by David Parker
The increasing prevalence of leasing incentives against the background of a rising vacancy rate in the City of London office market has drawn attention to the effect of such incentives at rent review. With five-yearly rent review patterns as standard and a relative infrequency of oversupply, this phenomenon is a new challenge for the UK rent review surveyor.
In Australia, however, the role of leasing incentives in rent reviews has been a contentious issue for the past two years. It is common to have two- or three-yearly open market rent review patterns within leases of office accommodation in the major Australian capital cities. This, coupled with considerable oversupply of office accommodation recently, has led many advisers, landlords and tenants to consider in depth the effect that the granting of incentives for a new letting or a lease renewal has on the review of rent to open market value for an existing tenancy.
Vacancy rates for prime office accommodation at December 1990 were estimated by Jones Lang Wootton to be as follows:
By international standards, the level of vacancy in all cities except Canberra is unusually high. During the past four years, the movement in vacancy rates has been a generally upward trend as shown in the graph opposite.
The local press abounds with unconfirmed reports of significant leasing incentives, such as:
- three years rent free to Mallesons, a major firm of solicitors, for committing to lease 20,000m2 in the as yet unbuilt Governor Philip Tower in the Sydney CBD;
- the provision of the equivalent of between five and six years rent free to Arthur Andersen for committing to a 12-year lease of 12,000m2 in Melbourne Central, Melbourne;
- a total of $A37m being applied in incentives in the leasing of 333 Collins Street, Melbourne — a high-rise office tower in the CBD;
- five years rent free for the legal firm, Parker & Parker, who committed to lease accommodation in Perth’s QV1 building (though this deal subsequently failed to proceed).
Against such a backdrop, many hundreds of open market rent reviews have been successfully agreed over the past two years in the major capital cities — including all the rent reviews in Sydney’s premier office tower, the State Bank Centre, owned by Schroders Property Fund. This could be interpreted as suggesting that the role of incentives in open market rent reviews was uncontentious, but this is far from the case.
As in the UK, the Australian valuer’s first job in assessing the rent at review is to look at the precise wording of the rent review clause. Words like “fair”, “reasonable” and “best” when applied to rent in the review mechanism cause the same problems in Australia as they do in the UK. The same applies to a series of hypothetical assumptions attached to the definition of rent to be agreed on review (such as assumptions of vacant possession, yearly rent etc).
While being aware of precedent such as the Bishopsgate(*) case, the valuer’s approach to the interpretation of lease incentives in the context of a rent review in Australia is guided by two key decisions in the local courts.
The landmark case of Edmund Barton Chambers (Level 44) Co-operative Ltd v The Mutual Life & Citizens Assurance Co Ltd (1986) 6 NSWLR 322 provided the first judicial guidance on the issue. The case concerned a lease of accommodation in the MLC Centre in Sydney, generally held to be one of the city’s prime office buildings. The review clause specified a review to “current market rent” and the court considered, in particular, the relevance of different types of evidence.
Glass J concluded that “rent review rentals constitute material relevant to the determination of current market rent” but that such rents were not the product of market forces and, as such, may “require adjustment up or down in the process of determining current market rent”. The court, therefore, effectively concluded that evidence from rent reviews should not be disregarded but that evidence from free bargaining is superior.
This clearly places the onus on the valuer to have primary regard to evidence derived from open market lettings as same is higher order evidence than that derived from rent reviews, with the latter requiring “adjustment” to establish the market rental level. It is interesting that the court did not consider the extent, if any, of adjustment required to evidence of open market lettings which included leasing incentives.
Judicial instruction to valuers was taken further, at about the same time, by the Victorian case of Broken Hill Pty Co Ltd v Australian Mutual Provident Society (1986) (The Valuer — October 1986). The case concerned a lease of office accommodation in Melbourne subject to rent review in 1982 when the market was in a position of significant oversupply giving rise to a two-tiered market where rents achieved on new lettings (between a willing lessor and willing lessee) differed from those achieved on rent review (between a willing landlord and a sitting tenant) though the rent review machinery in the subject lease did not cover such an eventuality.
Nicholson J commented that:
Where a rent obtainable on the market is to be assessed, it is the market which must be examined and the market would include rents payable by continuing tenants as well as new tenants … the figure (that the arbitrator) would arrive at would ignore special discounts to new tenants in order to attract them into occupation but would similarly ignore loadings which might be attached to the rentals payable by an existing tenant such as taking into account factors of the expense of a move and corresponding inconvenience resulting therefrom.
The court, therefore, effectively confirmed the decision in Edmund Barton and acknowledged that evidence from both new lettings and rent review/lease renewal was applicable but that same was to be subject to adjustment by the valuer to derive a market rent.
The requirement to adjust comparables to obtain a market rent is significant, as it effectively suggests that evidence from both new lettings and rent reviews/lease renewals are not directly admissible as evidence.
Although interesting, the judgment does not give objective guidance as to the basis upon which “discounts” and “loadings” are to be quantified or treated, effectively leaving same to the valuer’s experience and the precise wording of the rent review clause for interpretation. Thus, while giving some direction as to the admissibility of evidence, the court simultaneously created further potential areas of dispute regarding interpretation.
Exactly how a valuer regards incentives in determining a rent in Australia can be supposition only, as each individual valuer may approach the issue differently before arriving at his opinion. As in the UK, a rent determined as such is just that — an opinion — and two valuers can have very different opinions given the same information.
There has been considerable discussion of late in Sydney regarding the interpretation of leases that contain a rent review clause which requires a review to open market rental value but, later in the lease, have a clause that instructs the parties to disregard the effect of incentives, either in the subject building or in the market as a whole. Given that such clauses are not uncommon for office leases in Sydney, how should a valuer approach such a clause? As yet, there is no definite answer.
It has been suggested that, in this circumstance, the rent review clause may be capable of consideration in isolation and, as such, the valuer merely has to address what is the open market rental value in accordance with the rent review clause. Whether in addressing this issue the valuer takes into account incentives is a matter for his own professional skill and judgment.
It is often contended that the clause requiring the valuer to disregard incentives may be severable and so could be disregarded in interpreting the rent review clause. However, in the recently reported Rosenblum’s case, the Supreme Court of New South Wales held that, as the parties to the contract had specified that incentives were to be disregarded, then that is what should happen.
A variation on this theme, which also occurs in some Sydney office leases, is a rent review clause that requires the valuer to determine the rent payable at review on the basis of a series of assumptions.
One such may be that the valuer is to disregard incentives. Here, the assumption is contained within the rent review machinery and not elsewhere in the lease. It is suggested that, in this case, the valuer is not seeking to assess the open market rental value of the tenancy but, instead, has to assess what is the hypothetical amount that the hypothetical tenant would pay the hypothetical landlord if all the hypothetical assumptions as specified in the rent review mechanism are made. This view is, of course, consistent with that of Fox LJ in Denis & Robinson Ltd v Kiossos Establishment (1987) 54 P&CR 282.
There is, as yet, no consensus regarding the treatment of the above among Australian valuers though, as more reviews are settled or determined, a pattern may be expected to emerge — probably assisted by local and international legal precedent. In a very recent case concerning a Brisbane office tower, the Supreme Court of Queensland reiterated that evidence of other rents should be adjusted or discounted to take account of any incentives. Accordingly, the issue of incentives is beginning to lead to sporadic litigation throughout the mainland cities of Australia as landlords and tenants negotiate rent reviews in a market characterised by oversupply.
A common problem in Australia, as in the UK, is that most of the major leasing transactions involving incentives are also subject to confidentiality agreements. Unlike the UK, there does not appear, as yet, to have been any cases of agents being threatened by subpoena to disclose details of incentives in particular transactions with which they were involved. This is, however, a topic that has been discussed with increasing frequency of late among valuers locally and the outcome of similar situations in the UK will be closely observed.
As the economic recession continues in Australia and the prevalence of incentives in the leasing market is maintained, it could be expected that both landlords and tenants will become more aware of the rent review clauses in their leases and seek to exploit any opportunities provided by same. Though relatively low-profile to date, with few significant disputes reported and many parties not seeking professional advice at rent review, given the considerable sums of money now involved, the vested interests of landlords and the pressures facing the businesses which form the majority of tenants, the role of incentives in rent reviews is likely to become all the more contentious in Australia in the future.
As will be evident from the above, there are many parallels between the approach to incentives at rent review in Australia and in the UK. It is not inconceivable, therefore, that custom and practice created by Australian valuers in the negotiation of rent reviews in a climate of oversupply of office accommodation may provide a precedent for UK chartered surveyors facing similar situations.
