by Patrick Cooke-Priest
In an article headed “Retail Lettings — Key money or opportunity value?” Leslie Aarons argued the necessity to return to first principles. In this reply, Patrick Cooke-Priest accepts that exhortation and suggests that Mr Aarons did not go back far enough.
In his article of September 24 1988 Leslie Aarons exhorted us to return to first principles: I therefore do so. In the beginning there was land, labour and capital. There now abideth these three but the greatest of these is land.
The landowner applies labour and capital to his land to create buildings. It does not matter whether he does this directly or with the aid of a developer. What he does is to provide a space in which a trader can trade. It is he who provides that opportunity: in return he seeks the best rent that the market is willing to pay. It is both misguided and illogical to suggest, as Mr Aarons does, that the trading opportunity is provided by a former tenant.
Before the second world war, and immediately afterwards, leases were usually granted for long terms at fixed rents. This, reflecting the opinions of the time, was because the rental value of properties was not expected to rise, and landlords preferred to have the security of knowing that the rent would be paid for a long period. For this reason the payment of substantial premiums for the purchase of leases was not common — before 1927, tenants were not even compensated when their leases came to an end. After the war, however, it was recognised that security of tenure should be given to the tenants of business premises, and it is this security, provided under the 1954 Act, which makes the acquisition of a tenancy of well-located trading premises so potentially valuable — and at the same time contributes towards the scarcity of premises coming on to the market.
It was also accepted that, in order to be fair to the landlord and to ensure that landlords would continue to provide suitable business premises, provisions for rent would have to be made in order to put the landlord in the position that he would have been in before the passing of the Act — ie, he would have been able to obtain vacant possession of his property and relet it on the open market. The effect on the supply of property resulting from a failure to do this is well demonstrated in residential property, where the supply has been reduced to a trickle because landlords cannot obtain the open market rental value.
The provisions for rent are contained in section 34 of the Act, and the clear intention of Parliament is that, with certain exceptions, the landlord is to be put into precisely the same position as he would be in if he were able to obtain vacant possession and put the property on the open market to let. This is the first principle to which one must return.
The exceptions are those matters which have become popularly known as “Section 34 disregards”. These refer to matters which might enhance the rental value of a property but which are not in any way attributable to the opportunity provided by the landlord but are ascribed either to the skill and reputation of the tenant as a trader or to his expenditure on the property, which he has incurred himself rather than the landlord. Even this is limited, for if the expenditure on the improvement to the premises has been carried out more than 21 years before the application for the new tenancy, it is not to be disregarded and the value of it accrues to the landlord.
The problem with assessing rent under section 34 is one of proof. Clearly it would have been nonsense for the statute to have empowered the landlord to force a temporary vacancy of the property, test the market, and then be required to relet it to the original tenant. What a wonderful opportunity that would have given a rival to put in a huge bid knowing that his competitor would have to pay, and could well go out of business. It is inevitable, therefore, that the burden of proof of a new rent falls upon the landlord, and he can only substantiate his argument by drawing the attention of the court to comparable transactions. In times of rising rents he will always be at a disadvantage in that these comparables are historic.
Obviously the best evidence is where he can point to a similar property, properly advertised and let in the open market with vacant possession: so often, however, the only evidence of an open market vacant possession transaction involves the payment of a premium. Clearly there are cases where the premium includes sums which are directly attributable to one or other of the section 34 disregards. If these sums cannot be separately identified then the premium is of little direct use in assessing the rent, other than to give an indication of the level of demand.
However, in many cases premiums are paid where no part can be attributed to the disregarded matters — where, for instance, the trade is changed and the shop is completely refitted by the new tenant. In these circumstances the premium can be attributed only (as Mr Aarons states) to the value to the new tenant of the opportunity of trading in the premises in the knowledge that he will have security of tenure. That opportunity is provided by the landlord.
Premiums of course are paid not at the end of leases, when the 1954 Act applies, but during the currency of leases. When security of tenure was first envisaged rental values were virtually static and premiums were not in fact paid except for goodwill or for the purchase of tenants’ improvements. Premiums have arisen with the rise in open market rental values — clearly an indication that they represent the rental value of a property over and above that which is payable under the lease, and possibly also that which is expected to be payable in future. If the intentions of Parliament in drafting the 1954 Act are to be properly carried out, that value belongs to the landlord with effect from the next renewal.
Some time after the early 1950s, rent review provisions began to be introduced in leases providing for the landlord to increase the rent during the currency of a lease. As values increased more rapidly so the frequency of these reviews was increased. In considering rent review clauses it is usually the landlord’s intention that the rent shall be reviewed to the full open market value with vacant possession and these clauses are often similar to the provisions of section 34 of the 1954 Act. The two words “vacant possession” do not appear at all in Mr Aaron’s arguments, yet these are of vital importance to the assessment of rent and the consideration of the treatment of premiums. Premiums are not paid for premises without vacant possession. Therefore, if there is some other assumption in a rent review clause, premiums may not be useful evidence. However, after taking out any element to be disregarded, what is left can only be capitalised profit rent, however it is otherwise described.
Mr Aarons states, rather simplistically, that premiums or key money will disappear if the level of demand for property is reduced, citing as an example that premiums are not paid for properties in new shopping developments where a number of shops are marketed at the same time. This is perfectly true — but does the idea of a vacant possession valuation require the hypothetical assumption that other properties are also on the market at the same time? If so, how many — two or three properties, a whole street, the whole town? This is surely too far fetched, and in any case would be a distortion of the very market which is supposed to be reflected in the rent. Therefore, the hypothetical market to be assumed for rent review or section 34 purposes is intended to be exactly the same as the real market. In my view, having found a premium which is uncomplicated by disregards, only the method of devaluation remains to be considered.
In strict logic, premiums should be devalued for the period up to the next rent review but, as we have seen, rent reviews and lease renewals are based on historic evidence, and in times of rising values this gives the incumbent tenant an advantage which is no doubt reflected to some extent in the premium. It is, however, possible to take a view on the extent to which a rent, proved by historic evidence, is less than the rent achieved in a genuine open market letting.
With the benefit of hindsight it is possible to do this quite accurately. Part of the premium should therefore be devalued up to the time of the next rent change and the balance over the expected occupancy of the incoming tenant in question. Under current law this could be an indefinite period — but the valuer must take a view.
Clearly the level of premiums being paid reflects the view that they will not in fact be taken into account when the rent is next assessed, for to devalue some of the premiums over the period to the next rent change would produce rentals which are patently absurd. In order to overcome this problem it is probably necessary to devalue these premiums over a longer period, perhaps for the rest of the lease or for the rest of the lease plus a statutory extension of 14 years, even though this procedure is not logically sound. It is my view that if purchasers of leases were aware that the prices they paid would be reflected in their rents at the next change, premiums would fall to more sensible levels, and values, which rightly belong to landlords, would be restored to them.
As a check on this approach to premiums, consider the position when a trader is unable to assign a lease because the open market rental value has fallen or — to put it another way — because the demand for the property has fallen. He offers a “reverse premium” — a capital payment to compensate the incoming tenant for the liability to pay excess rent for a period, perhaps until the end of the lease. When that happens the landlord has to accept a reduced rent on renewing the lease, just as he is entitled to an increase if the market has risen.
Finally, Mr Aarons should not be exhorting courts and arbitrators to ignore premiums. He should give more heed to the case of Warrington & Runcorn Development Corporation v Greggs plc [7] 281 EG 1075, in which leave to appeal under section 1 (3) (b) of the Arbitration Act 1979 was given to the landlords precisely because an arbitrator had failed to take account of premium evidence.