What is meant by the term “constant rent”?
The purpose of periodic rent reviews is to maintain the value of the landlord’s income and to allow him to participate in any future growth in rental value. Even the briefest analysis of the changing patterns of rent review periods provides a clear indication of the effects of inflation and growth on rental value over time. The standard five-year pattern is now commonplace, but rent reviews were exceptional before the 1950s, and leases granted in the 1960s and 1970s on 14-year review patterns or longer are by no means unusual. Of course many of these leases are still coming up for review at a time when the vast body of comparable rental evidence will inevitably be drawn from leases subject to the modern pattern of reviews every five years.
It is widely accepted that, at times of inflation or growth in rents, a longer period between reviews will be of great benefit to the tenant. It creates an opportunity for a greater profit rent to be enjoyed over a longer period of time in between reviews, and provides the added bonus of a corresponding increase in the capital value of the leasehold interest.
In these circumstances it is not unreasonable to suppose that the tenant would be prepared to pay more for the privilege of a longer review pattern, over and above the rent payable for an identical property subject to the standard five-year interval. This amount is sometimes referred to as overage or uplift. The problem for the valuer is to determine the appropriate size of uplift in any particular case.
As is the case with many such issues in valuation, quantifying the amount of the uplift is often a matter of intuition. But, as there is no clear basis for the application of such an intuitive approach, this can give rise to uncertainty and dispute.
The principle of uplift is clearly supported by case law on rent reviews, and, in particular, case law on interim rents under section 34 of the 1954 Landlord and Tenant Act. Section 34, of course, requires the holding-over rent to be determined on the basis of a yearly tenancy. It has been successfully argued that a yearly tenancy, which, after all, provides no opportunity for a profit rent, would be less attractive to a tenant than a standard tenancy subject to a normal review pattern.
In Ratners (Jewellers) Ltd v Lemnoll Ltd(1), the amount of interim rent was in dispute and it was held that the rent payable under a yearly tenancy would be less than that payable for a term of years. Accordingly, a deduction of 15% was made from the open-market rental value.
By the same token, the relative attractiveness to a tenant of a lease with long intervals between review is widely recognised. It is normal to reflect this difference by making a percentage adjustment. The practice for an interval which exceeds the norm is to adjust by 1% to 2% for each year over and above the normal five-yearly pattern, to arrive at an “uplifted” rent.
The uplifted rent can be referred to as the “constant” rent because it is the figure at which the capital value of the interest will be constant or equivalent to its value, had the lease been subject to normal lease terms.
This is best illustrated by a simple example.
Example 1
What is the appropriate rental value on review for a shop let on a 21-year lease with a single review after 14 years? The only comparable evidence is the rent of an identical shop in the same location which is let on the standard five-year review pattern. The current full market rent for the shop let on the five-year review pattern is £15,000 pa, and rack-rented shops of this nature have been sold to show an initial yield of 5% on the full rack rent.
In this case an intuitive adjustment would suggest a rent for the shop under review of between £16,350 and £17,700:
This represents the increase in rent necessary to compensate the landlord for the length of time between reviews. For the purpose of illustration it is assumed that the landlord and tenant agree a compromise for the rent on review at £17,000. The extent to which the adjusted rent fully compensates the landlord for the longer review period can be assessed by comparing the capital values of the two shops.
Taking the yield of 5% on the comparable property, this produces a capital value of £300,000 calculated as follows:
In valuing the shop which is let with a further 14 years to the end of the lease, however, it is the uplifted rent which is capitalised for the term, but at a higher yield to reflect the comparatively inflation-prone nature of the term income, which is, of course, fixed for 14 rather than five years. Again, this adjustment would be made by intuition. Adjusting the yield to say 6% would result in the following valuation:
The adjusted valuation falls short of the value of £300,000 for the comparable shop and it would appear, therefore, that either the rental adjustment or the intuitive rate adjustment or a combination of the two are incorrect. Such an approach is clearly rather hit and miss. The fact that the valuation is tolerably close to £300,000 is fortuitous, based, as it is, on two intuitively derived variables.
An alternative and more precise approach is to use the constant rent formula from Rose’s tables(2) to arrive at the amount by which it is necessary to adjust the review rent to compensate the landlord for any loss of growth resulting from the comparatively long review period.
Rose’s constant rent formula
Where:
K = The constant rent factor
n = number of years between reviews in the subject lease
t = normal review period
g = implied growth rate
y = the lessor’s risk rate, or equated yield.
The equated yield is the overall yield required by the investor which should be based on the return which could be derived from a low-risk, no-growth investment such as government stock.
The normal review pattern in this case is, of course, five years and for the subject lease it is 14 years. The lessor’s risk rate can be taken to be his opportunity cost or the equated yield. It is normal to relate this to the return on medium-dated stock plus the allowance of a margin for risk when applied to property. This could be taken to be 13%.
Once a figure for the lessor’s risk rate has been established, the growth rate implied by the all-risks yield of 5% on a fully rack-rented freehold investment, with reviews every five years, can be established, using the implied growth rate formula.
Implied growth rate formula
where:
n = the number of years between reviews, five
d = the equated yield, say 13%
y = the rack-rented yield, say 5%
SF = the sinking fund to replace £1 at the equated yield over the period between reviews:
So, where the all-risks yield is 5% and the equated yield 13%, this implies that the average annual rental growth will be 8.71%. This value for g can then be substituted into Rose’s formula to find the value for K, the constant rent factor:
Constant rent calculation
Rose’s tables provide the necessary uplift figures for given lengths of lease, compared with normal rent review intervals, at given risk rates and a range of anticipated growth rates. As the growth rates are at intervals of 0.5%, direct comparison for Example 1 is not possible with the tables, but, at 9% growth and a 13% risk rate, the uplift figure is shown to be 1.341.
It is possible to check whether this is correct by comparing the value of the conventionally let shop with the capital value of the shop to be valued. Valuing the property with the conventional review period, using the initial yield derived from comparables, produced a capital value of £300,000. However, this simplified direct approach to value cannot be used in the case of the shop with the 14-year review period because the yield of 5% is derived from sales of shops with a five-year review, and to apply this direct would result in an over-valuation which would take no account of the comparatively inflation-prone nature of the term rent which will be fixed for 14 as opposed to five years. To use the conventional year’s purchase method would require the use of yields drawn from transactions in respect of properties with similar lease terms, and, of course, the problem here is that this evidence just does not exist.
A more accurate valuation can be attempted using the “rational model” which produces a valuation that applies the equated yield to the relatively inflation-prone term period, but which allows explicitly for rental growth on the review rent. The term is valued by capitalising the uplifted rent at the equated yield and the rent on reversion is taken as the current FRV suitably inflated at the growth rate and capitalised at the normal initial yield. Again, this approach is correct for the reversion on the assumption that after 14 years the landlord will take the opportunity to relet on more conventional terms.
Rational model valuation(3)
If the landlord is to be compensated for the initial loss of growth this can be achieved only by increasing the term rental value by the appropriate factor, which can be found using Rose’s tables or Rose’s formula. This calculation shows that the effect of increasing the term rent by the uplift found from Rose’s tables is to bring the value into line with the value of the comparable.
Alternatively, the uplift factor, K, can be found by comparing the conventional valuation of the comparable at £300,000 with the rational method solution. As can be seen below, without any increase in rent, the property would have a value of £269,086, the uplift factor when applied to the term rent will bring the two valuations into balance by increasing the term value to accord with the value of £300,000.
Valuation using rational model without uplift
Using the rational model to find K
The principle is that the landlord should be in no worse position than if his property were let on the same terms as the comparable which has a value of £300,000, so:
K = 1.327, which, of course, accords with the “uplift” figure shown by Rose’s formula. The above calculation is shown in conventional layout, but could equally be carried out using the rational method formula.
Calculation by rational model formula
In the example the calculations have been used to find the constant rent for a longer than normal period between reviews. The formulae could equally be used to find an interim rent, compared with normal rents, in exactly the same way. Of course, the K factor or the constant rent factor will be less than 1, indicating that the rent on a yearly basis will be less than the rent on a five-year review pattern.
Calculation using Donaldsons investment tables(4)
The above calculation using the rational method is shown to illustrate the theoretical correctness of the constant rent calculation using Rose’s tables or Rose’s formula. It is quite understandable that valuers are reluctant to undertake such lengthy calculations and an alternative means of finding K is by reference to Donaldsons investment tables by dividing the initial yield for the longer review pattern by the initial yield for the normal review pattern.
Taking a growth rate of 9% (the nearest figure in the tables to 8.712%, the growth rates in the tables are given only for increments of 1%) the initial yields are as follows:
Example 2
Use the evidence of the comparable shop let on a five-year review pattern at £15,000 to assess the interim rent of an identical shop.
Calculation using Rose’s formula
To be strictly fair, of course, these valuations should be carried out from both the landlord’s and tenant’s point of view. The answers will differ, particularly if different risk rates are applied to the value of the leasehold interest and even more so where the leasehold interest is valued using dual rate adjusted for tax. But it will at least provide a starting point for negotiations and it is suggested in Example 1 that if the landlord had carried out the above calculations, to establish that his break-even rent was almost £20,000, he would have been extremely reluctant to accept even the maximum rent of £17,700 suggested by the rule-of-thumb approach.
The issue does not end with the calculations and a number of arguments have been put forward in opposition to the method. These suggest that the bargain for the lease has been made and the longer lease term will have been reflected at the outset. There is also the objection that the use of any form of growth assumption is highly speculative and difficult to determine. A final argument is that the tenant is being expected to pay a rent which exceeds that of his competitors, by virtue of the front-loading which results, and this will affect his profitability in the short term.
There is, of course, some force behind these arguments, but Baum and Sams comment:
Whether such defensible (constant rent) techniques are to be employed by courts in the calculation of interim rents in preference to arbitrary deductions is by no means probable in the short run, but valuers should not be diverted from a professional approach such as this when suitable comparable evidence is unlikely to be found.(5)
Whatever the objections to using the constant rent method, it is surely preferable to pure intuition and does at least give both landlord and tenant a clearer indication of the effect of any agreement reached.
References
(1) Ratners (Jewellers) Ltd v Lemnoll Ltd (1980) 248 EG 987(2) Rose J J, Tables of Constant Rent Required to Compensate the Grantor of a Lease For the Omission or Deferment of a Rent Review Pattern, Technical Press Oxford, 1979(3) Sykes S G, “Property Valuation, A Rational Model” The Investment Analyst 61: 20-6, 1980(4) Marshall P, Donaldsons Investment Tables, 3rd Ed, Donaldson & Son, 1988(5) Baum A and Sams G, Statutory Valuations, Routledge, 1990
VAT on property
In the article on VAT on property (September 9, p 127), it was suggested that in the case of the sale or lease of bare land for residential development, the post-1989 treatment for VAT purposes is exempt from VAT. There is no distinction in the treatment of residential and non-residential development land, both being exempt with an option to elect to waive the exemption.
