Options to Renew: Watch That Calendar!
Tom Acitelli May 16, 2011, 9:33 a.m.
Having an option to renew is a terrific benefit to any tenant and represents a substantial landlord concession. Let me count some of the ways.
Most significant-especially for tenants to whom location is very important, like retailers and medical offices-it gives continuity of service to customers. The lease/location becomes an important part of the company’s good will, especially when large sums of money in custom TI work have been invested. Further advantages include lengthened depreciation on improvements and avoiding the downtime and loss of business that can result from a move.
Bottom line: Every tenant negotiation should have a renewal option as one of its main goals. Without an option to renew, you can be forced out at the end of your lease, resulting in costly (and serious) disruptions to your business. Planning for business continuity is an insurance policy that can save the tenant (and counsel) untold cost and frustration in the long run.
The option language often reflects the parties’ goal of some cost certainty; for example, negotiation of a fixed increase during the renewal term (say the 3 percent per annum that the tenant has been paying annually during the initial term). More typically on a larger deal, the renewal rent is keyed to Fair Market Value (FMV), and as the renewal notice date nears, the tenant can then get an idea of the market and make a more educated decision as to whether or not to renew.
While they rarely outweigh the pluses, some downsides for the tenant include not being able to precisely know the rent, or missing the notice date (very telling in those business areas where automatic renewal clauses are common and the tenant must give a certain amount of notice if it does not wish to renew).
Also, changes in lease accounting as proposed by the FASB (Financial Accounting Standards Board) will make a drastic difference in the way lease obligations are featured on tenants’ books. Now leases are carried as an expense; the new rules will require that lease obligations be shown as a liability. What this means for the tenant is that the renewal option will now be factored in on the liability side of its balance sheet. Many believe that will make having an option less attractive.
Let’s not forget the landlord’s perspective, which views the option as potentially troublesome and costly-a sometimes necessary evil. It is generally regarded as a significant concession. This is stated as a corollary to the “rule” that landlords are at risk when tenants are granted lease rights that may reduce the landlord’s control over the premises.
That degree of risk can be mitigated by pre-exercise criteria (e.g., tenant not in default), and a long notice period (typically six months to a year). The longer notice period gives the opportunity to seek a replacement tenant should that be necessary, and the pre-conditions are typically designed to make sure that the landlord is not stuck with a chronically defaulting tenant for any longer than the (now regretted) initial term.
What then are the hallmarks of the option clause?
1. Conditions precedent: Tenant not in default. But as of when? The date of the notice of exercise of option? The date the option term begins? Both? Anytime during the term? Also, what of a default that occurred during the term but has been long-cured? Must the default be material? Have required notice and opportunity to cure periods run?
2. Option notice: Where to be sent? When? Form (language)? Signed by? May attorneys give notices?
3. Method of delivery: Certified mail? Overnight courier?
4. Date deemed delivered: On mailing? Three days after mailing? Deemed next-day delivery?
5. Renewal rent: Fixed or formula? If formula, mechanism to implement. Note that a lease that says “the rent for the renewal term will be set per the parties’ agreement”-i.e., one without a fixed rent or a formula and mechanism for determining rent will be unenforceable as an “agreement to agree.” Today, the most common is FMV, as determined by baseball arbitration (to be discussed in detail in Part 2 of this article).
So the exercise of the renewal option is in the tenant’s court. What are some of the relevant criteria? They include an analysis of the current market; available alternative space; determination of the real cost of moving; and, significantly, whether the current space is still adequate for the tenant’s business needs-and the same goes for the length of the renewal term.
Of course, here’s where the tenant’s savvy real estate adviser will earn his or her keep.
Exercising the Option
Exercising the Option
Many cases hold that to be effective, the option must be exercised “clearly and unequivocally” in strict accordance with the lease. The tenant must be in compliance with conditions precedent-i.e., no rent default-and the notice of exercise of option given exactly as prescribed: address, addressee and method of delivery. (By the way, this is not the time to add qualifying matters like “I’m exercising this option provided landlord gets the elevator to work” or the like, as that may be deemed to negate the notice-dilute the message-meaning that a court may rule the renewal option has not been properly exercised.)
O.K., SO YOU’VE got the renewal clause and you’re now in the last year of the original term and you have every intention of renewing; so you finally get around to dusting off the lease and find that the last day to exercise the renewal option was a week ago. You blew it, right? End of story? Well, this subject has led to a number of interesting New York cases, and I’d like to review some of them with you.
A case that gives a good overview of the subject is 221-06 Merrick Blvd. Associates LLC v. Crescent Electric Acquisition Corp. (citations here and elsewhere omitted), where the court ruled that the tenant’s late notice of exercise of renewal was ineffective. The court begins by citing a long line of New York cases to the effect that “a notice exercising an option to renew a lease is ineffective if it is not given within the time specified. …”
But there is a life preserver sometimes thrown to the hapless tenant who has blown the exercise date. It’s a three-prong test, as the court goes on to say: “Equity will intervene, however, to relieve a tenant of the consequences of an untimely notice of an option to renew a lease where (1) the tenant’s failure to exercise the option in a timely fashion resulted from an honest mistake or inadvertence, (2) the nonrenewal of the lease would result in a substantial forfeiture by the tenant, and (3) the landlord would not be prejudiced by the [late] renewal. …”
The lease required at least 120 days notice and service by certified mail. Here, the tenant, Crescent Electric, sent an ambiguous inquiry as to the procedure for renewal options and sent it by email. Late.
The tenant failed to convince the court it was entitled to that special, equitable relief described above. In particular, the court said the tenant had not established that a substantial forfeiture (loss of investment in substantial TI work, goodwill and the like) would result if equitable renewal was not granted or that the landlord would not be prejudiced by the renewal.
So no life preserver for Crescent.
From the lower court:
“The requirements of the lease as to when and how notice was to be given were clear and unambiguous, and tenant has offered no testimony or other evidence that its failure to timely send a proper notice was the result of mistake or inadvertence.
“Moreover, tenant failed to offer sufficient proof that it made improvements in reliance upon renewal. Both tenant’s witnesses and its documentary proof submitted at trial failed to distinguish between repairs which tenant was required to perform by the lease and any actual improvements made by tenant. In addition, tenant has not alleged that it would lose any goodwill if it had to change locations. Accordingly, tenant failed to establish that it would suffer forfeiture if the lease were not renewed.”
A similar result can be found in the case of Baygold Associates Inc. v. Congregation Yetev Lev of Monsey Inc. (late notice; not given per the lease terms rejected: “an election to renew must be timely, definitive, unequivocal and strictly in compliance with the lease term.”).
And now for the “good” news …
Thanks to colleague Scott Mollen, who does such a yeoman service digesting important real estate cases for the New York Law Journal, for bringing to my attention 135 East 57th Street LLC v Daffy’s Inc., a recent local case that illustrates the circumstances under which a late notice might be forgiven. Caution: Do not rely on this one. Get your notices in on time. So, Jeff, what happened?
The case involved the Daffy’s clothing store in midtown and the specific facts of the case are very important in trying to divine why the court was lenient here; why the court invoked an equitable remedy for Daffy’s-not holding fast to the black letter line as to exactly when and how the notice had to be given. (Here tenant missed the date by four days.)
As reported, the facts were that:
1. The option was to have been exercised by notice given by fax and email.
2. The tenant’s employee in charge of notices said he had medical problems, so was not able to focus on the lease notice requirements.
3. The tenant had made very substantial improvements to the store.
4. The store was one of the tenant’s best-performing, and if it lost its lease, it would suffer irreversible financial damage and more than 100 workers would lose their jobs.
5. By reason of its many years at the location, the premises were a valuable component of Daffy’s corporate goodwill.
6. There was no comparable space in the vicinity.
7. The landlord had not made any commitments to re-rent to another tenant.
8. The notice was (only) four days late.
First the court cited the rule that to effectively exercise an option to renew, all the formalities-especially timely notice-would have to be observed. Now that the general rule had been stated, it then proceeded to invoke its equitable power to forgive Daffy’s late notice.
Justice Yates’ ruling in favor of Daffy’s held that the late notice was an “honest mistake, that the delay was slight, that [tenant] would suffer a significant forfeiture if the Lease is not renewed, and the [tenant] has demonstrated an absence of prejudice to [landlord] from the four-day delay in exercising the … option.”
So, Daffy’s got its life preserver. It was found to be “equitable relief worthy,” but there were some exceptional facts and circumstances present. Most careless tenants and their counsel, if counsel has taken on that responsibility, will not fare as well.
Jeffrey A. Margolis is founding principal of the Margolis Law Firm in New York City where he specializes in “dirt law”-buying, selling and leasing. He writes monthly for The Commercial Observer on legal issues. This discussion as to options to renew will continue later this month.