Julie Gattegno and Anna Ralston walk readers through the basics of rent review
Key points
- Rent reviews are contractual mechanisms – drafting is king
- The parties will need detailed valuation advice to identify comparable transactions and then advise on the valuation impact of the assumptions and disregards contained in the lease
- If a negotiated settlement cannot be reached, then a third party will determine the appropriate level of rent acting as either expert or arbitrator
Whether landlord or tenant, the amount of rent payable tends to be the thing that the parties care about most. But if the lease is for longer than five years, then it is likely that the level of rent that has been so carefully negotiated will only apply for part of the lease term. This is because most modern commercial leases which are longer than five years will provide for a review of the principal (also known as “basic”) rent payable under the lease, usually on a five-year cycle.
Therefore, the rent review clause will directly impact the level of rent that is payable for the later stages of a lease and is, as a result, vitally important.
Drafting is king
A key thing to remember is that rent reviews are contractual mechanisms. Though case law will provide some insight into how certain wording should be interpreted, the lease itself is king. The “output” figure on a rent review will depend on the valuation impact of the “input” (ie the words included in the rent review clause). Therefore, both landlords and tenants should spend time considering the proposed drafting (and its likely impact) – including taking valuation advice where necessary – before the wording is set in stone and the lease has completed.
The different types of rent review
• Open-market rent reviews. These are the most common and this article focuses on them.
• A review of the rent in line with the performance of an external index. For example, the rent will increase (or decrease) to mirror the performance of the Retail Prices Index. If the rent review is done by reference to a formula, it can be extremely useful to include a worked example to make sure the mechanism works, rather than finding out five years later that there is an issue.
• Fixed or stepped increases (which are agreed at the start). For example, it is agreed that the rent will be £100,000 for the first five years and then £125,000 in year six, £135,000 in year seven and so on.
What’s the aim of an open-market rent review?
The purpose of a rent review mechanism is well summarised in the following extract from British Gas Corporation v Universities Superannuation Scheme Ltd [1986] 1 EGLR 120:
“…the general purpose of a provision for rent review is to enable the landlord to obtain from time to time the market rental which the premises would command if let on the same terms on the open market at the review dates… to reflect the changes in the value of money and real increases in the value of the property during a long term.”
It is important to understand the purpose of a rent review clause. The drafting is king but if there is an ambiguity which needs to be resolved, then a judge will have regard to the underlying purpose.
For example, a judge will try to avoid a construction which would give a landlord a windfall benefit that it would never obtain if the landlord was actually letting the property on the rent review date.
Zoning in on open-market rent reviews
At its most basic, the point of an open-market rent review is to “recapture” what is the open-market rent of the property were a letting to occur at the relevant rent review date. For example, the lease completed in 2012 for 10 years and the rent agreed was £100,000 per annum. It is now 2017 (so five years into the term). The question is: what level of rent would the property achieve in 2017?
Rents go down as well as up and therefore it is perfectly possible for the parties to include an “upwards and downwards” rent review clause but, in reality, these are rare. The most common position is an “upward-only” open-market rent review.
This means that if the market rises, a landlord can capture that increase at the rent review. However, if the rent goes down, the tenant will continue to pay the same amount. This is because an upward-only rent review will require the tenant to pay the higher of the rent that is currently payable and the market rent at the review date. Therefore, the best outcome that a tenant can achieve at an upward-only rent review is a “nil increase”.
The Lease Code 2007 is voluntary for landlords. Although it does not prohibit upward-only rent reviews, it encourages a move to upward/downward rent reviews by stating that, if asked by a prospective tenant, a landlord should offer alternative rent review structures on a “risk-adjusted basis”.
However, to date, there has been little movement from the status quo (even during periods where the market was “tenant-friendly”) and upward-only open-market rent reviews remain the most common.
The mechanisms of an open-market rent review
In general terms, the rent review clause in the lease will usually provide that the parties are to assume there is a hypothetical letting to a hypothetical tenant of the actual premises on the relevant review date.
It is for a valuation surveyor to determine what that level of rent would be. Each party will instruct a valuation surveyor to argue its case. In most cases, they will agree a negotiated figure for the rent that should be payable from the relevant date. How do they do this?
The starting point is the “presumption of reality”, which means the valuation surveyors value what is before their eyes. The principle was explained in Basingstoke and Deane Borough Council v The Host Group Ltd [1988] 2 EGLR 147:
“Of course rent review clauses may, and often do, require a valuer to make his valuation on a basis which departs in one or more respects from the subsisting terms of the actual existing lease [ie the assumptions and disregards which are discussed below]. But if and in so far as a rent review clause does not so require, either expressly or by necessary implication, it seems to us that in general… the parties are to be taken as having intended that the notional letting postulated by their rent review clause is to be a letting on the same terms (other than as to quantum of rent) as those still subsisting between the parties in the actual existing lease.”
However, as in Basingstoke, the lease will usually provide for “counter-factual” assumptions or disregards to be made. This is where the surveyors are directed to value something other than how the property currently is. These are usually drafted with the aim of achieving a “level playing field” between the parties.
What assumptions and disregards should be included in a rent review clause is entirely a matter for the parties to agree and their lawyers to draft. There is a freedom to include whatever the parties can agree but there are a number of common assumptions and disregards. Some of these are:
• An assumption that the property is vacant (and a disregard of any of the goodwill that attaches to the premises by virtue of the tenant’s occupation). This is with the aim of “replicating” a new open-market letting of the premises and to ensure the tenant does not have to pay an increased premium for having successfully traded from the premises.
• An assumption the property is in repair and that the tenant has complied with its lease covenants. This is so the tenant does not benefit from its “bad behaviour” by securing a lower level of rent because the premises are valued as if they are not in repair (even though the tenant should have kept them in repair).
• A disregard of any improvements carried out by the tenant. This is so the tenant is not penalised by having to pay a higher rent because works it has carried out to improve the premises are rentalised.
Then the parties’ valuers will try to find evidence of comparable lettings to support the level of rent for the premises subject to review. This is where the actual premises and terms of the lease are compared with: (1) recent “arm’s length” lettings in the open market (which is the best “grade” of evidence); or (2) recently agreed rent reviews; or (3) recent renewals under the Landlord and Tenant Act 1954 (this is a lower quality of evidence and it can only be considered where a rent is agreed between the parties,
as opposed to a rent which is determined by the court).
The aim is to find a similar property in a similar location for a similar use that has recently been let in the open market (where both parties had the freedom to agree a level of rent and do a deal or walk away).
Once a comparable transaction has been identified, the valuer will make adjustments to the level of rent from the comparable transaction to take into account differences between the subject premises and the premises from the comparable transaction, with the aim of making the two as similar as possible.
Then there will be a negotiation to try to agree the level of rent payable from the rent review date.
What happens if the parties cannot agree?
Again, the rent review clause – if properly drafted – will determine what happens next.
Usually, the parties are free to appoint a third party to determine the level of rent if agreement cannot be reached. If they cannot agree on who that third party should be, then the RICS will usually choose.
The third party can be appointed as expert or an arbitrator. There are significant differences between a rent review that will be determined by a third party acting as an expert and a rent review that will be determined by a third party acting as an arbitrator. Two of the major ones being (1) the extent to which the third party is restricted to making a decision based on the evidence presented to them (an arbitrator) or whether they can take into account their own expertise (an expert) and (2) the rights of appeal if a party is dissatisfied with the third party’s decision.
Why this matters
Rent tends to be what parties care about the most. The rent review mechanism is instrumental to determine or set the rent that will be payable in the later stages of a longer lease.
Who needs to know
- Landlords
- Tenants
- Agents
- Lawyers
Further reading
- Woodfall on Landlord and Tenant (Sweet & Maxwell)
- Handbook of Rent Review, Kirk Reynolds QC and Guy Fetherstonhaugh QC (Sweet & Maxwell)
- British Gas Corporation v Universities Superannuation Scheme Ltd [1986] 1 EGLR 120
- Basingstoke and Deane Borough Council v The Host Group Ltd [1988] 2 EGLR 147
Julie Gattegno is a partner and Anna Ralston is a senior associate in the real estate disputes team at CMS Cameron McKenna Nabarro Olswang