A sign of the times: Fair Market Rental Value.   In recent boom years, the term was seldom seen.  Rents were reaching new highs, and a consistent cost of living increase (CPI) or pre-set increase through the option term was acceptable to almost all parties.  It was a steadfast way to project cash flows on both the landlord and tenant sides.  Today, however, I can honestly say that the large majority of the leases that we negotiate integrate the fair market rental value as the starting point for the first year of any presented option term(s).   The question is: how do you establish the fair market rental value?  In other words, what is the fair way of determining the market rent of a particular space three, five, or even ten years down the road?

The price of a rental space can vary greatly over time, often out of alignment with the CPI.   Therefore, tenants and landlords often agree to adjust future rent based on the fair market rental value at that particular time.  The method of calculating fair market rent should be clear and unambiguous.  For example, the phrase “as mutually agreed upon between Landlord and Tenant” will lead to problems.  Similarly, a phrase like “as determined by Landlord” is really the Landlord’s way of saying that they are just not going to give you an option to renew.  Although many other methods exist, here are three other (and often better) ways to determine fair market rent:

Appraisal/Valuation Method. With the appraisal/valuation method, the landlord and tenant agree that an appraiser or even a real estate broker will determine the fair market rent.  The appraiser or real estate broker used should be stipulated in the lease, and ultimately, should be acceptable to both parties.  However, should landlord and tenant disagree on the appraiser or broker, the lease should stipulate a method as to how the appraiser or broker is selected.

Arbitration. If the landlord and tenant cannot reach an agreement, some leases attempt to resolve the problem by providing arbitration as a solution. While this sounds like a simple solution, arbitration can be both expensive and volatile, especially if the terms of the lease are ambiguous.

Baseball Arbitration. This one’s my favorite.  Not because it has sports in the title, but because it’s actually fair.  “Baseball Arbitration” is when each side makes its own determination of fair market rent and lets a neutral third party decide which determination is more accurate (that is, if the two sides do not reach the same conclusion in the first place).  In this case, it’s common for both parties to choose their own appraiser or broker to come to a fair market rent.  If the appraisers agree, then the rent is established.  If they are very close (usually within 10% or so), then the two appraisals are averaged.    And if they are too far apart, the parties (or often the appraisers themselves) pick a third appraiser, whose conclusion is averaged with the closer of the previous two.  I find this to be the best option as it eliminates the high cost of arbitration, and above all, is tedious enough to encourage the parties to reach an agreement on their own.

Ultimately, I think the most important requirement in determining fair market rent for a lease agreement is that before any of the above methods are used, the landlord and the tenant meet at least once to informally (or formally) discuss the fair market rent.  I would say that so long as both parties seem reasonable, the chances are pretty decent that an agreement will be reached without calling in outside help.

Santino DeRose

DeRose & Appelbaum | sd@deroseappelbaum.com | office (415) 781-7700 | cell (415) 336-0151

There is definitely a lot of hype on the Pop-Up restaurant these days.  It’s quite remarkable, really.  In a nutshell, a restaurateur finds a temporary home in an existing restaurant space to try out their concept and showcase their culinary skills.  If the concept doesn’t draw the crowds – well, then you close and maybe even try again.  The nice thing about the pop-up game, however, is that you get to keep your shirt if you lose.

The most well-known Mission Pop-Ups today are Radio Africa, Mission Street Food, and our boys at Wise Sons Deli.  However, the East Bay has gotten in the game with Guerilla Cafe and Local 123, both in Berkeley.   These businesses all share one common thought – they are aware of the amount of money that can be saved and the lessons that can be learned by entering the restaurant business through the Pop-Up location.

Considering that many losses are incurred as a result of high food costs, labor costs, and rent, the idea of having a trial run through a Pop-Up is actually kinda brilliant.  By having a fully equipped place to work, the operator and/or chef can focus on recipe development instead of choosing paint colors and glassware (how many mason jars can you drink out of, anyway…).  They can monitor food costs on a smaller scale before preparing their menu for the larger business, and they can learn how to efficiently staff their operation.  Most of all, they are not committed to the high restaurant rents as seen through the City, nor are they committed to a location or the lease that goes along with it.

There are several great articles written on the subject.  I would recommend the recent SF Chron article from food writer Tara Duggan – here.  She deftly analyzes the business side of the fad as opposed to the mere fashion.

It looks as though the Pop-Up restaurant works for everyone…..oh, except the City.   Will be interesting to see how the local governments will find new ways to profit if this concept continues to take off.

Santino DeRose / DeRose & Appelbaum, Inc. / sd@deroseappelbaum.com

Commercial Real Estate Brokers / San Francisco CA

We recently took on a couple of listings in San Francisco’s Chinatown for one of our favorite clients.  The spaces are located at 41 and 43 Ross Alley, in between Washington and Jackson Streets, and directly across from the Golden Gate Fortune Cookie Company – which I believe is the only one in Chinatown still hand rolling its fortune cookies.  While preparing these properties for the market, I wandered around Chinatown’s commercial market in order to get a better idea of what makes this neighborhood resilient to the commercial real estate downturn.

San Francisco’s Chinatown is the oldest in North America, and is said to be the largest Chinese community outside Asia.  There are two hospitals, numerous parks and squares, a post office and over 300 restaurants.  I read that Chinatown is the most densely populated neighborhood in the city, and in addition, one of the most densely populated neighborhoods in the United States.  Its estimated population in the 2000 census was at 100,574 residents, which accounts for two thirds of the overall ethnic Chinese population in San Francisco.

Maybe that density is one reason why Chinatown has a commercial vacancy rate of just 1.3%, the lowest in San Francisco.  Another possibility could be the profusion of businesses, ranging from the herbal shops to antique dealers to grocers and restaurants.  Whatever it is, Chinatown’s commercial real estate market is strong, stable, and desirable.  According to CoStar, the average annual rent in Chinatown is $30.88 per square foot, or approximately $2.58 per square foot per month.  In comparison, Union Square (one of San Francisco’s premier shopping districts) has only a slightly higher rental rate of $3.08 per square foot, but with a vacancy rate of 6.2%.  And Chinatown has more supply, with over 5 million square feet of gross leasable area.  Compare that to just over 3.2 million in Union Square.

After looking into the zoning, I also found that unlike its chain-free North Beach neighbor, Chinatown’s restrictions are loose – encouraging food, bar, and additional uses otherwise discouraged in North Beach.  Its businesses not only serve the neighborhood, but offer items such as spices and fish, attracting both people from surrounding areas and tourists from around the world. According to SF Gate, Chinatown has more visitors than the Golden Gate Bridge.

Due to zoning, local neighborhood support, tourist traffic, and eclectic businesses, Chinatown may have just the right formula to succeed in these down times.

Santino DeRose / DeRose & Appelbaum, Inc. / sd@deroseappelbaum.com

There is no doubt that the last few years have marked some of the most dismal of economic times.   Nevertheless, leases are still being executed all the time. With the help of new ideas and consistent small business financing, businesses continue to sprout in the San Francisco Bay Area and the rest of the country.  However, the liberal spending tactics that existed with new businesses just a few years ago are long gone, and have been replaced by conservative company policies focused on efficiency, longevity, and maintaining a tight belt.  As a result, today’s entrepreneur tends to lease just enough space to support their current business, with possibly some additional space – albeit a small percentage – designated to sustaining growth.

But what happens if/when the economy turns a corner and the space that was once acceptable now becomes too small?  Was there language in the lease that the tenant could have implemented that addresses this situation?  Simply put – yes.  I think that including language today in a lease agreement that that provides a tenant with (i) right of first refusal, (ii) a right of first offer, or (iii) terminations rights, will allow the tenant to lease additional or new space as the company grows, and also prevent the tenant from over-committing to unnecessary space while the business is in its developmental stage.

Interestingly enough, these clauses also provide incentives to landlords.

Under a Right of First Refusal, the landlord must first bring to the tenant any offer for an adjacent (or other space) space from a third party that the landlord would otherwise find acceptable, and the tenant is provided with a short time in which to meet the terms of the offer.  There is not much wiggle room here – the tenant either matches the terms exactly or loses their right to lease the space.  However, if the tenant does, in fact, match the terms, then the landlord is obligated to lease the space to the tenant, setting aside the offer made by the third party.  In today’s market, with buildings experiencing ten to twenty percent (or more) vacancy rates, a right of first refusal clause could be a clever way to provide expansion space for a tenant without tying the tenant down to a larger rent.

Another alternative is the Right of First Offer, in which the landlord notifies the tenant that a certain space will be coming available, and also provides the tenant with terms in which landlord would be willing to execute a lease with the tenant for the new space.  The tenant is again provided with a small window of time to decide whether or not they wish to move forward, and during that time, Landlord agrees not to offer the space to any outside third parties.   The right of first offer tends to be more neutral than the right of first refusal because it provides the tenant with the ability to lease a space, but only on terms set by landlord.  In this economy, however, the right of first offer may result in the landlord offering a similar rent as that of the previous tenant, or what could be a rent amount above the fair market rental rate.

In this economy, Termination Rights are also becoming more and more practical.  Termination rights allow a tenant or landlord to terminate the lease under certain circumstances or for no reason at all by providing the other party with a prior notice and possibly, a termination or relocation payment.  For a tenant, a termination option may prove to be beneficial as it provides them with the ability to terminate the lease and find new space altogether should they outgrow their space or wish to downsize.  A tenant’s termination right is most likely coupled with a lease termination or cancellation fee, which may be related to the anticipated losses incurred by the landlord as a result of having to re-lease the space, or may just be an arbitrary number negotiated by the tenant and landlord at the outset of the lease.  Regardless, although a termination fee may be expensive, it will usually be far less so than the remaining total rent due under the lease.   And landlords take note – if a tenant exercises their termination rights, keep in mind that recovering possession of the space provides you with the opportunity to recapture fair market rent and ultimately, come out ahead.

When negotiating a lease with a landlord or tenant, consider your long term goals with your company and/or your property – and include language in the lease that facilitates these goals.  It could be a win/win situation for the tenant and the landlord.