Use ‘Baseball Arbitration’ to Settle Rent Disputes at Renewal Time

Here's an all-too-common scenario: A tenant's renewal option says the renewal rent should be set at the fair market value of the space at the time the lease expires. When the lease expires, the tenant says that the renewal rent should be $30 per square foot. But you determine that the space would rent for $60 per square foot on the open market.

The next step for you and the tenant could be a costly, time-consuming court fight. Or it could be a quick and relatively cheap procedure called “baseball arbitration,” says New York attorney Jacob Bart. Baseball arbitration is a good way to resolve disputes about real estate values, especially fair market rent disputes, he says. If your lease provides for baseball arbitration, you'll have a handy way to resolve any fair market rent disputes that come up.

We'll tell you what baseball arbitration is and how to include it in the procedures your lease sets out for determining the fair market rent in a renewal. And there's a Model Lease Clause on pp. 3–4 that you can adapt and use for that purpose.

Baseball Arbitration Basics

Baseball arbitration got its start as a way to resolve salary disputes between major league baseball teams and players who had become free agents, notes Bart. It has since become popular in commercial real estate.

Briefly, here's how baseball arbitration works for a fair market rent dispute: You and the tenant submit to “binding arbitration.” That means that you and the tenant pick an arbitrator and agree to abide by the arbitrator's decision. You and the tenant each tell the arbitrator what you think the fair market rent figure should be. The arbitrator chooses either your fair market rent figure or the tenant's fair market rent figure—no compromise is allowed. The arbitrator picks the figure that he believes is more reasonable and realistic.

If either you or the tenant proposes an unreasonable and unjustifiable figure, the arbitrator will likely choose the other side's proposed figure. As a result, you and the tenant are more likely to try hard to come up with a reasonable and realistic figure, notes Bart.

Advantage over Conventional Arbitration

Like many owners, you may find baseball arbitration more appealing than conventional arbitration because it solves one of the major drawbacks of conventional arbitration. In conventional arbitration, you and the tenant present your cases, and the arbitrator decides on a figure, which typically splits the difference between the amounts you each sought. For example, if a tenant wants to pay $30 per square foot and you want to charge $60, the arbitrator might pick $45. So you may be reluctant to entrust valuation disputes to conventional arbitration, even though it may be cheaper and faster than a lawsuit.

Baseball arbitration solves that problem by requiring the arbitrator to pick one figure or another, not some compromise figure in-between, notes Bart.

What Lease Should Say

If you decide that baseball arbitration is right for you, you'll need to set out in the lease how it works. You should include the baseball arbitration procedures, along with other procedures to determine the fair market rent for the renewal term, in a clause you place in the same lease section as the renewal option clause. (Note that the fair market rent is called “Market Value Rent” in our Model Lease Clause) [Clause, par. a].

Your lease clause, like our Model Lease Clause, should set the following five steps:

Step #1: You determine fair market rent. Make it your responsibility, when you get a tenant's notice that it wants to renew its lease, to calculate the initial determination of the fair market rent figure, says Bart. You'll give the tenant your figure in a written notice [Clause, par. b].

When should you give the tenant your figure? If the tenant requests the fair market rent figure in its renewal notice, give it that figure by a set date that's one month after the tenant's deadline to exercise its renewal option, says Bart. For example, if the tenant must exercise its renewal option by Dec. 31, 2005 (which is six months before the lease's expiration date), you must give the tenant the fair market rent figure by Jan. 31, 2006. If the tenant doesn't request the fair market rent figure in its renewal notice, then give the fair market rent figure to the tenant at least two months before the lease's expiration date, he adds. In the above example, you must give the tenant the fair market rent figure by April 30, 2006.

Step #2: Tenant accepts or rejects your figure. Allow the tenant only a short set time—say, 15 days—after it gets your fair market rent notice to accept or challenge your fair market rent figure, advises Bart. The shorter the period you set, the greater the chances that the tenant won't make its challenge in time. If the tenant doesn't challenge your fair market rent figure, that figure becomes “final and binding.”

To challenge the figure, require the tenant to give you a written objection notice, saying that the tenant disagrees with your fair market rent figure and proposing an alternative figure. To prevent a spiteful tenant from proposing a ridiculously low figure, require the tenant to determine its fair market rent figure in “good faith,” advises Bart [Clause, par. b].

Step #3: You and tenant agree or baseball arbitration begins. You and the tenant may agree quickly—say, within 15 days after you get the tenant's objection notice—to use the tenant's fair market rent figure or some other fair market rent figure. Then that figure will be final and binding. But if you and the tenant can't agree on a figure, have the baseball arbitration process start—by having you and the tenant appoint an arbitrator to determine the fair market rent figure [Clause, par. c(i)].

Step #4: Arbitrator is appointed. If you and the tenant agree on the arbitrator quickly within a set period—say, within 30 days after you get the tenant's objection notice—the process moves on to Step #5. But if you and the tenant can't agree on an arbitrator within that time, say in the lease that you or the tenant can ask the American Arbitration Association to designate an arbitrator. To protect your interests, you'll want an arbitrator who's experienced in real estate matters. So require either a real estate broker or consultant who has an MAI membership certified by the Appraisal Institute (meaning that the broker or consultant is experienced in the valuation and evaluation of commercial properties) and has at least a certain amount of continuous experience—say, 15 years—in appraising or managing real estate in your area, suggests Bart [Clause, par. c(ii)].

Step #5: Arbitrator issues decision. To keep the process moving quickly, require the arbitrator to issue a decision on the fair market rent quickly—say, within 30 days after being designated the arbitrator, advises Bart. Make it clear that the arbitrator's decision is final and binding on you and the tenant, so neither of you can try to change the chosen fair market rent figure. To be fair, you and the tenant should pay your own attorneys and split the other arbitration costs, he says [Clause, par. c(iii)].

Practical Pointer: If, for some reason, the fair market rent figure isn't set before the renewal term begins, require the tenant to pay the fair market rent figure that you proposed, advises Bart. If the fair market rent figure is finally determined as the figure that you proposed, the tenant will continue to pay that amount. But if the tenant's proposed fair market rent figure becomes the final figure, you'll have to refund any overpayment to the tenant, he says [Clause, par. e].

Alternative: Resolve Dispute Yourselves

Baseball arbitration can work so well that it may eliminate the need for an arbitrator, notes Bart. It disposes you and the tenant to try to pick reasonable renewal rent figures from the start. So the difference between the two figures often will be very small. Bart recommends dispensing with baseball arbitration if that happens. Instead, require that you and the tenant automatically split any difference if the tenant's figure differs by, say, 8 percent or less from yours, he says [Clause par. d]. For example, you propose $32.50 per square foot and the tenant proposes $30 per square foot, $2.50 less than your proposal. That's a difference of 7.7% ($2.50 divided by $32.50). You split the dollar difference ($2.50 divided by 2 = $1.25). The tenant pays $31.25 per square foot.

Although this may seem like the same kind of compromise that turned owners off arbitration in the first place, it's only a small compromise, Bart says, and it's one reached by you and the tenant, not by an arbitrator. The time and money you both save by resolving the dispute yourselves without an arbitrator should go a long way toward making up for the small amount you each may give up, he notes. Plus, there's no guarantee for either of you that an arbitrator would have chosen your figure.

CLLI Source

Jacob Bart, Esq.: Member, Stroock & Stroock & Lavan LLP, 180 Maiden Ln., New York, NY 10038-4982; (212) 806-5400; JBART@stroock.com.