No one wants to go to arbitration. It’s risky, unpredictable and has the potential to get contentious. Avoiding it is pretty much a foundational goal for everyone involved in lease renewal negotiations. And yet, sometimes it’s the only way to get where everyone needs to. In our careers we’ve only been involved in a small handful of arbitrations. But they’re fascinating and educational, and sometimes necessary.
So how do you end up in arbitration? We recently had a lease renewal that ended up in arbitration, so we thought it might be interesting to give you a picture of what happened, why and how, and the eventual outcome. This process took us a year to finish.
One of our most valuable landlord clients had leased a property to an independent retailer that was new to the market; this was 20 years ago. There were a lot of unknowns with the new company and its slice of the overall segment, but our client felt the tenant company was worth taking a chance on. The tenant negotiated a pretty favorable lease, at below-market rates for the time (around $16/sq. ft., for comparison purposes later), and has been thriving in that location and growing as a business for the ensuing two decades.
When the tenant’s lease was four to five months from its renewal deadline, we contacted them to start working on new lease terms. The tenant at that point was paying rent of $21.51/sq. ft., and had two five-year options at the end of their existing lease. The first five years was at fair market rate, and the second five years were at a 10% flat increase over the first five-year rate. Working with the landlord, we proposed a rate in the $33-$34/sq. ft. range for the market-rate option, which we thought reflected a fair current rent. They countered at around $24/sq. ft. So we weren’t really close, and here’s why: Settling on a number in this case was quite complicated.
There are multiple factors involved in trying to set a fair market rate for a retail property: location, property condition, market rental rates, rent versus sales ratios, etc. With NAI Elliott’s length and breadth of CRE experience, we have a lot of data we can access, and experience in assessing and interpreting it. It essentially comes down to triangulating between all the relevant factors, to develop some comparison points as references.
Now, if you’re buying a house in a suburban development, it’s pretty easy to find comps—similar homes that have recently sold—to get an idea of the value of your home, down to the square-foot level. But this was a different story; the tenant’s property was by far the highest-performing store in the now-growing chain. So us looking at rent-versus-sales ratios told one story, while the tenant’s view of fair market rates was skewed toward averages calculated across many properties.
Our job is to negotiate a palatable deal for our client, who felt there should be some consideration given to the fact that the original lease was done at very favorable rates and terms all those years ago. Now the tenant was doing blockbuster business: time to balance the scales a bit.
We offered a rate and terms; they countered with their own numbers. Rinse and repeat; the tennis match continued for months. Eventually the tenant agreed to what we considered a decent package.
And then, in the midst of the negotiation, there was a leadership change in the tenant company. Boom: new negotiators, new terms, new demands, reneging on previously agreed terms. Suddenly we were back to a lease offer that was not at all palatable to the owner.
Our landlord client was irritated. The tenant company wasn’t willing to move off their terms. Gradually everyone realized there wasn’t going to be an agreement without third-party involvement: arbitration.
How does arbitration work? Each side provides a broker or appraiser—an expert in the field who works from their perspective. Each expert comes up with a figure they think represents fair market rent. If the two sides still can’t agree, a third, objective expert must come in and make the final decision.
Why is it risky? There are two basic kinds of arbitration: “middle-ground arbitration,” and “baseball arbitration.” In middle-ground arbitration, the third expert can choose a final number anywhere in the range between the two side’s figures. In baseball arbitration (it’s called that because this is how it works in professional baseball), the third expert must pick one number or the other—no middle ground.
In our situation, the tenant’s expert came up with a figure of $27/sq. ft. Our expert came in at $31/sq. ft. The lease specified baseball arbitration, which could easily be called “winner takes all arbitration.” The final number was going to be either $27/sq. ft. or $31/sq. ft.; those were the only choices.
In this case, the arbitrator chose $27/sq. ft. And the deal finally closed, roughly a year after we started the conversation.
Our conclusion? It was just too hard to derive a reasonable number in this case, given the industry-outlier status of the property. Because the other side wouldn’t budge, we felt we had to take the risk.
It’s important to remember that arbitration is not personal: It shouldn’t be acrimonious, and you want to maintain a long-term relationship for mutual success. We would have liked a higher rent number— but in the end, the new rent is a 26% increase, our client has another 10 years of commitment from a successful tenant, and the tenant is likely to pay for several million dollars in improvements. We think the property will remain viable and continue to steadily increase in value over time.