by Colin Bell
As the vacancy rate for City of London office accommodation has increased from 2% in 1987 to approximately 14% today, extended rent-free periods and inducements have become a normal factor of the market, widely available, in order to attract both the hypothetical and the actual tenant. Against this background it is perhaps an appropriate time to review just how far from its original intention the modern rent review clause would appear to have moved in practice.
It is now five years since the case of 99 Bishopsgate Ltd v Prudential Assurance Co [5] 1 EGLR 72; (1985) 273 EG 984 in which the Court of Appeal upheld the tenant’s appeal under section 1 of the Arbitration Act 1979 and substituted the arbitrator’s alternative award.
The case involved a 300,000-sq ft tower block in the City of London, let for a term of 98 years, and full details were widely reported in both Estates Gazette and the Handbook of Rent Review (Case 53). However, it is useful to reproduce the arbitrator’s alternative award verbatim to illustrate the impact a rent-free period had on the eventual rental level established:
Under my alternative award it is necessary for me to assume that the entire building is vacant and that a lessee holding under the subject lease would … require an allowance for marketing to find tenants for the entire subject premises, and additionally would probably find it necessary to allow prospective subtenants a rent-free period for completing the fitting out of the premises to suit their requirements prior to actual occupation. While at the valuation date there was a shortage of prime and prestigious accommodation in the City centre core suitable for potential tenants within the banking and financial services’ sector, the effect on the market of the availability of 300,000 sq ft in a tower block would in my opinion enable prospective tenants, particularly tenants with a high calibre of covenant, to negotiate more favourable terms than those which generally applied as at March 25 1982. Hence I would find and award the 16-month rent-free period claimed by the respondents … but as I find it likely that any such underlettings would be for a term of 14 years, I have applied this rent-free period over that term rather than over the period of seven years for which they contended.
In his alternative award the arbitrator determined the rent at £6,065m pa compared with £6.7m in the actual award two years earlier, a significant reduction of 9.47%. I do not propose in this article to comment on the mathematical formula adopted by the arbitrator; clearly there have been a variety of arbitrators’ awards which have indicated alternative methods of dealing with rent-free periods.
However, the case appeared to clarify the assumptions made in rent review negotiations regarding the meaning of the words “vacant possession”. Where the words “vacant possession” appear, the valuer is now generally required to assume that the actual tenant has moved out and that the premises are on the market to let with vacant possession, (a) in the condition assumed to be in accordance with the terms of the lease; and (b) generally disregarding any improvements the tenants may have undertaken. The 99 Bishopsgate case was therefore a landmark case in opening a line of argument of considerable financial advantage to the tenant in a weak letting market.
In today’s depressed letting market a tenant generally receives a rent-free period in negotiating a lease on new premises. However, since the 99 Bishopsgate case, not surprisingly, landlords, legal draftsmen and surveyors have endeavoured to find an alternative form of words to overcome what has become known as the “rent-free” argument in new leases themselves. Indeed, the RICS and Law Society have issued guidelines contained in the “Model Form of Rent Review Clause” (1985 ed) which are widely adopted. The inevitable result, five years on, is that we are now beginning to see a number of leases of a hybrid nature subject to review, particularly where the wording adopted has moved the argument rather further than was originally envisaged in favour of the landlord.
It is, I believe, generally accepted by both landlord and tenant that a rent-free period is an initial concession (excluding for one moment any incentive element) made by the landlord to enable the tenant to fit out the premises to his specific requirements and that this single concession should not apply at future reviews where the tenant is, of course, in actual possession. Thus, the willing landlord is prepared to accept a rental of, say, £50 per sq ft throughout the term, with the provision for review generally every fifth year; the tenant is prepared to pay that rental throughout the term, provided he is given a realistic rent-free period to fit out the premises to his specific requirements at his own cost.
The words “fit for immediate occupation and use” in the rent review clause have, until now, therefore been regarded as the appropriate form to reflect the interests and intentions of both the landlord and tenant. But since 99 Bishopsgate a number of alternative forms of wording have come into use, such as “fitted out for immediate occupation and use”, “equipped for immediate occupation and use” and many other derivatives which perhaps go beyond the original intentions of the parties.
Richard Ellis have recently been involved in a rent review dispute on a 2,500-sq ft unit, which forms part of a 200,000-sq ft building, where the lease contained very standard valuation assumptions but included the words “fitted out for immediate occupation and use”. I set out the precise wording of the rent review clause, defining the market rent, as:
the annual rack rent at which the demised premises in good order, repair and condition (assuming if not fact that no wants of repair or renewal are outstanding in respect of the whole or any part of the demised premises) if vacant at the commencement of the review period could be let at that time either as a whole or to the best advantage in the open market by willing landlords to a willing tenant assuming that vacant possession of the demised premises could be given for a term of 25 years and on the same terms and conditions as are contained in this Lease and assuming that the demised premises are at the commencement of the review period fitted out and available for immediate occupation and use by the tenant provided that in calculating the market rental value for the purposes of this Clause there shall be disregarded:
(a) any effect on the rent of the fact that the tenant has been in occupation of the demised premises;
(b) any goodwill attached to the demised premises by reason of the carrying on thereat of the business of the tenant;
(c) any effect on the rent of any improvement to the demised premises carried out by the Tenant otherwise than in pursuance of an obligation to the Landlords;
(d) any effect on the rent of any rent free period or hypothetical rent free period granted or to be granted to an ingoing tenant.
In this instance, the hypothesis was advanced successfully that because the premises were assumed to be vacant but “fitted out for immediate occupation and use” the hypothetical tenant would make a “premium” bid to reflect the fact that he would not have to use his own capital to fit out the premises himself.
If the open market rental value of the premises on a “vacant possession” basis was, say, £50 per sq ft, it was argued that because the premises were deemed to be already fully fitted out for immediate occupation and use that the hypothetical tenant would increase his bid to reflect this fact, as the premises would meet his specific requirements.
If this line of argument is tenable, it then becomes open to debate as to the amount of increase in rental the hypothetical tenant might be prepared to bid. Take a very simple example: let us assume that a 10,000-sq ft office building would normally cost the tenant, say, £30 per sq ft to fit out with partitions, kitchen and dining rooms, etc. According to the argument, this could potentially represent £300,000 which the tenant would not have to spend on the assumption that the premises are already fully fitted out. It becomes a relatively simple step to show that the tenant may be prepared to increase his rental bid by the cost of borrowing and repaying this amount of capital, say, £5 per sq ft pa, equivalent in this example to a full 10% increase in rental.
The extent to which the logic of the “fitted out” assumption can be pursued is open to debate. It may be possible to argue, if the principle is correct, that the “fitted out” assumption goes well beyond the simple partitioning. Could it, for example, also include the provision of desks, telephone systems and the tenant’s normal movable trade fixtures, as these are certainly required if the tenant intends to take immediate occupation and to make use of the premises at the date of review? Clearly the greater the cost of fitting out and the more it is assumed that the tenant’s specific requirements are already catered for, the greater the tenant’s actual rental bid might be expected to increase correspondingly.
Having taken counsel’s opinion, the expert in the dispute to which I refer eventually agreed the principle and added approximately 4% to the rent he would otherwise have determined to reflect the assumption concerning the meaning of “fitted out for immediate occupation and use”. If this principle holds — and it has yet to be fully tested — it may also apply to the assumption that the premises themselves are fit for “immediate occupation and use”. Was this really what the parties intended?
If, as advisers to both landlords and tenants, we are to achieve the original intentions of the parties in assessing the open market rental upon rent review in the future, there may be a clear need to go back to the drawing board to define a form of words suitable for the modern rent review clause.
I hope that this article will stimulate considerable debate in the legal and surveying professions. It is unlikely that we will know exactly what the words “fit”, “fitted” or “fully equipped for immediate occupation and use” actually mean until the courts have had an opportunity to consider the matter — as, inevitably, they will.
