Three months boil down to day one

Valuation Does the lack of a rent-free period for fitting out retail space entitle tenants to a lower rent at review time? Mike Crump explains There is a valuation adage that goes: “Value as you devalue.” Rental evidence derived from the analysis of comparable transactions is the determining factor in rent review, so it is up to the valuer to ensure that the evidence is of a high quality. An industry has developed around this in relation to rent reviews and valuations. Many well-established rules and precedents have been developed relating to allowances for lease terms, physical issues and appropriate adjustments for payments. It is this last area of capital payments and rent-free periods that should be considered. Here the battleground is growing between the landlord and tenant. Day-one rents A relatively new tactic adopted by tenants is the “day-one rent” issue. Where there is no express provision in the rent review clause that the rent payable by the tenant should be exclusive of a rent-free period for fitting out, the tenant may argue that as he will not receive any rent-free period for fitting out on the hypothetical letting, he is effectively paying a rent from “day one”. The length of the rent-free period for fitting out will depend upon the nature of the premises and the extent of the proposed fit-out. In the context of the retail market, it is common practice to allow three months rent free for fitting out most high street and shopping centre units. Anything above this is considered a landlord’s incentive and is discounted accordingly. In the case of the day-one rent, the tenant will commonly claim an end allowance of 5%, which amortises a three-month rent-free period over the first five years of the term. Thus: rent (100%) ÷ 4 (three months rent free) ÷ 5 (first five years of the term) = 5%. Is this a fair and reasonable approach? The issues involved demand consideration. ● A literal approach to the interpretation of the review clause would suggest that if there is no disregard of rent-free periods, and that the comparables include a rent-free period, then the tenant must receive his discount. However, many arbitrators are unhappy with such an interpretation. For example, while there may be no express assumption relating to the grant of a rent-free period in the hypothetical lease, equally in the vast majority of cases, there will be no express provision that we are to assume a hypothetical tenant will not receive an appropriate rent- free period either. At worst, most leases are neutral on this point. It would be unusual to grant a lease that allows future rental concessions to the tenant on review (as per the “day one” issue). In such circumstances, one would expect the intentions of the parties to be expressly stated in the contract. Rent-free periods are customarily granted for fitting out, and their length, as discussed earlier, will reflect the nature of the premises. No repeat of rent-free period As anyone involved in leasehold acquisitions will know, the parties negotiating the lease accept the rent-free period as a one-off at the start of the lease, and it is not intended to be repeated on future reviews. Conversely, for the day-one issue to stand up, it must be assumed that the intention of the parties was that the tenant on each review was to receive the benefit of a rent-free period for fitting-out purposes. But this would appear to go against commercial reality. And why should the tenant be allowed a reduction on every review, simply because of the possibility of vacant possession? If there was such an intention, then surely again it would be clearly stated in the lease. Where there is no express assumption relating to the grant of a rent-free period in the hypothetical lease, and also where the day-one rent issue applies, then the discount achieved on the initial hypothetical letting must also apply to all subsequent reviews. Where the hypothetical term is 10 years or longer, the tenant will receive a discount on each subsequent review, and the longer the hypothetical term, the greater the benefit will be for the tenant. It is not unreasonable to suggest that the hypothetical tenant would be prepared to bid more in terms of rent in return for a 5% discount on each and every future review. In the case of the 25-year hypothetical lease term, one could argue that the tenant would pay a premium rent, notwithstanding the day-one argument, in the knowledge that he would receive a discount on all future reviews. It would also undermine arguments for a discount for a hypothetical term that is longer than the market norm. At the very least, one would expect the discount for a day-one rent to be cancelled out by the benefit of receiving a discount on all future reviews. The argument thus is polarised between a literal interpretation of the day-one issue and consideration of the commercial and practical realities surrounding it. The key question, as it is so often in rent review clause practice and procedure, what was the intention of the parties? Devaluation of tenant’s incentives It is an accepted convention that on the letting of new properties, the tenant is granted an initial rent-free period to enable him to complete his fit-out works before the rent commences. In retail, the accepted norm is three months rent free and any rent-free period in excess of this, or additional capital contribution, is classed as tenants’ incentives and devalued accordingly with a consequent reduction in the headline zone A rent. However, there is no consensus on how long a period or indeed how the capital contribution (including excess rent-free periods) should be devalued. The conventional valuation approach is to amortise the total incentive package on a straight-line basis. There are more complex approaches that can be made involving valuation tables and tax considerations, although the straight-line approach does give a common benchmark. The term over which the capital contribution is to be devalued is problematic, but there are certain ground rules, listed at left. Should the incentives be valued over five years, 10 years or the term of the lease? The truth is that the valuer must look under the surface and consider each case on its merits and be clear in his own mind exactly for what purpose the incentive has been made. Mike Crump is a partner with King Sturge Valuation ground rules Shop fitting or soft fit-out Accepting that there are sectorial differences, from a retail perspective, contributions towards shop fitting are usually devalued over a five-year period. This is because many retailers will often refit after five years (in part or in whole) and will often write off their shop fitting costs over a five-year period. However, we must be clear as to what we understand by “shop fitting”. My interpretation is that this includes what one might call the “soft fit-out” elements, including trade fixtures, lighting, suspended ceilings and carpets. It does not include “hard fit-out” works, such as staircases, lifts, WCs and other building works. Hard fit-out Staircases, escalators and lifts have a much longer shelf life than the “soft fit-out” items noted above. It would be appropriate to discount any contribution made in respect of these items by not less than 10 years, and depending on the circumstances, over the length of the lease. Tenant’s inducements A capital payment or extended rent-free period may be granted to induce the tenant to take the lease. This should be easy for the valuer to deduce. In my view, in these circumstances, it would be appropriate to discount the incentive package over the length of the term. Therefore, in analysing extended rent-free periods and capital contributions, the valuer must make an attempt to discern and understand why and for what purpose the incentives were granted. The better he understands the reasons underlying the payments, the more accurate the devaluation of the comparable evidence and the subsequent valuation.