Presumption of reality At rent review, if the lease is drafted unambiguously, courts will usually follow the lease rather than consider what the tenant gets, even if the result makes little commercial sense. By Edward Bannister
Where there is ambiguity in the drafting of a rent review clause, courts have always had to consider and choose between what a rent review clause appears to state, in a literal interpretation of that clause, and what the court believes to be the commercial purpose.
The general trend has been for the courts to take a robust commercial approach, save where the wording in the lease is clear, in which case the courts have followed that wording, even if the parties almost certainly did not appreciate the effect and the result makes little commercial sense.
One aspect of this commercial purpose approach is the “presumption of reality”, where the courts try to ensure that the valuation exercise remains as close to reality ― what is in the lease and its subject matter ― as possible. Examples where the presumption has been considered include arguments over the assumed term at review, the contents of the assumed lease and rental concession assumptions. The presumption has tended to be used by tenants to back up their arguments that they should not have to pay rent for some benefit they do not receive. As a general rule, where there is an ambiguity or a doubt as to whether something should be assumed and that doubt or ambiguity contradicts reality, the courts will usually give effect to the presumption of reality.
In two recent rent review cases, the judge was called upon to apply “the presumption of reality”, only to ignore that call, for similar reasons in both cases. In one case, the landlord was putting forward the argument and, in the other, the tenant.
Does the presumption of reality still have a part to play in the realms of the hypothetical lease? I suggest that, notwithstanding the failure of the argument in the two most recent cases, the presumption can still apply.
The presumption could be said to have emerged from the guidelines laid out in British Gas Corporation v Universities Superannuation Scheme Limited which, briefly summarised, put forward the following guidelines:
(i) words that produce a result that is manifestly contrary to commercial common sense should not be given literal effect;
(ii) other clear words that may produce a very unlikely result must be given effect to, however odd they and their effect may be;
(iii) subject to (ii), unless there are special circumstances, the parties should give effect to the underlying commercial purpose of a rent review clause.
The British Gas guidelines were followed in later cases, such as Basingstoke & Dean Borough Council v Hose Group Limited, which sought to establish what the intention of the parties was at the time the lease was completed, by considering the language used and the commercial purpose behind a rent review clause.
The courts have acknowledged that clauses often require a valuer to provide his valuation on a basis which departs from the subsisting terms of the lease but otherwise, to the extent that such departure was not required, the hypothetical lease should bear as close a resemblance to reality as possible. Accordingly, where the lease is silent over the assumed term at review, the courts have generally gone for the actual residue, as that reflects the actuality: what the notional tenant is being offered is what the actual tenant has unless there are strong indications to the contrary.
Canary Wharf Investments (Three) v Telegraph Group Limited: the Telegraph Group occupied four-and-a-half floors and some car park spaces at Canary Wharf under a 25-year lease, which commenced on 1 April 1992 with a review every five years. The April 2002 review was the subject matter of the dispute.
Canary Wharf argued that the assumed 25-year term of the hypothetical lease should be the same as the original lease term ― from 1 April 1992 ― leaving an assumed 15-year term (the residue) to be valued at the 2002 review.
Applying the “presumption of reality”
In other words, Canary Wharf sought to apply the “presumption of reality” ― that is, the rent review should be on the basis of what the tenant actually had at the time. The valuation consequence of this assumption, if upheld, would be strongly in the landlord’s favour as, in the current market, the hypothetical tenant would bid more for a 15-year term than a 25-year term. (Some commentators have argued that, in the present market, the rent payable under a 25-year lease would attract a discount of between 5% and 10%, against that payable under a 15-year lease. In this case, it was suggested that this could amount to a reduction of £500,000 pa in the amount of rent payable by the tenant. This would have a corresponding effect on the capital value of Canary Wharf’s interest.)
The Telegraph Group argued that the hypothetical 25-year term should commence on the actual review date ― 1 April 2002 ―and, accordingly, the hypothetical tenant would bid less than it would for a lease of 15 years. The tenant was arguing against the presumption of reality.
The relevant points of the lease were as follows: the “term” and “term commencement date” in the lease were defined as 25 years, commencing on 1 April 1992; the “open market rent” was defined as the rent at which the premises “could be expected to be let as a whole at the relevant rent review date by a willing landlord to a willing tenant…for the grant thereof, the term of 25 years, and otherwise on the terms and conditions and subject to the covenants and provisions contained in the hypothetical lease…” [emphasis added], the “hypothetical lease” was defined as: “A lease on the terms and conditions and subject to the covenants and provisions contained in this lease, subject to…the rent reserved under such lease shall be reviewed on the fifth anniversary of the term commencement date of such lease and at five-yearly intervals thereafter”, assuming that the car park review provisions do not apply and that the hypothetical lease incorporates all necessary amendments.
The landlord’s argument was that, applying the earlier cases, the term to be assumed was 25 years, and that that 25-year term, applying the presumption of reality ― that the hypothetical lease was, as closely as possible, to be based upon the existing lease ― was to be from April 1992, so there were just 15 years left.
The problem with this argument was the fact that, for the presumption to apply, there needs to be some “gap” in the drafting, and Neuberger J stressed that “one must be careful of placing too much weight on the decisions relating to other leases when it comes to construing the words of a particular lease”. In other words, the presumption only has to be considered where the lease is unclear.
“Natural meaning” of open market rent
Neuberger J’s review of the terms of the lease can be summarised as follows: the “natural meaning” of the definition of the open market rent was that it ran from the review date which would be how it “would strike an ordinary commercial landlord or tenant, a surveyor, or, indeed, a lawyer”; lawyers would focus on the words “for the grant thereof” as meaning exactly that, the point being that a lease term comes into effect when granted, and it cannot retrospectively vest. This, and the last point, probably disposed of the landlord’s argument, as far as Neuberger J was concerned, but he continued; the only thing to be reviewed in 1997 was the rent of the car parking spaces, so the lease was drafted to ensure that in 2002 and subsequently, this anomaly would be ignored (and be of no further relevance) and the premises would be reviewed as a whole, disregarding the 1997 review which was just of the car park spaces. If the landlord’s argument were to be followed, that would make the reference to the car parking provisions (to be ignored) as being irrelevant — there would be no need to disregard a rent review provision which had already occurred in the fifth year of the term. The reference to “the term commencement date of such lease” [emphasis added] was also indicative, if not conclusive, that the hypothetical lease start date was later than the actual lease. Accordingly, the landlord could not fall back on “the presumption of reality” as the wording of the lease was clear.
Neuberger J went on to stress that the presumption was no more than that: the court in British Gas was keen to stress that it was laying down guidelines, rather than a mechanistic rule and, if he were to follow the landlord’s approach, he would be running contrary to those very guidelines.
This may not be the last of this case, as Canary Wharf has been granted leave to appeal, although, given Neuberger J’s clarity, the basis of the appeal is likely to focus very much on semantics. It lodged an appeal on 9 July 2003 and this is still pending.
In an area of few comparables
The second recent case is Beegas Nominees Limited v Decco Limited, which related to a lease of a distribution warehouse with ancillary offices, comprising two floors totalling 111,815 sq ft in Stone Business Park, which, when granted, was in an area where there were few, if any, comparables. Accordingly, the rent review directed the valuer to assume that a lease of a building within five miles of two other towns more than 20 miles away, where there were established business parks, could be used as evidence of the rental value of the property “as if those premises were situated upon the Stone Business Park”.
The landlord argued that this meant that the rent of the other locations could be used without any discount. The tenant’s argument was that this departed from the presumption of reality and the property should be valued on the basis of what and where it was. The other locations could be considered as comparables, but they should then be discounted to account for the fact that they were in different locations.
Patten J disagreed with the tenant’s approach: he noted that it was “now common form for the landlord to manipulate reality so as to ensure, for example, that he receives at least the same level of income following review”. The dispute related to the valuation process to be followed in calculating the open market rent and the wording was a clear direction to depart from what would otherwise be the normal process. The judge was “reluctant to assume, without further confirmation, that the draftsman introduced words into the clause which were effectively redundant”.
The fact that, as a result, the tenant would end up paying higher than a market rent was noted but there were express words in this case which required the valuer to “make a departure both from reality and from normal valuation practice”. There was an “intelligible commercial objective”: the landlord was trying to make sure that the rents for its business park were “pegged” to more established parks.
Conclusion
Even though the judges in these two cases declined to apply it, the presumption of reality still has a place to play in rent reviews but only where the lease is not clear and, as Neuberger J noted, its force will depend upon what is at issue, as well as the wording used.
Where there is a clear meaning (and result) on the face of the wording of the review clause, as was the case in these two cases, the court will be unlikely to consider, let alone resort to, the presumption, even if this means the tenant ends up paying more (or less) rent ― the guidelines in British Gas still apply.
If there is doubt, then the courts may consider the rent review on the basis that the parties should be rentalising what they actually have, namely the lease. As in British Gas, unless there are clear words to the contrary, the court will try to give effect to the underlying commercial purpose of the rent review clause. In these cases, there were clear words and, although the result may have been at odds with what was intended, the result did not fly in the face of all commercial common sense.
Canary Wharf also illustrates how changes in market conditions following the grant of a lease can lead to consequences unforeseen by the original draftsman. The 25-year lease is seldom seen now but that can work both for and against either party to a lease, depending upon the market at the time of the review.
Edward Bannister is partner in the real estate department of Field Fisher Waterhouse
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How to keep leases clean and simple |
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Unless there is a sound commercial reason not to, rent review clauses should be based on “reality” and the actual lease and the subject matter of that lease, namely the property, as that will make applying market principles and understanding the rent review clause much easier. Avoid drafting in further clauses, as they will only add to the arguments available on review to dispute one or other side’s comparables. It may be either the landlord or the tenant who is on the receiving end and, as the two cases show, a lot will depend on the market conditions at the time. If you want, or need, to introduce hypothetical terms, make sure that they are clear. Otherwise, the provisions will still be open to attack by the other side. At the same time, ensure that all the clauses in the rent review have a clear purpose and are not at odds with other provisions. (In both cases, there were points made in respect of subsidiary clauses, which could have had an influence on the final outcome ― for example, the car park spaces in Canary Wharf.) Beegas is not the first time a sale and leaseback has been tested on rent review. When considering a lease that has been the subject of a sale and leaseback, from either a landlord’s or tenant’s perspective, remember that it would not have been negotiated in the usual way because the selling future tenant may well have accepted some provisions to get more value on the sale and may have insisted on some other provisions which it would not normally expect in the open market. |
