Back to Basics: Rent reviews in commercial leases

The mechanisms for rent review in a commercial lease are a key term for negotiation between landlords and tenants. Much will depend on the nature and location of the property, the intended use, the bargaining strength between the parties and how well each side is professionally advised. Underestimating these mechanics can have significant consequences, and it is crucial for both landlords and tenants to be absolutely clear on how the rent reviews will work well before the lease is signed, sealed and delivered. While the parties to a lease are free to agree how the rent will be reviewed as they see fit, there are a number of mechanisms commonly used. Open market rate The open market mechanism seeks to ascertain a level of rent that is commensurate with what a willing tenant would be prepared to pay on the open market for properties of a similar nature, use and location. Open market reviews will take into account a number of “assumptions” and “disregards” to ensure that the rent review is calculated on the same basis as at the start of the lease, ie a “hypothetical lease” wherein (for example) both parties have carried out their obligations under the lease, the tenant has not carried out any works that have increased or diminished the value of the property and any goodwill accrued by the tenant’s trading is disregarded. The lease will usually provide for a professional surveyor to be appointed by agreement to assess the open market rate if the parties cannot agree on a figure. The cost of appointing the surveyor will generally be borne equally between the parties, as will the cost of adjudicating any disputes. Given the complexity and expense of carrying out such assessments, open market reviews tend to feature in longer leases of 10 or more years, usually occurring at intervals of five years. Theoretically, the parties are playing the market, yet in practice landlords will insist on an upwards-only review. This means that even if the market plummets, the tenant will continue to pay at least the rent set at the most recent review date. As the rent will not fall when the market falls, this can make it difficult for the tenant to assign the lease in a falling rental market. Key tips for landlords and tenants For both parties, the following measures can minimise legal drafting costs and the cost of resolving any disputes: Seek professional advice at the heads of terms stage Ensure that you fully understand the mechanisms of the proposed rent review Consider the frequency and timing of break options Consider cap and collar provisions. Indexation Index-linked rent reviews have inflation as their general point of reference and are most commonly linked to either the Retail Price Index or the Consumer Price Index. They generally result in upwards-only reviews and – where the base index month changes at each review – may eventually far outstrip the actual rate of inflation. The RPI measures the average price of retail goods and services, including mortgage interest rates. However, the RPI has fallen increasingly out of favour in recent years, largely due to its volatility in following the housing market. In 2020, then prime minister Rishi Sunak announced plans to abolish the RPI by 2030. However, whether the Labour government intends to proceed with this remains unclear at the time of writing. The CPI measures the average price of consumer goods and services, including pensions and statutory pay. It excludes the fluctuating housing market and therefore tends to measure less volatile movements. Alternatively, the CPI including owner occupiers’ housing costs (CPIH) includes the cost of housing as opposed to mortgage interest rates. Landlords have historically tended to prefer RPI rent reviews as they can lead to substantial increases during a buoyant housing market. Conversely, tenants will prefer rent reviews based on core inflation, with the CPI or CPIH tending to result in steadier, more manageable rent increases. Both parties should consider the current and forecast economic climate when committing to index-linked reviews, as well as the option of a “cap and collar”, whereby the parties agree that rent will never go above or below certain rates of inflation. This protects the landlord from low inflation and the tenant from high inflation. With index statistics being released monthly, such rent reviews are preferred in shorter leases of under five years, owing to the relative ease and low cost of their calculation. Longer-term inflation may not be an accurate reflection of the state of the commercial real estate market, and any inflationary volatility due to sociopolitical uncertainty – which is increasingly common – may have disproportionate consequences on either party, or both. Turnover rent Most common in the retail sector, turnover rent reviews are linked to the tenant’s annual turnover, with the landlord generally seeking a minimum base rent plus a percentage of that turnover. More akin to a form of commission, turnover rent reviews can be beneficial for landlords in attracting anchor tenants to new developments where customer footfall is initially low. They can also be beneficial for tenants in the early stages of their business, allowing rent to increase in line with growing productivity. Ultimately, both parties will share in the success of the estate, with high footfall in a shopping centre contributing to higher sales for the tenant. Landlords need to carefully consider the assignment provisions in turnover leases to ensure that the desired level of rent can be obtained from the incoming assignee. Stepped rents While not technically a form of review, the parties may agree that the rent will increase by a fixed rate over a defined period – for example, £100,000 in year one, £110,000 in year two, £120,000 in year three, and so on. That may be followed by an open market or indexed rent review after a certain period. It is also possible to combine review mechanisms. For example, the rent could be determined by the higher of the open market rate and the rent reviewed at RPI. Of course, such arrangements will exclusively benefit the landlord. Unless specified otherwise, time is generally presumed not to be of the essence for rent reviews. For example, if the review date is the fifth anniversary of the term but the review in fact takes place several weeks later, the review stands and the landlord can even charge interest on the shortfall between the initial rent and the revised rent from the review date. Tread carefully Rent reviews are often among the least understood provisions in a commercial lease, particularly if the parties are not adequately professionally advised. Most likely, the greatest risk will be to tenants, who may have minimal bargaining power and could accept the landlord’s preferences with little to no negotiation for fear of losing the premises. Portfolio landlords may adopt a “take it or leave it” approach, meaning that the tenant will have little success in challenging the rent review mechanism in any event. For anyone unprepared, the RICS provides a stark warning: “Poorly conducted rent reviews can lead to financial loss, stalemate in agreeing new rents and even termination of the lease.” Bee Gebhardt is a solicitor at Brabners NEXT TIME: Authorised guarantee agreements – what are they, how do they work and what key terms should be included? Photo © Shutterstock