3 Ways to Protect Yourself When Trading Renewal Rent Breaks for Tenant Improvements

Don’t get burned if the tenant doesn’t complete the improvements work.

Landlords may have to reduce renewal rent to retain tenants, especially when the market is soft. One way to reduce the financial bite of these concessions is to require the tenant to improve the space as part of the lease renewal or extension. Rent-break-for-tenant-improvement deals can be an ideal solution for certain situations. But you also need to get some key protections in case tenants pocket the rent breaks without making good on their promise to perform the improvements. Here are three different ways to accomplish that objective.

When Deals Make Sense

Trading renewal rent concessions for tenant improvements is a lemonade-from-lemons solution to consider when replacement tenants that are ready, willing, and able to pay at least what the current tenant is paying now are in short supply. In these circumstances, retention is likely to represent the best option. But that may also strengthen the current tenant’s hand in negotiating the terms of the extension or renewal. If the tenant uses that leverage to demand reduced rent, requiring improvements enables you to salvage something positive from the situation.

The key is making the renewal rent rate low enough to give the tenant an incentive to make the improvements. Such a deal may make sense when:

• The space is badly in need of repairs, which the tenant has been reluctant to make without any incentives; and/or
• The tenant’s space is highly visible and its rundown appearance is having a negative impact on both the tenant’s and your own business.

Example: A small deli located in the lobby has become something of a “fixture” of an office building, having occupied the space for over two decades. The problem is that it looks old and worn out, with a cracked and fading counter, torn stools, and other ancient furnishings that threaten to undermine the landlord’s recent investment to renovate and modernize the lobby. While loyal customers still come, the eyesore appearance drives away new diners, as well as prospective tenants considering leasing space in the building.

In this scenario, the landlord and tenant both have an interest in keeping the deli in the space while also burnishing its appearance. So, as the lease term ends, a renewal rent break in exchange for improvements could be a win-win.  

Make Deals Work for Both Sides

The costs and types of improvements you can demand in exchange for renewal rent breaks may range from the purely cosmetic, such as signage, awnings, minor furnishings, carpeting, or even a new coat of paint, to something more substantial, such as space expansions, replacement of HVAC and other systems, or installation of new counters, shelves, or other fixtures. It all depends on the state of the rental market, condition of the property, and, perhaps most important, what the tenant can reasonably afford.

For the deal to work, both sides need to benefit. From the tenant’s perspective, cosmetic changes alone may be enough to make the space more attractive and improve the volume and quality of traffic, while more substantial improvements might constitute a capital investment that makes the tenant’s business more efficient, cost effective, and competitive.

Of course, landlords also benefit when a tenant’s business improves. A financially stable tenant committed to a full extension or renewal lease term is a valuable asset that can improve traffic and the financial value of the property. The improvements may also make it easier to re-lease the space at a higher rent when the current tenant moves out.

3 Ways to Structure Rent-Break-for-Improvement Deals

The risks of agreeing to cut renewal rent in exchange for a promise to improve the space is that the tenant won’t follow through on its commitment. Getting the right lease language is the key to guarding against this risk. Specifically, there are three ways to structure the deal to ensure that you don’t get burned if the tenant doesn’t complete the improvements work.

Option 1: No Improvements, No Renewal. The first option is to make the lease renewal or extension contingent upon the improvements’ being completed by a specific date. You’ll need to give the tenant ample time to complete the improvements before the current lease expires. Accordingly, this kind of arrangement requires advance planning and can’t be made at the last minute.

The other downside of conditioning the renewal on the improvements is lack of flexibility. Resort to it only when you’re sure you want the tenant out if the improvements aren’t made. Take a different approach if you still want to be able to explore other renewal options with a tenant that doesn’t follow through on its promise to make improvements.

Model Language

The term of the Lease, due to expire on [insert expiration date of your current lease] (the “Expiration Date”), shall not be extended or renewed unless Tenant completes the renovation work set forth in Section __ of this Renewal Agreement on or before [insert date that falls before the Expiration Date] (the “Completion Date”). If Tenant (1) is not in default under the Lease or the Renewal Agreement, and (2) completes the renovation work on or before the Completion Date, the term of the Lease shall be extended in accordance with this Renewal Agreement. If Tenant does not complete the renovation work on or before the Completion Date, the Lease shall expire on the Expiration Date without any right of Tenant to renew or extend the same.

Option 2: No Improvements, No Rent Reductions. A less rigid way to protect yourself is to make not the renewal/extension but the rent breaks contingent on completion of the improvements. This way, if the improvements aren’t done by the deadline, the tenant can still renew or extend the lease at the current or originally agreed-to renewal rent without getting the lower rate.

An all-or-nothing approach might not work with a tenant in a strong bargaining position, especially if any previously agreed-to renewal rent is above current market rates. Instead, you might have to agree to reduce rather than totally eliminate the rent concession if the tenant doesn’t complete the improvements on time, at least until the improvements are completed. The tricky part will be to ensure that the gap between the completion and non-completion rent concession rate is enough to motivate the tenant to finish the work on time.      

Model Language

Provided that Tenant completes the renovation work set forth in Section __ of this Renewal Agreement on or before [insert date] (the “Completion Date”), then, in consideration for the performance and completion of such renovation work, the base minimum rent for the extended term shall be $____ per annum. If such renovation work is not completed on or before the Completion Date, then the base minimum rent for the extended term shall be $_____ [insert higher rental rate] per annum, until the date on which such work is completed.  

Option 3: Renew Now, Raise Rent or Terminate If Improvements Not Made Later. The way this approach works: The landlord agrees to renew or extend the lease at the lower rent. The sides specify the date by which improvements must be completed, which may be either before or after the renewal date, depending on how much time the tenant reasonably needs to finish the work. If the tenant doesn’t complete the work by the deadline, the landlord has the option either to:

• Terminate the renewal or extension lease term upon 30 days’ written notice; or
• Revoke the rent concession and require the tenant to pay higher rent, at least until it completes the work.

This approach gives you maximum control and an almost guaranteed favorable outcome. The tenant has a major incentive to make the improvements on time; and if it doesn’t, you get to either raise the rent or boot the tenant out if a more favorable prospect willing to pay higher rent for the space comes along. Of course, tenants are also likely to object to this alternative for these very same reasons. One way you might be able to make the approach more palatable to the tenant is by agreeing to accept either the rent increase or the termination option but not both.

Model Language

Tenant agrees to complete the renovation work set forth in Section __ of this Renewal Agreement on or before [insert date] (the “Completion Date”). Tenant agrees that if Tenant does not complete the renovation work on or before the Completion Date, then, Landlord, at its sole option, may exercise either one of the following remedies:

(a)        Landlord may terminate this Lease upon thirty (30) days’ written notice to Tenant at any time; or

(b)        Tenant shall pay to Landlord additional rent in the amount of $____ per annum, payable in equal monthly installments together with the base rent due hereunder, such payment to be effective thirty (30) days after Landlord’s written notice to Tenant exercising this option. [Optional:] Tenant shall continue to pay this additional rent throughout the extended term until such time as Tenant completes the renovation work.