Six Considerations for Rent Arbitration Clauses in Commercial Leases

When a commercial tenant exercises an option to renew a lease it is imperative that the landlord and tenant have effective mechanisms in place to determine the rent for the renewal term. Ideally both parties will agree on the new rental rate, but if a dispute arises there needs to be a framework to quickly resolve the disagreement. The following are six key considerations for landlords and tenants negotiating rent arbitration clauses in commercial leases.

1. Carefully define Fair Market Rent in the Lease/Option to Renew

Typically, an option to renew allows a tenant to extend a commercial lease for a specified time period, according to the terms of the original lease, except that the rent for the renewal term is to be renegotiated on the basis of “fair market rent.” The term “fair market rent” is often not defined at all or very well in many commercial leases. Time needs to be taken by both the landlord and tenant at the outset of the lease to define carefully from their perspective the term “fair market rent”. The wording desired by and beneficial to the landlord may be very different from that desired by and beneficial to the tenant. Issues that should be considered by either the landlord or the tenant or both in defining fair market include whether the rent for the renewal terms is based on the improved or unimproved (i.e., original) conditions of the premises, the point-in-time for valuation, the geographic scope and use of comparable properties (e.g., same building, same street, same city, same type of use (e.g., retail space versus a restaurant)), the strength of the covenant of the tenant (e.g., a strong retailer versus a start-up restaurant), and whether or not potential tenant inducements ought to be factored in. This will focus negotiations, and give clear parameters to an arbitrator if agreement is not reached.

2. Interest on Rent Arising from the Renewal that Ends Up Being Paid after the Renewal Date

Often the arbitration that determines the “fair market rent” does not take place until long after the renewal term starts. In the mean time, the tenant normally is continuing to pay rent based upon the rental rate used during the initial lease period or a previous lease renewal period. Landlords, particularly in rising real estate markets, should consider including wording in the lease that specifies what interest rate should be charged on any difference between what the tenant initially pays for renewal-term rent, based upon the previous lease term or renewal period, and what the landlord is awarded at the arbitration. In a falling real estate market, this interest issue would be the concern of the tenant.

3. Mediation before Arbitration

With a detailed definition of “fair market value” in the lease, an experienced commercial real estate mediator may save time, expense and goodwill between the landlord and tenant. Stipulating that mediation is first and arbitration is second may help keep both parties in a negotiating mindset. A neutral suggestion from an independent party with appraisal expertise often helps parties reach agreement when they are not too far apart on what rent should be. While the arbitration clause can provide that the mediator becomes the arbitrator (a so-called “med-arb” scenario) if mediation is unsuccessful, the “med-arb” scenario is not in our view normally advisable. The parties should be concerned that any mediator who suddenly becomes the arbitrator for the same dispute, may be prejudiced in his or her decision as arbitrator by virtue of views he or she took of the parties and their positions during the mediation.

4. Design Your Arbitration Process

Arbitration is an extremely customizable process. Arbitration clauses should take advantage of this flexibility, and at minimum should specify:

  • Single Arbitrator vs. Three Arbitrators (the default under most provincial arbitration statues is one arbitrator if the parties do not specify) ,
  • Acceptable timelines for completing the arbitration,
  • The place of arbitration, and
  • The language of arbitration.

Generally, there is not sufficient money involved in most commercial lease disputes to justify using three arbitrators. Accordingly, the use of only one arbitrator will normally be specified in the arbitration clause if the default provision of the local provincial arbitration statute is not being relied upon (which default provision will also usually result in a single arbitrator being used). Unlike a judge in court, you are paying an hourly rate to each arbitrator used. Once the issue arises regarding the rental rate for the renewal term, if the arbitrator cannot be selected by agreement of the parties, most provincial arbitration statutes indicate that a Justice of the superior court of the province involved will select the arbitrator if the parties have not otherwise provided a means of selecting an arbitrator. Accordingly, parties may wish to consider specifying a third party other than a superior court judge to select an arbitrator. A number of institutions exist that can be considered for such purposes, one example being the ADR Institute of Canada, Inc.

As suggested above, most arbitration statutes allow parties, either expressly or impliedly, to contract out of most of the provisions of those statutes. Parties should consider whether they want to rely on the default provisions of such arbitration statutes, craft their own rules or perhaps even rely on rules of a third-party institution such as the ADR Institute of Canada. Generally for rent arbitrations, one wants some form of pre-arbitration production of records, particularly as it relates to comparables used by appraisers retained by the parties but not an all encompassing production of relevant records and pre-arbitration examination of witnesses such as exists in a court proceeding. This fact should be taken into account in specifying in the arbitration clause any details as to the procedure that is to be followed.

5. Have Your Lawyer Retain the Appraiser to Act as Your Expert in Such Dispute

Once a dispute appears to clearly exist between landlord and tenant, in order to preserve privilege associated with any expert report of an appraiser that is obtained, it is best if legal counsel retains such expert and requests the report. For example, this may avoid production of an appraisal report which the party initially retaining such expert may reject. Use of the lawyer at this stage can also avoid inappropriate letters being sent to an expert retaining them for the arbitration. Inappropriately worded retainer letters sent to an expert may turn out to be producible in the arbitration and embarrass the party responsible for sending such a letter, or reflect negatively on that party in an arbitration.

6. Consider a Separate Arbitration Agreement or More Detailed Arbitration Clause

Parties are not restricted to a single arbitration clause within the lease. A separate arbitration agreement, which takes advantage of the customizability of the arbitration process, can provide a much more detailed road map for the conduct of the arbitration than can be included in one or two clauses in the lease. An arbitration agreement should be created at the time a dispute arises (keeping in mind some arbitrators want their own form of arbitration agreement). If one wants certainty about the arbitration process at the time the lease is initially entered into, then a more detailed arbitration clause specifying that process should be outlined in the lease or an appendix to such lease. This will entail more upfront costs, but may avoid tactical wrangling if a dispute arises.

Topics:  Appraisal Clauses, Arbitration, Commercial Leases, Commercial Tenants, Fair Market Value, Landlords, Option to Renew, Tenants

Published In: Alternative Dispute Resolution (ADR) Updates, General Business Updates, Commercial Real Estate Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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