Tenants, reviews, renewals and rent

An understanding of landlord and tenant is not a requirement of management surveyors alone. This introduction discusses the basics Landlord and tenant work broadly comprises rent reviews and lease renewals, together, for example, with assignments and sublettings, user provisions and repair/dilapidations. A basic introduction is provided here mainly for students, but also for property support staff who may become involved in the more straightforward case work traditionally undertaken by the surveyor. Rent review The purpose of rent review is to maintain the rental value of a property, helping keep the rent in line with inflation and the general rise in property values. This also helps to maintain the capital value of property, also known as investment value, bearing in mind that the general objective of landlords is to secure growth in rental and capital values in order to maximise profitability. At rent review, the landlord and tenant seek to establish a new “market rent”, known also as the “rack rent”. The lease contains a range of assumptions and disregards relating to a “hypothetical” letting. This ensures that the valuer assesses the amount of rent that the property would expect to achieve if exposed to the market, seeking to attract a tenant on the basis that the property is vacant – and therefore ignoring the presence of the current tenant. This “open market” basis is the most common means of review, but rent may alternatively be increased by reference, for example, to the retail price index (RPI), to a tenant’s turnover/sales, to sublease rents, or to pre-agreed/stepped increases. In most leases, rent reviews take place every three or five years, although in older leases in particular, reviews may, for example, take place at seven-, 14-, or 21-yearly intervals, or not at all. Factors for the landlord to consider at the start of the rent review process include: the “effective date” of the rent review, which is the date that the revised rent will commence; the current level of rent, known as the “rent passing”; the likely level of the new rent, that is, the market rent – enabling an initial assessment to be made as to whether there is a prospect of a rental increase; whether the rent review clauses in the lease provide that the rent can go upwards only or could actually go down – although most leases have upward-only reviews; the provisions in respect of the service of notices – such as the “rent notice” typically required to be served on the tenant to instigate the review, and the “counter-notice”, usually served subsequently by the tenant on the landlord, objecting to the level of rent required, and seeking to negotiate. Some modern leases may, however, dispense with such formal notice procedures. Many factors can influence the rental value of property, and therefore the negotiations which take place between the surveyors acting against each other on behalf of the landlord and the tenant. Surveyors examine evidence of other rental transactions, which are known as “comparable evidence” and include lettings, rent reviews and lease renewals. For most property types, including retail, offices and industrial, comparison is made of the rates per m2/per sq ft obtained, with adjustments being made between various factors affecting value in order to determine the value of the subject property. Alternative valuation methods may be used for other properties, such as a profits basis for licensed and leisure interests. Straightforward factors affecting value could include the location or size of the property. More technical factors affecting value could include the length of the unexpired term of the lease. If, for example, a rent review was taking place with effect from 2000, of office accommodation held on a 25-year lease commencing in 1980, the tenant may argue that the unexpired term of five years is so short that there would not be any tenants in the market for such a facility. The tenant would suggest that prospective tenants would require a lease term of, say, 15 years, and that, therefore, a significant discount should apply to a rent based on a five-year term. In order for a landlord to avoid such a problem, there may be “hypothetical” rent review provisions in the lease which provide, for example, that the unexpired lease term shall at each review be assumed to be 15 years. In other situations, short leases will command higher rents, owing in particular to their greater flexibility for tenants. If the landlord and tenant cannot agree a revised rent, there are usually provisions in the lease whereby an arbitrator or an independent expert can be appointed. Once the rent is agreed, the parties usually need to sign a rent review memorandum. The new rent will also need to be entered into the computer/management system in order to generate rent demands/invoices. User clause The “user clause” is a covenant within the lease which governs the use to which the property can be put by the tenant. The lease may, for example, provide that “the tenant shall not use the property other than for the purpose of a clothes shop”. This is an absolute prohibition against changing the use of the property – and termed an “absolute” user clause. Here, if the tenant wishes to change the use of the property, the landlord could refuse outright, or could require a consideration from the tenant. The tenant could, for example, be required to sign a new lease, pay a higher rent, and/or give the landlord a lump sum in exchange for allowing the change of use. Another lease may provide that “the tenant shall not use the property for anything other than a clothes shop, without the consent of the landlord”. This is a “qualified” user clause. Here, if the tenant wished to change the use of the property, the landlord could still refuse, but could not demand a consideration, such as an increased rent, for granting consent. A further lease may provide that that “the tenant shall not use the property for anything other than a clothes shop, without the consent of the landlord, such consent not to be unreasonably withheld”. This is a “fully qualified” user clause. Here, the landlord would not be able to unreasonably withhold consent and would not be able to demand a consideration for granting consent. In addition to the management issues surrounding user clauses, an important aspect is their effect on rental values. If there is a “restrictive” user clause, such as being able to use a shop only for the purpose of selling clothes, then this would have a depressive affect on the level of rent that the property could command. This is because the market is effectively restricted to the demand from clothes retailers, when there may be a variety of retail users who could take the property. The extent of the discount having to be applied for the restrictive user could be in the order of 15% – with the use as a clothes shop commanding £8,500 pa, for example, against £10,000 for a shop which could be used for any retail purpose. In other situations, the discount could be much more. It is also worth noting that any other restrictive or onerous lease terms can limit the level of rent that can be achieved. Regard has to be given to all the other terms of the lease when considering the effect of an individual aspect – with the need to construe user and alienation provisions together being a good example – noting that it is likely to be a new tenant rather than an existing tenant that wishes to change the use, thus requiring consent for both user variation and assignment/subletting. The ability to end or “break” during the term of the lease, may, for example, mitigate the effects of restrictive alienation or user provisions. Alienation Alienation provisions are included in a lease in order to allow the tenant to “assign” the lease, or to “sublet” the whole or part of their interest. If a tenant is committed to a number of years’ occupation under the lease, it is only reasonable that they are allowed to relinquish such a liability by finding another occupier who will pay the rent and meet other obligations. Landlords need to control the type of tenant in order to protect their investment but, as mentioned above, need to ensure that the alienation provisions are not unduly restrictive so as to have a detrimental effect on the ability to achieve rent increases. Assignment involves selling the lease to a new tenant. A “premium”, really a purchase price, may be paid by the new tenant to the existing tenant, and would reflect the fact that the new tenant would benefit from a rent below the market rent until the next rent review or lease renewal. The current tenant may sometimes have to pay a new tenant to take over the lease. This is known as a “reverse premium”, and would apply, for example, where the current tenant pays a rent above market value and the property is “overrented”. The reverse premium makes up for the fact that the new tenant could obtain a cheaper market rent elsewhere, such as taking a lease of a vacant property direct from a landlord as a “letting”. Tenants who assign their interest would no longer have any control over the property. But in subletting the whole or part of their interest, they would continue to be liable directly to the landlord for the rent and any other obligations, notwithstanding the obligations they may place on sub-tenants. “Privity of contract” is a situation where the original tenant of a lease is liable for rent and the performance of other covenants for the duration of the lease, irrespective of the number of times that the lease may be assigned. If, for example, a tenant took a 20-year lease in 1985, and assigned the lease in 1988, they could still today be pursued for rent arrears that have resulted from the default of the current tenant – over whom the original tenant had no ability to choose, or control thereafter. This potentially unfair system was remedied in part by the Landlord and Tenant (Covenants) Act 1995. For leases entered into on or after 1 January 1996, original tenants are liable only up to the point at which they lawfully assign the lease. However, the alienation provisions in these new leases may oblige the outgoing tenant to enter into an “authorised guarantee agreement” (AGA) with the landlord on the assignment of any such lease – making the tenant (T1) liable for rent arrears or any other default of the next tenant (T2 – the “assignee”). But T1 will cease to be liable under that agreement when T2 lawfully assigns to T3. Privity of contract still applies to leases entered into prior to 1 January 1996. However, for all leases, for the landlord to be able to pursue original tenants, previous tenants, guarantors and so on for “fixed charges” such as rent and service charges, those parties have to be advised of the amount claimed within six months of becoming due. As with user provisions above, alienation and subletting provisions may be absolute, qualified or fully qualified. However, for the qualified covenant, the law implies that consent by the landlord should not be unreasonably withheld – unlike user clauses. Most modern leases impose different controls in respect of assignment and subletting, and impose various restrictions – including, for example, restrictions on underletting at less than the open market rent and/or the passing rent and prohibiting the payment of a capital sum by or to the subtenant in respect of the subletting. Repair The tenant will require the repairing obligation within the lease to be fair having regard to the age and condition of the property, and to the other terms of the lease, including the length of the lease. The landlord ideally places the responsibility for repairing a standalone property on the tenant, thus enabling a “clear” income to be secured which helps optimise investment value. The landlord will, however, be mindful of imposing repair obligations on the tenant which are so onerous that they restrict the level of rent that can be secured. In larger multi-occupied properties, the cost of repairs is typically covered by service charge contributions made by tenants. If a property is not in an acceptable condition at the start of a tenancy, the tenant may include in the lease a “schedule of condition”, which records the condition of the property. This ensures, firstly, that the tenant will not be responsible for bringing the property up to a better condition and, secondly, that rent reviews will reflect the unimproved condition, rather than any improved condition which the tenant may have created at its own expense. At the end of a lease, a tenant may be pursued by the landlord for damages in respect of the disrepair of the property. It is worth noting that the landlord’s claim for damages is not necessarily the cost of undertaking the repairs to the property. The claim is either the cost of undertaking the repairs or the diminution in the value of the property which results from the state of disrepair – whichever is the lower. If, for example, at the end of a lease, an old vehicle repair garage would cost £5,000 to be brought to standard of repair required by the lease, but new tenants would only spend £1,000 owing to the fact that the property will soon return to the current condition, then the level of damages could be £1,000. Also, if, for example, the property were to be demolished at lease expiry for the purpose of redevelopment, then there would be no liability placed on the tenant in respect of disrepair. Other areas Landlord and tenant and estate management work often overlaps. In addition to the above areas, surveyors’ work may include: dealing with tenants’ rent default; dealing with breaches of other covenants, such as repair, user and alienation; granting consent to tenants for improvements and/or alterations; service charge administration; registering assignments and sublettings; establishing maintenance plans, arranging works and co-ordinating contractors; ensuring that the property is insured, either directly as the landlord’s responsibility, or as either insurance rent paid by tenants, or within a service charge contribution; ensuring compliance with health and safety legislation; considering the effects of new legislation such as the Disability Discrimination Act, and the extent of compliance measures; minimising liability for rates, particularly for void areas, which may attract “empty rates” charges; being alert to new income-producing opportunities such as telecoms facilities, short-term lettings, parking licences and advertising rights; periodically inspecting properties to ensure tenants are generally in compliance with covenants. It is also important that agency surveyors have a good understanding of landlord and tenant, because the terms agreed at the initial letting determine the basis of rental value determined at subsequent rent reviews. Investment surveyors especially will have a keen eye on how lease terms affect income security, and the scope to achieve rental and capital growth. Valuers also need to be able to price the effect of certain lease terms. Lease renewal and the 1954 Act – assessing the future possibilities for a property The process of lease renewal takes place at the expiry of a lease. This provides an opportunity for the landlord and tenant to consider their aspirations for the property. The possibilities include: the tenant wishes to vacate the property and relocate the business; the tenant wishes to take a new lease on suitable terms that will help the business develop; the landlord wishes to secure possession from the tenant in order to redevelop the property or to occupy the property themselves, or because the tenant is in default of certain obligations contained in the lease; the landlord wishes to grant the tenant a new lease at a market rent, and on other terms, which will help optimise the investment value of the property; Under the Landlord and Tenant Act 1954, tenants have “security of tenure”. This means that at the end of their lease, they have the right to a new lease, subject to the ability of the landlord to establish a ground for possession. Compensation for disturbance is due under some grounds, and compensation for improvements may also be payable. Not all business leases are afforded the protection of the 1954 Act, with exceptions including fixed-term tenancies for less than six months (with no right to renew or extend the term, and where the tenant has not been in possession for more than 12 months), tenancies at will and contracted out tenancies (see later). Licences are also excluded. There are notices that need to be served in order to bring the lease to an end and commence the renewal process, noting that the lease does not simply end because its expiry date has been reached. The landlord, for example, wishing to formally bring the lease to an end, to either grant a new lease or to secure possession, has to serve a “section 25 notice”. The tenant wishing to end the lease, and request a new lease, has to serve a “section 26 notice”. One of the differences between rent review and lease renewal is that at rent review, the terms of the lease are fixed, whereas at lease renewal, the terms of the lease are renewed, and could therefore change. The general principle is that the terms of the existing lease should be incorporated into the new lease, and the party seeking any variation will need to justify the change. Also, whereas the revised rent payable with effect from any rent review is fixed by reference to the terms of the lease, the rent payable on lease renewal is governed solely by reference to the provisions of the 1954 Act. Another difference is that at rent review, the lease is most likely to provide that the rent can go upwards only, whereas at lease renewal there is no such provision. If, for example, the current rent/rent passing is £10,000, and the market rent is £8,000, the landlord would not try to increase the rent at rent review. At lease renewal, the rent would still be to market value, but would go down to £8,000. Also, whereas the effective date of an increase at rent review does not alter if negotiations are delayed, with lease renewal, the new rent commences from the eventual commencement date of the new lease. “Interim rent” is payable in the meantime, but the 1954 Act does not contain any provision to enable tenants to apply for an interim rent if they are paying a rent above market value, and/or rental values are falling. If the parties cannot agree new lease terms between themselves, the matter is determined by the court. Lease renewal is an area where surveyors often have to work closely with solicitors in respect of procedures, and the service of notices, in order to protect the interests of either the landlord or the tenant – noting that a business could have to relocate if it fails to apply to the court for a new lease within a set time scale. It is also an area where surveyors and finance staff have to follow laid-down procedures, and ensure that the rights of either the landlord and tenant are not, for example, prejudiced by neglecting to make the requisite computer inputs that affect the generation of rent demands. Once the new lease has been executed, details will need to be entered into the management/computer system largely as if it were a new letting. For a commentary on proposed reforms to the 1954 Act, see “Fail to get Act together” by Christopher Hancock and Suzanne Lloyd Holt of Wragge & Co (25 August, p94). Leases, tenancies and licenses – types of agreement for landlords and tenants The term “lease” is used to denote the contract by which a tenant holds its “leasehold” interest in property. The terms “lease” and “tenancy” are often used interchangeably. Leases for more than three years must be granted by deed. Leases for lesser periods, where the tenant takes immediate possession and pays a full open market for the property, and periodic tenancies, need not comply with this requirement. The traditional “institutional lease” favoured by institutional investors was 25 years, but leases of 10 or 15 years are increasingly common, owing mainly to changes in economic and property market conditions and developments in landlord and tenant and other legislation. A commercial periodic tenancy will continue indefinitely until determined by one of the parties, typically at six months’ notice expiring at any time. This is more commonly granted by local authorities or otherlarge in-house property teams, but also smaller landlords, for properties at the lower end of the market where tenants require flexible terms. A “contracted out” lease/tenancy is one in which the parties exclude the security of tenure protection afforded by the Landlord and Tenant Act 1954. At lease expiry, the landlord may choose to grant the tenant a further lease without having to undergo the statutory lease renewal process – but noting that a tenant’s absence of rights may place them in a precarious position, owing to the negotiating strength that therefore rests with the landlord being able to require them to vacate. Licences are granted in respect of rights, for example, to park a vehicle, obtain access or use a storage facility. As a general rule, however, if exclusive possession is granted of a defined area, the agreement may, in fact, constitute a tenancy, thus providing security of tenure. A tenancy at will, however, does not afford protection. This is a personal relationship between the original landlord and tenant, and is determinable at the will of either of them. The use of the words “tenant at will” in an agreement will not create a tenancy at will if there is any suggestion that the tenant will be entitled to possession for a definite period. The documentation should not therefore make reference to rent being payable in advance, as this would suggest that the tenant has a right to occupy for that period. The agreement must make it clear that the landlord is, at all times, entitled to ask the tenant to leave. This is generally unacceptable to tenants, because it offers no certainty. Landlords must take care not to inadvertently afford security of tenure to tenants, such as by entering into an agreement which could ultimately be construed as a tenancy, by incorrectly administering a tenancy at will, or by accepting rent beyond a short term or contracted out tenancy. This could be particularly costly in the case where tenants are situated within potential development opportunities. From student to specialist – the training of an L&T surveyor At university, landlord and tenant is often covered initially by examining the legal and procedural elements, particularly of rent review, and demonstrating how surveyors’ valuation and management roles operate within the legislative framework, supported also by case law. Students go on to examine how rent reviews and other landlord and tenant work is conducted in practice, including consideration of how particular lease terms determine the precise rights and obligations of the parties, and also how they influence rental value. Investment valuation is applied to scenarios where, for example, the value of improvements can be reflected in the rent achievable at the next rent review, or where tenants may be due compensation at lease expiry. On graduating, landlord and tenant work is initially likely to be in respect of lower-value cases. Such work may also be dealt with by support staff, including those taking NVQs, the ATC and/or or part-time or sandwich degrees. In combining case work with professional development/CPD study, learning is accelerated, and a greater level of both technical and practical knowledge can be applied to cases of higher value which the surveyor is increasingly able to take on. This equips graduates well for the APC, and while a breadth of experience is required over a training period of two or more years, a relatively specialist knowledge developed in landlord and tenant, for example, should enable a high-quality critical analysis to be produced, and give the candidate the further opportunity to impress the assessors under interview questioning. Once qualified, surveyors may wish to specialise in landlord and tenant, particularly if working for the larger practices. Even if working in smaller practices or for in-house teams, including the public sector, landlord and tenant may still be a speciality alongside the usual range of other work.