Commercial leases generally include a provision that gives tenants the option to extend or renew at a fair market rent once the initial term expires. But without a crystal ball, it’s hard to determine the market value that the leased space will command at that time. So, rather than a specific rate or formula, landlords and tenants often choose to establish a mechanism or process for setting the renewal or extension (which we’ll refer to collectively as the “extension”) rent when the time comes. 

A Washington, D.C., attorney has devised a unique hybrid process that combines negotiation with arbitration. The process is effective because it gives the parties ample time and opportunity, along with a powerful incentive to negotiate an agreement on extension rent—namely, the mutual understanding that failure to do so will result in a binding resolution by a third party that neither side controls. The way the process works: 

• First, the landlord proposes an extension rent that the tenant either accepts or counters with its own proposed figure, and the sides then have a window to negotiate;
• If no agreement is reached, the tenant brings in a qualified appraiser to propose a figure, and the parties go back to the negotiating table; 
• If the negotiating window closes without an agreement, the landlord gets the next crack to select an appraiser to propose an extension rent followed by a last-chance negotiation;
• If the sides still can’t agree, the two appraisers select a third, neutral appraiser to choose one of the first two appraisers’ proposals, which then becomes the extension rent. 

While the process can unfold in multiple stages, the D.C. attorney says it rarely gets that far because the binding resolution endgame incentivizes both sides to act reasonably. “It’s amazing how accommodating people can be when they understand that the only way to control the outcome is to reach mutual agreement.” 

Here’s a closer look at the process along with a Model Lease Clause you can use to implement it.

The 5 Steps of the Extension Appraisal Process

The extension rent-setting mechanism kicks off when and if the tenant notifies the landlord of its intention to exercise the lease extension or renewal option. 

Step 1. Landlord notifies tenant of proposed extension rent. Upon receiving notice of the tenant’s election, the landlord has a set amount of time to propose a fair annual base rent for the space during the extension term, starting in year one [Clause, par. a(i)]. “The landlord normally has a better understanding of the market than the tenant,” the D.C. attorney explains in justifying why the landlord should have the first shot.

Step 2. Tenant counterproposal & first negotiation. If the tenant doesn’t accept the landlord’s proposal, it must submit a counterproposal within a specific number of days (our Model Lease Clause provides for five days). If the tenant doesn’t submit a timely counterproposal, the landlord’s proposal becomes the annual base rent for the extension period. If the tenant does counter in time, the sides have a specific window (10 days) to negotiate (the “first negotiation”) [Clause, pars. a(ii) and (iii)]. 

Step 3. Tenant brings in appraiser & second negotiation. If the sides are still deadlocked after the first negotiation, the process moves to the next phase, with the tenant’s hiring a qualified appraiser to propose the fair market extension rent. The clause should specify:

• The credentials the appraiser must have, e.g., current membership in the Appraisal Institute, to serve in this role;
•  The deadline for the tenant to notify the landlord of the appraiser’s selection, e.g., five days; and
• The deadline for the tenant to submit the appraiser’s proposal to the landlord, e.g., 20 days.

If the tenant doesn’t provide an appraisal, the landlord’s most recent proposal becomes the extension term base rent; if it does, the sides have 15 days to negotiate (the “second negotiation”) [Clause, pars. a(iv), (v), and (vi)]. 

Step 4. Landlord brings in appraiser & third negotiation. In the unlikely event that the process reaches this stage, give the landlord the chance to appoint its own qualified appraiser. Establish a timetable for passing along the appraiser’s proposal to the tenant and carrying out a “third negotiation” on the basis of that proposal. In parallel with the tenant appraisal phase, the landlord’s failure to submit its appraiser’s proposal to the tenant on time makes the tenant’s last proposal the annual base rent for the extension term [Clause, pars. a(vii), (viii), and (ix)].    

Step 5. Third appraisal & binding agreement. The “third negotiation” is the parties’ last chance to settle the matter on their own. If they don’t, provide for the tenant’s and landlord’s appraisers to select a third appraiser. Designate another independent party to serve in that role, such as the president of the board of realtors in the county where the property is located, in case the first two appraisers can’t agree. Have the third appraiser choose between the landlord’s and tenant’s final proposals as in a “baseball arbitration.” Require the parties to then sign an extension agreement incorporating whichever fair market rent the third appraiser selects with no further negotiation [Clause, pars. a(x) and (xi)]. “The all-or-nothing outcome maintains the pressure to act reasonably and settle before things reach the third appraisal stage,” the D.C. attorney explains.   

Timetables & Deadlines Are Negotiable

While the extension rent-setting process should follow the five basic steps outlined above, the D.C. attorney suggests that the 170-day overall timetable provided for in the Model Lease Clause can be extended or compressed, depending on the situation and parties’ needs. For example, a timetable of 150 or fewer days may be in the landlord’s interest when the market is strong and finding replacement tenants poses less of a challenge. 

The same flexibility principles apply to the process’ incremental times and deadlines. Thus, for example, a tenant may want more than five days to respond to the landlord’s initial proposal or think that the various negotiating windows are either too long or too short. The time span for appraisal is another potential sticking point. While 10 to 20 days is generally enough given that a full appraisal isn’t needed, some might object that this isn’t enough time.     

Three Additional Lease Safeguards

In addition to the procedural dynamics, there are some important legal protections that may be in play during lease negotiations. 

1. Criteria for setting fair rental value. A lease clause outlining a process for establishing fair market rental value upon lease renewal or extension should include specific criteria for determining what the space is worth. That includes whether the value of the space will be based on:

• Its current use;
• Its present form, including the tenant’s improvements and installations; or
• Its “highest and best use.” 

While “highest and best use” is generally the landlord’s first choice, you may have to be prepared to value the space based on its current use and as if it included your standard renovation but no other alterations, furnishings, or fixtures [Clause, par. a].

2. Extension rent floor or ceiling. When it comes to setting future extension or renewal rent, landlords may not be fully willing to “trust the process” regardless of how carefully that process is negotiated. One way to allay these concerns is to insert language establishing a specific floor below which the extension rent may not go [Clause, Optional par. a(xii)]. Of course, mistrust of the process can work both ways with strong tenants demanding an extension rent ceiling. 

3. Tenant cancellation right. Tenants may be unwilling to unconditionally commit to a future lease extension or renewal without knowing exactly what the rent will be. Although the Model Lease Clause doesn’t do this, you may still be able to sell it to tenants by adding language giving them the right to revoke the extension or renewal at different points during the rent-setting process [Clause, Optional par. d]. Agree to this only if there’s no other way to get the tenant to accept the deal, the D.C. attorney advises.