Expert: Jim Avancena, CPM - 2/14/2007

Question
I'd like to lease my property and building which is currently a restaurant. The tenant wants a 20 year lease. I'd like to give a triple net lease with the first 5 years rent spelled out (i.e. year 1 and 2 for $19 per SF/year; year 3 $19.57, year 4 $20.15 and year 5 $20.75), then offer 3 additional five-year options. But I'd like not to lock in the rental amounts for the options. What language should I include concerning the rental rate for the options. Should I include a %-range, or a %-maximum (i.e. no more than x-percent per year).  Thank you for any advise.  

Answer
Ron-
There are many options; each with certain benefits and
associated risks.  There will also be a number of inter-related factors to consider that you have not mentioned - probably most of which you are already aware.  Consider for example:

1.)If the lease is set-up with the tenant paying up-front a substantial amount of its own funds to prepare the space as a restaurant, it is going to give you greater leverage regarding the amount of rent that is paid in the option periods; the tenant will be reluctant to have to expend those funds again at the end of the initial term.  The reverse situation works in the tenant's favor:  if the tenant gets you to contribute significant amounts of your own funds to make an average space into the Taj Mahal, you may seek option rents that are overly aggressive seeking to recoup your initial improvements investment or you may be hesitant to create option rental terms that you feel may  appear detrimental to the tenant when it comes time to exercise its right to extend.

2.) Do you to expect the submarket the restaurant serves to  improve economically during the initial term of the lease?   Is this an area that most anticipate will grow dramatically in the next few years and dramatically increase the number of customers and/or their disposable income?  Larger restaurant operators will actually bring in regional decision makers for a final helicopter tour of the area and a critical part of that flight will be pointing out the projected growth areas (planned housing developments and office parks) to the decision makers.

3.) What is the tenant's track record for setting up and realizing successful eating establishments?  This could be  an individual that simply fancies the idea of having their own restaurant because it looks easy to do on TV shows and   movies, to a chain that has started a dozen successful locations in the last year.

4.) How narrowly defined is the "Use" provision in you lease?  If the elegant French menu and concept don't create the revenue the tenant needs to pay the rent, can they change it over to a biker or topless bar and increase their revenue, but destroy the image of your property for renting it in the future?     

5.) What sublet and assignment rights are you including in the lease terms?  Can the tenant you are executing a lease with now, sublet or assign your property to someone that operates a restaurant or other retail operation that you don't want in the property as a long term tenant; for example a check cashing business, pornographic video store  , etc.    
 
This list of considerations is literally endless and I am certain you have already considered those of consequence.

The rent for the 3 additional option terms can be set up several ways:

1.) Ideally, the rent going to a "market" rent for each of the 3 option terms is the fairest method, however the stipulations for arriving at the "market" rent for each additional term can be difficult to prescribe in a way that both the landlord and tenant find acceptable and the specific terms can become quite convoluted.   Many "market"  based option period rent provisions include going to a objective third party if they cannot come to an accord, but both sides must be very careful to draft language without "holes" in it that create a disadvantage.  The devil is in the details of "market" based rental agreements.     

2.)  If you are fairly certain of what your costs will be to
hold the property over the 20 year term, and your lease is really triple net, a x-percent maximum increase each option term may be the most universally acceptable basis for adjusting the rent.  However, if your tenant becomes another Wolfgang Puck and the world flocks to his door, you may miss out on some rental revenue you could have gained with another method.

3.) If you feel like you will be able to trust this tenant's
certified accountants books and records - and I see you have obviously avoided this method of determining the base rent in the initial term -  you could base your option term rents on the revenue's earned by the tenant.  If the tenant doesn't reach certain minimums in revenue each year, you must retain the option to terminate the lease with acceptable notice.
    
There are many ways to set the option rental, but in the end you must come up with an arrangement that gives the tenant the incentive to work all those long hours to make his establishment a success.  Large national chains will have certain favored corporate rental option terms they seek and will press for in the lease negotiations.  You will need to decide if the financial security - but perhaps more modest rental - of a major restaurant operator is more valuable to you than the increased risk, but more beneficial upside rental structure of a smaller tenant.   You will also want to consider the critical "bankability" of your tenant if you intend to refinance or sell the property.     

Finally, although nearly every lease articulates that the terms of the lease do not create a partnership between the landlord and tenant, it is not uncommon for tenants and landlords to mutually modify certain provisions of their lease agreements as the lease term matures.  

I hope this has been helpful. If you seek specific lease language or provisions, an attorney SPECIALIZING in commercial leases and landlord/tenant matters should be consulted.  This is a situation where component wording of a complex provision can cripple the intent of the parties.

-Jim