Long-Term Leases: Rent Reset Analysis.

Author:Sevelka, Tony
 
FREE EXCERPT

Abstract

A provision for resetting rent is often found in long-term leases, with the objective being to periodically analyze the value attributed to the leased real estate. The property rights to be valued at each rent reset depend on the language of the lease, especially the rent reset clause. The lack of specificity associated with use of the term market value has led to questionable application of the term in rent resets. Inconsistent interpretations of a lease can lead to divergent opinions of value. Sometimes rent resetting provisions have no connection to the terms of the lease or the actual property rights; this may result in situations where it is difficult to apply conventional appraisal methods. This article summarizes and discusses a sample of rent reset cases and explores creative valuation solutions to rent reset valuation challenges.

Introduction

Rent reset clauses are typically found in long-term leases for land (unimproved or improved). (1) A lease is "a contract in which the rights to use and occupy land, space, or structures are transferred by the owner to another for a specified period of time in return for a specified rent." (2) A lessee's (3) intended use of the leased premises, the time required for recovery or amortization of the capital invested in the business and leasehold improvements, and lender requirements for financing of leasehold improvements generally determine the length of the lease term.

The lease may provide for resetting the rent periodically during the term of the initial lease or when an option to extend or renew the lease has been exercised by the tenant. The basis for the rent reset is dictated by the provisions of the lease, and the lease usually calls for arbitration if the landlord and tenant are unable to negotiate a new rent within a specified time frame.

A rent reset analysis for a land lease has the same objective as for a space lease--quantifying a new rent--unless the land lease only calls for a fee simple estimate of land value to which is applied an annual rate (percentage rate of return) as specified in the lease. (4) The language of the lease, specifically the rent reset clause, and the market conditions prevailing at the time of the scheduled rent reset can have a profound impact on the rent to be paid by the tenant. Over time, a long-term lease may prove unfavorable to either the lessor or lessee, as noted by the appeals court in Cook Associates, Inc. v. Utah School & Inst. Trust:

Long-term commercial leases, by their nature, are risky. Neither side can foretell future market conditions with any certainty. We presume that both [parties] bargained for the best terms and conditions each could get. Each party took the risk that unpredictable market forces would at some later day render the contractual terms unfavorable to themselves. (5) The Rent Reset Clause

A lease that calls for an adjustment of rent during the life of the lease generally includes a procedure to be followed by the parties to the lease or the professional advisors identified and tasked with fixing the new rent. (6) A rent reset clause can function to reset rent as an independent exercise or in relation to all or some of the subsisting clauses (provisions) in the lease itself.

Analyzing the adjusted or revised rent can be a contentious issue. Sometimes the rent reset clause is unclear or ambiguous as to the improvements (if any, and in what condition), property rights, methods, procedures, formulas, or factors that are to be taken into account--or disregarded--in estimating the revised rent. If the lease itself is to be disregarded, and the objective is to estimate the market value of the leased premises as if unencumbered, the rights to be valued are a fee simple interest. (7) Conversely, if resetting the rent involves an analysis of a tenant's use and occupation, it is the rental value (8) of the leased premises for the rent reset period that is to be estimated. In relation to these two mutually exclusive valuation exercises, the appellate court in Bullock's Inc. v. Security-First National Bank of Los Angeles (9) drew a distinction between market value and rental value:

Rental value is measured partially in terms of time, by the month or by the year, et cetera. The parties were not fixing rental value in the lease, they were fixing rent. They determined such rent by taking a ... fixed percentage of the full value (not the rental value) of the land. The parties based rent upon the fair market value of the property rather than upon its rental value for any given period of time. In the Bullock's case, all that was required was a point-in-time estimate of the "appraised value of the land," exclusive of buildings and improvements, which the court found to mean fair market value. The appeals court did not define market value but relied on the term market value as referenced in the lease's repair and maintenance clause and the lease's condemnation clause. (10) The court noted,

The parties have thus provided for a reduction in rent based upon the difference between the market value of the land before condemnation and the market value of what remained thereafter. And the reduction is calculated in the same manner as that provided for calculating rent--five per cent per annum of the predetermined amount. Since the lease provides that a reduction in rent due to partial condemnation is to be measured by the drop in market value of the property covered by the lease, it may reasonably be inferred that the parties were thinking in terms of market value when they drafted the provisions of the lease relating to the calculation of rent. [emphasis added] Market Value and Property Rights

Definitions of market value often are silent as to what property rights are being valued. In his 2018 Appraisal Journal article, Sanders examines the evolution of market value definitions and the "varied conditions imposed on the hypothetical market" inherent in the numerous definitions of market value. (11) None of the various definitions of market value presented by Sanders explicitly considers property rights, with the exception of the following market value definition suggested by Marchitelli and Korpacz in their 1992 Appraisal Journal article:

The price in cash and/or other identified terms for which the specified real property interest is likely to sell as of the effective date of appraisal in the real estate marketplace under all conditions requisite to a fair sale. (12) [emphasis added] Many definitions of market value emanate from eminent domain, where for state and federal purposes the market value of condemned land is determined based on the unencumbered, undivided fee, and disregards all other real property interests. (13) Likewise, in most states the valuation of real property for assessment purposes denotes property rights in a fee simple type interest when there is more than one interest in a property. (14) In these two areas of real property valuation, the value sought carries a presumption of undivided free and clear title, not burdened by an encumbrance such as a lease, and legislation to achieve this intended purpose overrides the contractual rights and obligations between a lessor and lessee.

When parties enter into a lease in the world of commerce, they agree to be bound by the terms and conditions of the lease. Even if a lease makes provision for resetting rent during the life of the lease, the lease remains in effect throughout the entire term, including any period covered by a lease extension or renewal option exercisable at the discretion of the tenant. In this situation, it may not be appropriate to assume that the property is unencumbered by the lease at the time of the rent reset unless the rent reset clause manifests a clear intention to disregard the lease. At the end of the life of the lease, the leased premises revert to the landlord, and all tenant-owned leasehold improvements become the property of the landlord unless the tenant is obligated to remove the improvements under the terms of the lease.

The 1992 Marchitelli and Korpacz definition of market value as it relates to property rights is consistent with the current definition of market value in The Dictionary of Real Estate Appraisal, sixth edition, and in The Appraisal of Real Estate, fourteenth edition. The most widely accepted components of market value, including a reference to property rights, are incorporated into the definition:

The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress. (15) [emphasis added] Directly related to the concept of market value is the identification of the specific property rights to be appraised. When references to "(fair) market value" appear in leases but the term is not adequately defined, it can cause uncertainty as to how the valuation analysis should proceed.

In the context of a lease involving the division of property rights between lessor and lessee, if the referenced market value does not specify the property rights to be taken into consideration, the analysis for resetting rent should generally be taken to include consideration of the lease itself.

Some misunderstandings as to the meaning of market value can be directly attributed to the misuse or commingling of terms related to market value. In appraisal literature, market value and market rent are not synonymous terms, but the parties to a lease are free to agree to their own valuation-related definitions. (16) For example, in Georg Jensen, Inc. v. 130 Prince Associates, LLC, (17) the lease made no distinction between market value and market rent in a rent reset involving a...

To continue reading

FREE SIGN UP