By Richard A. Laney and Patrick T. Wittenbrink, Attorneys at Law
– Lease extension options are commonly negotiated and included in commercial leases and lease amendments across all sectors of commercial real estate. When negotiating lease extension options, tenants will seek favorable option terms, such as rent savings, improvement allowances for the leased premises or other tenant inducements. Landlords, on the other hand, want to maximize rent, reduce tenant inducement costs and provide flexibility for termination of the lease down the road. Recent Missouri cases have highlighted the importance of clearly written extension options in the lease and have highlighted practical concerns in the exercise of extension options. This article provides an overview of recent Missouri case law, analyzes practical considerations in drafting and negotiating commercial lease extensions to avoid litigation, and identifies pitfalls that should be avoided in exercising extension options.
Recent Missouri Case Law
Green Street 2900 Investors, LLC v. The St. Louis Woodworks, Inc., involved an unlawful detainer action[i] against a tenant who sought to exercise an option to renew the term of its commercial lease. The lease provided two five-year renewal options for tenant.[ii] The lease stated that the monthly rental rate during the second option would be at “market rent,” defined as the lesser of (i) rent quoted to prospective tenants within six months prior to the expiration of the lease term and (ii) rent paid by other tenants for comparable space within the surrounding area.[iii] However, the lease was subsequently amended several times, and such revisions modified the renewal provision. The fourth lease amendment provided that the lease would expire on October 31, 2020 and provided tenant with an additional renewal option. Rather than using the “market rent” formula that was set forth in the original lease, the amendment instead provided that the monthly rate for the renewal term would be at “the current market rate as negotiated and agreed between [l]andlord and [t]enant,” with all terms and conditions of the lease remaining unaltered unless “expressly modified” by the amendment.[iv]
Tenant timely notified its landlord of its intent to exercise the renewal option contained in the fourth amendment; however, landlord and tenant failed to reach an agreement as to the rental rate during the renewal term.[v] Upon the expiration of the then-current term, landlord demanded that tenant vacate the leased premises.[vi] Tenant proceeded to file an action for specific performance and declaratory judgment, and landlord subsequently filed an unlawful detainer action against tenant.[vii]
The Missouri Court of Appeals, Eastern District, held in Green Street that the renewal option contained in the fourth amendment “expressly modified” the original lease’s renewal provision, and that the fourth amendment’s option was unenforceable due to lack of certainty.[viii] Real estate contracts are required to have a price to be enforceable, and the Court found that the fourth amendment’s provision providing that the renewal rate was to be determined after execution of the option to renew was an agreement without a price term.[ix] Since the term had expired and there was no enforceable option to renew, the Court held that landlord was entitled to immediate possession of the leased premises as a matter of law.[x]
Another recent Missouri case, Eighty Hundred Clayton Corp. v. Lake Forest Dev. Corp,[xi] also involved an unlawful detainer action. Here, a tenant failed to timely provide its landlord with notice of its intent to exercise its renewal option under the express requirements of the lease. Nevertheless, the court deemed that by tenant remaining in possession and paying rent after the expiration of the lease, and landlord accepting such payment, tenant had exercised its option and landlord had waived its right to notice.[xii] In Eighty Hundred Clayton Corp., a commercial lease was set to expire on October 31, 2019 and provided tenant an option to renew the lease for successive ten-year terms until 2049.[xiii] To exercise such renewal options, the lease required tenant to notify landlord of its exercise of the renewal option at least six months before the end of the then-current term.[xiv] No evidence was found that tenant timely provided written notice to landlord.[xv]
When the lease term expired, tenant held over in possession and continued to pay monthly rent, which landlord accepted and deposited.[xvi] Six months after the expiration of the lease term, landlord notified tenant that it considered the lease to be expired, but continued to accept and deposit rent payments until landlord later filed a petition for unlawful detainer to terminate tenant’s possession.[xvii] The Eastern District stated that when a lease provides that a tenant has the option to extend the term of the lease with a written notice requirement, the option is for the benefit of the tenant, and the written notice requirement is for the benefit of the landlord.[xviii] The Court further stated that by remaining in possession and paying rent after the expiration of the lease, tenant elected to exercise the renewal option, and by simply accepting rent, landlord waived the written notice requirement.[xix] The Court held that when these factors are proven, a tenant is deemed to have exercised its renewal or extension option as a matter of law, and the tenancy continues upon the same terms, conditions and covenants as in the lease.[xx]
Practical Analysis of Drafting and Negotiating Lease Extensions
The above cases establish important considerations to address (i) when drafting and negotiating lease extensions in commercial leases and (ii) when a tenant has exercised, or failed to exercise, an extension option. Green Street provides a reminder to tenants and landlords to make sure that lease extension options contain clearly written terms, including either the rental rate for the extension term or a clearly written mechanism for determining the rental rate during the extension term. Assuming that the rental rate for the extension term is not fixed at the time the existing lease is entered into, Green Street highlights the importance of clearly defining how rent is determined and avoiding language such as “to be negotiated and agreed upon,” which could be construed as an agreement to agree or an illusory promise. The most common methodology for determining extension term rent at a later date involves direct negotiations between the landlord and tenant for a set period of time, during which landlord will provide tenant with its determination of the extension term rent first. If the landlord and tenant are unable to agree on a rental rate for the extension term during the set period of time, an alternative can be included for the parties to turn to an appraisal or arbitration process for determining rent, or an option could be included for the tenant to rescind the exercise of the extension option (which will likely be resisted by landlords).
In the appraisal or arbitration process, it is common to see two methods of determination. In the first method, known as “baseball” arbitration, both the landlord and tenant will present their own determinations of rent to a qualified arbitrator, who then determines the rental rate that the arbitrator believes accurately reflects the market rent. In the second method, the “appraisal approach”, the landlord and tenant will each appoint an appraiser or qualified real estate professional to determine the market rent (i.e. the rent that a willing tenant would pay and a willing landlord would accept in an arms-length lease) for the extension option. With this approach, it is common to see language in the lease providing that if the appraisers’ submitted determinations differ by less than a certain percentage, the rental rate for the extension period will be the average of the two determinations. If the submitted determinations are not within the set threshold, the appraisers or qualified real estate professionals will mutually appoint a third appraiser or qualified real estate professional who will take the submitted determinations of the rental rate and determine the rental rate that the third appraiser believes accurately reflects the market rent.
In drafting and negotiating such a mechanism for determining the rental rate for the extension term, it is important for both the landlord and tenant to consider multiple factors which can impact the rental rate. First, it is helpful to define the appropriate market from which the extension rent is determined. For example, if the tenant is leasing class A office space in St. Louis City, provisions should be included stating that the market rent shall reflect the market conditions at the time of the extension for comparable properties in the class A office market in St. Louis City, Missouri within six months of the date the extension option is exercised. Additionally, a provision stating the required qualifications of the appraiser and/or arbitrator should be included to ensure that those selected by the landlord and tenant are qualified to determine the market rent. Requirements should include sufficient experience and expertise in the type of property being leased and the geographic area in which the property is located.
Along with the required qualifications of the appraiser or arbitrator, landlords should consider including a rental floor provision for extensions. These provisions typically will state that the rental rate during the extension term will not be less than the rental rate during the last year of the current term, protecting against a decline in rent. Finally, timing should be properly addressed. The amount of time for the landlord to deliver its determination of market rent, the period of negotiation between landlord and tenant, and the time frame for the appraisers and/or arbitrators to make their determinations should all be included. Timing becomes even more important for the landlord if the tenant has the ability to rescind its extension option. Landlords should ensure that they have ample time to market the leased premises to prospective replacement tenants in the event the tenant rescinds.
Additionally, conditions on the tenant’s right to exercise its extension option should be addressed. Landlords should push for the tenant’s exercise of its option to be restricted if (i) the tenant has been in default under the lease, (ii) the tenant has assigned or subleased all or a portion of the leased premises to a third party, (iii) there has been a material change in tenant’s financial condition, or (iv) tenant is no longer leasing the entirety of the original leased premises. The tenant, on the other hand, should attempt to negotiate a renewal provision that conditions renewal only on a material default existing beyond any applicable notice and cure period at the time the tenant would exercise the option.
Finally, assuming the extension option is not automatically exercised, how and when the tenant must provide notice to exercise its extension option should be specified. From a landlord’s perspective, tenant should be required to provide notice in writing via a specified delivery method (e.g. certified mail, return receipt requested) within a time frame sufficient for the landlord to market the property to prospective new tenants, should the tenant not exercise the option. Typically, the tenant is obligated to provide landlord with written notice at least three to nine months prior to the termination of the current term of the lease.
The cases summarized above not only highlight the importance of negotiating and including these factors in extension provisions, but Eighty Hundred Clayton Corp. also provides a cautionary tale for landlords on the practical effects of exercising an extension option. Generally in Missouri, if the lease specifies a type and manner of notice as exclusive for extension options, the provision must be complied with or the tenant’s election is invalid.[xxi] However, as shown in Eighty Hundred Clayton Corp., when a tenant holds over after the expiration of the lease and the landlord accepts rent payments, the landlord may be deemed to have waived the notice requirements under the lease, and the law implies a continuation of the original tenancy unless there are other factors which make it a question of fact as to whether a tenant exercised its extension option.[xxii] Accordingly, if the landlord desires to terminate the lease, the landlord must take appropriate steps to ensure that the extension option is not deemed exercised, and the notice requirement is not deemed waived, as a matter of law, even if the lease specifies a type and manner of notice for extension options. If a tenant holds-over after the expiration of the term and the extension option was not properly exercised, the landlord should avoid accepting rental payments from the tenant and should object in writing to the tenant remaining in the leased premises. Landlords should ensure that there is no question of fact as to whether the tenant effectively exercised its option.
Commercial Lease renewal options can benefit both tenants and landlords. The importance of carefully negotiating and drafting effective renewal options in commercial leases should not be overlooked. Recent Missouri case law illustrates the consequences of failing to adequately address lease extension options, which can significantly impact the business of landlords and tenants. Careful drafting is crucial in aligning the landlord and tenant’s expectations to avoid potential litigation and unnecessary third-party costs at the time of the lease extension.
This article was originally published by the Bar Association of Metropolitan St. Louis (BAMSL) in their Winter 2023 issue of St. Louis Bar Journal.
This column is for informational purposes only. Nothing herein should be treated as legal advice or as creating an attorney-client relationship. The choice of a lawyer is an important decision and should not be based solely upon advertisements.
[i] An unlawful detainer action can be brought when a person willfully and without force holds over any lands, tenements or other possession, after the termination of the time for which they were demised or let to the person. Section 534.030(1), RSMo.
[ii] No. ED 110459 (Mo.App. E.D. Aug. 30, 2022), at 1.
[v] Id. (emphasis added by the court).
[vi] Id. at 2.
[viii] See id. at 5.
[xi] 651 S.W.3d 217 (Mo.App. E.D. 2022).
[xii] Id. at 223.
[xiii] Id. at 221.
[xvi] Id. at 222.
[xviii] Id. at 223.
[xxi] See James v. Hutchinson, 211 S.W.2d 507, 508-09 (Mo.App. E.D. 1948).
[xxii] See also Grand investment Corp. v. Connaughton, Boyd & Kenter, P.C., 119 S.W.3d 101 (Mo.App. W.D. 2003) (quoting Pelligreen v. Century Furniture & Appliance Co., 524 S.W.2d 168, 171 (Mo.App. St.L.D. 1975)).