vary greatly over time, out of proportion to automatic cost of living increases or fixed rent increases. Therefore, landlords and tenants often agree to adjust future rent based on a determination of fair market rental value. Fair rent calculations may apply to options to renew, options to expand and periodic rental increases. The factors and mechanics applied in determining the fair market rental value will have a significant effect on the final amount of the fair market rent. Each of these should be considered when negotiating a fair market rent lease provision.

The fair market rental value will generally be based on "comparable leases of comparable space." What constitutes a "comparable lease" and "comparable space" will be determined by the factors listed in the lease provision. To permit comparisons only to comparable leases, the landlord should exclude subleased space, leases in which the tenant has an equity interest, renewal space, and space that is otherwise subject to third party rights.

Comparable space Defining "comparable space" involves a number of criteria. The comparable space must be in a building and area that are comparable to the premises. This factor may require more specification, designating which buildings will be used for comparison or the applicable geographical areas. The location within the center may be a critical factor; a highly prominent space will command a higher rate than a remote location. The age of the building may be significant. The configuration of a center and the type of tenants located in the center will also affect rental rates. If the center includes premium common area amenities such as Internet or satellite facilities, water features or amusement rides, mention those in the requirements for comparable premises.

In making rent comparisons, the landlord should urge the use of the premises be deemed the highest and best use available for the premises. However, the tenant will resist this notion, and argue that the value of the space is limited by the current use, to which the landlord agreed by executing the lease. This may be resolved by applying the highest and best use permitted in the lease. For a ground lease, it is important to state whether the premises will be appraised as vacant land or as improved, and whether applicable zoning and other private and governmental restrictions will be considered.

Commissions and concessions There is usually a give and take in lease negotiations between landlord and tenant. These negotiations determine which landlord expenses, incurred in the relevant "comparable leases," will be considered in determining the fair market rent for the premises. Among the landlord costs, which the tenant will want to use to reduce the fair market rent calculation, are brokerage fees, free rent, legal fees, tenant improvement allowance, limitations on common area maintenance charge increases and "other economic concessions." The outcome of these issues will depend on the relative bargaining power of the parties.

The lease provision should state whether future adjustments to common area maintenance charges (CAM) should be done in the same manner as currently done (with or without a base year and any caps on increases) or according to the existing leasing market practices. The parties should also specify whether the percentage rent being paid by the tenant will be taken into account in calculating the fair market rent.

If rental value not agreed If the parties disagree on the rent within a fixed time period, the lease provision should provide a mechanism for determining fair market rent. While the landlord may propose that the determination be binding, the tenant may want the opportunity to opt out if it determines rent is too high. In most cases, the determination is final and binding. In describing how this is to be done, there are two aspects to be considered. First, the person or persons who will decide the issue must be described. Will they be real estate brokers, appraisers or developers? How much leasing experience shall each of them have, and in which geographical area and type of rental properties? The second aspect involved is providing how and when the decision will be made. If there is to be more than one decision-maker, will an average of the two rent calculations be used? Will so-called "baseball arbitration" be used, in which the arbitrator must select one of the two rental amounts proposed by landlord and tenant? Other considerations regarding arbitration provisions generally are discussed in the May 2000 edition of this column.

Each of these issues should be considered in drafting a fair market rent provision in order that the rent arrived at will be a reasonable approximation of the fair market rent, and will be arrived at in a fair, expeditious manner.

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