This article was published in the Real Estate Law360 and Commercial Contracts Law360 on May 10, 2012. © Copyright 2012, Portfolio Media, Inc., publisher of Law360.
A right of first offer (ROFO) to lease is a contractual provision granting a tenant a preemptive right to lease additional space during its lease term. A ROFO is particularly useful in cases in which a tenant expects to grow during its lease term. When carefully negotiated, a ROFO can be beneficial to a tenant and not detrimental to a landlord.
A ROFO should require a landlord to present a tenant with an offer to lease any vacant space before it offers to lease the space to third parties. In some instances the parties agree that the ROFO will only apply to certain spaces (such as space that is contiguous to the tenant’s existing premises) or will not apply to space that is vacant at the time of lease signing (at least until it is leased and becomes vacant again). Once presented with the offer, the tenant has a set time in which to accept or reject it. The landlord may only offer the space for lease to third parties after the tenant rejects the offer or fails to respond to the offer during the period of time provided in the ROFO provision. The time period the tenant has to consider the offer is a point of negotiation. Landlords typically desire a shorter review period to avoid any delay in dealing with third parties. Tenants usually desire a longer period since the decision to take additional space is not always easy to make.
The terms of the actual offer will also be negotiated by the landlord and the tenant. For example, the landlord and the tenant may agree that, if additional space becomes available for lease, the landlord must offer that space (the ROFO Space) to the tenant on the same terms and conditions as the tenant’s current lease. Tenants usually desire this arrangement since they have already approved the terms of their existing lease. In addition, this would mean that the term of the lease for the ROFO Space would be coterminous with its existing premises. Generally landlords do not like to be bound to the current lease terms for ROFO Space because as time passes, the existing lease terms may be more favorable to the tenant than what the landlord could get from a third party. Likewise, if the term for the ROFO Space will be coterminous with the existing lease term, then the landlord could have to forego a longer-term lease with a third party in exchange for a shorter (coterminous) term with the existing tenant.
If the parties are going to use the existing lease terms as the basis for any ROFO, the landlord should insist that those terms will only apply if the tenant exercises its ROFO right in the early part of its existing term or, alternatively, that the existing term and the term for the ROFO Space will both be extended for some minimal term. Other adjustments to existing terms of a lease with respect to the ROFO Space are also warranted. For instance, if the term of the lease for the ROFO Space is going to be shorter than the term for the existing premises, the landlord has a shorter period of time to recover concessions (such as tenant improvement costs). Accordingly, if the ROFO Space term is going to be shorter than the original term those concessions should be reduced to account for the shorter term.
In the alternative, landlord and tenant may agree that the landlord’s offer of ROFO Space to the tenant will be same as that offered to a third party. Generally this arrangement is preferred by the landlord as it prevents the existing tenant from taking the space at what the landlord might believe is a below-market rate. In this case, the landlord gets the same deal as it was willing to do with a third party. However, this may not be acceptable to a tenant because it will then likely have two or more separate spaces with different lease expiration dates. The tenant should insist on making the terms of the lease for the ROFO Space and the existing premises the same. As such, the tenant should be willing to adjust the economic factors with respect to the ROFO Space to account for the shorter term. The tenant should also be willing to agree to extend its existing term, if needed, to ensure the landlord has an agreed to minimum term for the entire space if the ROFO Space is being added to the existing premises later in the existing lease term.
A third alternative for the parties is to provide that the ROFO Space will be leased at the fair market terms. There are many ways to arrive at fair market terms, such as using appraisers and arbitration. However, a properly drafted ROFO avoids the need to use this alternative because a landlord should not be permitted to offer terms to the tenant which are then materially improved when offered to a third party following the tenant’s rejection of the offer. Once the tenant rejects an offer made by the landlord, the landlord should have to re-offer the ROFO Space to the tenant if the landlord concludes it has to make the terms more favorable to a prospective tenant, for example because it is asking for a rental rate that is too high. This procedure should effectively determine the fair market terms. Accordingly, a tenant should insist that the landlord be obligated to re-offer ROFO Space to the tenant if the terms change significantly. The parties need to consider the entire economic package, such as allowances and base years not just the rental rate, in order to be able to compare one offer to another. Typically, the parties agree that if the terms of a landlord’s offer to a third party are materially more favorable to the third party than those terms offered to the tenant, then the ROFO Space has to be re-offered to the tenant on such more favorable terms. The parties usually agree in the ROFO what is “materially more favorable” in terms of a percentage change in the economic package. In this case the tenant should expect to have a shorter period of time to accept those more favorable terms than it had when it received the first offer since at this point the tenant should have already determined the terms upon which it might be willing to lease the ROFO Space. This process should continue until the space is leased to the third party or to the tenant.
A ROFO should not be confused with a Right of First Refusal (ROFR), which permits the landlord to market the building/space to third parties during the lease term, without first offering it to the tenant. Typically, with a ROFR the landlord finalizes its deal with the third-party tenant before it has to offer the same deal to the tenant. The tenant is then given a set time in which to accept or reject the offer. Landlords prefer ROFOs over ROFRs because ROFRs deter third-party interest as they leave open the possibility that a third party might spend valuable time and money negotiating a deal only to have the tenant swoop in at the last minute and take it.
ROFOs can be mutually beneficial to landlords and tenants, if drafted carefully. When negotiating a ROFO, it is important for both parties to understand what is important to the other party and to be flexible so that each party’s goals can be achieved.
Matthew J. Swett and Lauren M. Balsamo
"Leasing Corner" – a series of articles focusing on commercial real estate leasing. While the Pepper Hamilton Real Estate Practice Group handles all matter of real estate transactions, development, land use and litigation, one area in which we regularly provide legal services to our clients is commercial leasing. We have assisted many clients in connection with varied types of leases including, for example, ground leases, big-box and in-line retail leases, large headquarters-office leases, and laboratory, industrial and warehouse space leases.
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