Rent review remains one of the most important elements in a commercial lease. Here experts examine the most common types of rent review and look at current trends
The ups and downs of rent review
Rent reviews became common in commercial leases in the 1960s, introduced by landlords as a way of combating the impact of inflation on real estate. Historically, commercial leases were granted for terms of 25 years, with open-market rent reviews at seven or 14-year intervals, with five-yearly reviews later becoming the norm.
In recent years, this pattern has changed, largely due to the economic downturn and the reduction in appetite for long-term commitment from both landlords and tenants. The BPF/IPD Annual Lease Review indicates that the average lease length has decreased from 14.3 years in 1999 to five years in 2009/10 and this has led to a corresponding decrease in the frequency of rent reviews seen in commercial leases.
Notwithstanding this, rent review remains one of the most important elements in a commercial lease, given the critical nature of rental provisions for both landlord and tenant. This article examines the types of rent review most commonly encountered in commercial leases and looks at current trends.
Open-market rent review
Many new leases, particularly on secondary properties, are now for fixed terms without review, allowing the rent to fall on renewal to the tenant’s advantage. Alternatively, they have tenant breaks linked to review dates that may or may not result in an actual rent review taking place. Where rent reviews are included in new leases, they are still predominantly on an open-market basis. An open-market rent review aims to set the rent at a level that reflects the value of the premises on the open market at the time of review.
Open-market rent is usually assessed by a chartered surveyor, who will assume that there is a willing landlord and a willing tenant entering into a hypothetical lease (usually for the unexpired term of the actual lease) on broadly the same terms as the actual lease, but with various assumptions and disregards: for example, assuming that the tenant has complied with its lease obligations and disregarding any goodwill attached to the premises as a result of the tenant’s business. The surveyor will apply this and rental information from recent transactions involving comparable premises, to determine the appropriate rental level.
It is usual for an open-market rent review to be upwards-only, meaning that the rent can only remain at its current level or increase as a result of the review; it cannot be reduced, even if the market value of the lease has gone down. This is particularly important for landlords, investors and mortgagees, as such a review ensures that the income stream from a rental property is given some protection from downward fluctuations in the market.
Upwards-only rent review can, of course, result in financial burden for the tenant, especially as a lease with a rent above open-market value can be very hard to assign or underlet. The Code for Leasing Business Premises 2007 encourages landlords to avoid insisting on upwards-only rent reviews and to offer alternatives, if asked. Such alternatives can lead to a tenant being required to pay a higher initial rent, which, unsurprisingly, tenants are often reluctant to do.
Notwithstanding the code, landlords have generally been reluctant to offer priced alternatives to upwards reviews due to concerns over the effect on investment value and the resulting impact on availability of funding.
An alternative to upwards-only review is an open-market review with a set minimum rent, which may be the initial rent payable under the lease. Under this type of open-market review, the lease rent could decrease from one review to the next, but would not be permitted to decrease below the minimum level set. This is less common than upwards-only review and can be offered as a compromise to tenants who are resisting an upwards-only provision.
A disadvantage of an open-market rent review, for both parties, is the time and expense that can be incurred through its use. In addition, the outcome of an open-market rent review may be disputed by either or both parties, with most rent review clauses in leases providing mechanisms for reviewing and disputing an initial rent review decision.
Indexation
Index-linked rent review provides for the rent in a lease to be increased in line with a published index, usually the RPI, which is commonly expressed as a formula in a lease. As with an open-market rent review, it is usual for an indexed review to be expressed as being upwards-only, so the landlord does not lose out if the index decreases in a particular year.
Indexation provisions can be further refined to include a stated minimum percentage rent increase, frequently coupled with a maximum percentage increase (known as a “cap and collar”) to avoid imbalances for both parties at times of high or low inflation.
The main advantage of indexed rent reviews is their simplicity; the parties are able quickly and easily to determine the value of the reviewed rent on each review date by applying the formula set out in the lease. This ease of application means that indexed rent review can take place more frequently than an open-market one and may therefore be advantageous for leases of a shorter term, or leases where a more frequent review is appropriate.
They are also frequently encountered when it may be difficult to find suitable comparable premises, which is an essential component for an open-market rent review. On the flip side, a specified index, such as the RPI, while reflecting a change in retail prices, may not accurately reflect actual changes in property values.
For example, in the late 1980s a number of 25-year leases of office premises in central London were granted to the government where rents were to be reviewed to the higher of open market or RPI at each review. If at review RPI had risen but open market rents were either stable or had fallen, the rent would still increase. Over the life of these leases, the buildings became significantly over-rented with consequential alienation issues.
Today, caps and collars are seen on large prelet offices, properties in the industrial sector and in some parts of the retail market. Food stores and convenience store retailers are taking 15 to 20-year leases with rent reviews fixed by reference to a formula (often now based on the CPI, not the RPI), subject to a cap and collar to act as a hedge on inflation. In the current market, such assets have proved popular with institutional investors and funders, who see the advantage of a guaranteed return.
Turnover rent
Turnover rent provisions require a tenant to pay a proportion of its rent based on the income derived from its premises. Turnover rent is most commonly used for retail premises and is increasingly being adopted for secondary and tertiary retail assets where there is a lack of demand. It is also a mechanism used by serviced office providers. The tenant will usually pay a base rent (lower than market value) which is topped up by an additional rent, calculated as a percentage of the tenant’s business turnover for a specified period.
In the current market there has been an increase in lettings of retail premises with no base rent element at all, with the landlord’s rental income being aligned solely to the tenant’s turnover.
The advantage of turnover rent provisions is that they are a useful way of sharing risk (for example, in the case of new developments) or sharing success (for example, when a profitable new tenant joins an established shopping centre) between the parties. The disadvantage is the administrative burden that it places on a tenant; it requires accounts and evidence of turnover to be produced on a regular basis. There is also some disadvantage to the landlord, as rent collected will not be consistent from year to year.
Stepped increases
Although not strictly a form of rent review, some leases contain provisions for the rent to be increased by a set amount at specific intervals during the term. For example, a lease may provide for annual increases. This approach has the advantage of certainty and is a straightforward way of providing for rent increases.
The disadvantage of the stepped rent increase method is its inflexibility; the rent agreed at the outset may not reflect the changes in the market during the lease term, with possible financial consequences for both the landlord and the tenant, depending on the way the market has changed.
As a result, stepped rent increases are not usually seen in longer-term commercial leases. They can, however, be useful in shorter leases, where the rent-free period/inducement package that might otherwise be offered is replaced by a phased rent that rises over the term to reach the headline figure at the end of the term, or an open-market rent review date.
In the current market, there have been instances where tenants have secured 10-year terms with rent phased or fixed over the duration and no rent review. This will have interesting implications on any renewal for a lease inside the Landlord and Tenant Act 1954, as it will be difficult to introduce a rent review clause into the new lease.
The future for rent reviews
It is unclear how the market will change going forward or whether the current situation will remain. The Republic of Ireland has seen legislation introduced requiring rent reviews to be upward and downward in all new leases entered into after 28 February 2010, unless the lease is granted to comply with an earlier contractual obligation. This has had a negative impact on investment sentiment and property values in Ireland.
The market in the UK is unlikely to go down this route since leases have generally become shorter. While tenants, particularly those in the retail sector, have been calling for such a move, there is a strong investor base arguing that if this occurs, perhaps security of tenure should be removed to level the playing field. Unsurprisingly, tenants are not so keen on this proposal.
Teresa Edmund is a partner and Frances McKenzie is an associate at Bristows. Simon Warren, Ben Glickman, and Jeremy Elphick are partners at Knight Frank
