The fundamental principles of valuation

Following Mark Sefton KC’s article last week, it is Maggie Stobo’s turn to provide an abridged version of their joint paper on commercial rental valuation delivered as part of the 47th annual Blundell Lecture Series in June. Rental valuation is often at the heart of property disputes. In the past two years we have seen a number of uncontested lease renewal cases in the courts which have put valuers under the spotlight. The disputes have revealed there are still aspects of the Landlord and Tenant Act 1954 that require clarification as to their meaning and application. The cases highlight some of the difficulties faced particularly by valuers of retail premises in very challenging market conditions in the wake of the Covid pandemic.  Judicial thought What is striking in some of these cases is the extent of the disparity between the respective positions of the expert valuers. In WH Smith Retail Holdings Ltd v Commerz Real Investmentgesellshaft MBH [2021] PLSCS 68, concerning the store in Westfield London shopping centre, HHJ Richard Parkes KC described the gap between the experts’ valuations as “a most unusual one” and said: “Given the current lack of confidence in the direction of the retail market, it was perhaps not surprising that there was such a gulf between the valuations of the two experts.”  Judges have shown sympathy for the difficulty faced by valuers in the absence of transactional evidence, especially in the wake of a pandemic and an already declining retail market. However, they have also made it clear where they consider an expert witness has failed in their duties to the court to act with impartiality. Where the evidence of one expert has been found to be partial, greater weight has been attributed to the evidence of the other expert. The recent case of Clipper Logistics plc v Scottish Equitable plc (unreported, Sheffield County Court, 7 March 2022) delivers a powerful message to the valuer that expert evidence that is not impartial may be disregarded.  HPUT Trustee No 1 Ltd and another v Boots UK Ltd (unreported, Central London County Court, 24 May 2021) covered a number of issues of interest to valuers. It involved the uncontested renewal of the lease of a high street shop in Bridlington and was the first of a batch of 123 claims in a series between the same parties, concerning the renewal of tenancies granted in March 2005 and expiring in July 2020. The issues to be decided by the court included: the amount of rent; the duration of the lease (for five or 10 years); and whether it should contain breaks. The judgment serves as a useful reminder of the order and the approach to be followed by the court when deciding the terms of the new lease to be granted under the 1954 Act.  The previous lease to Boots had been for a term of more than 15 years. In accordance with section 33, the court was to order a term of such duration as is “reasonable in all the circumstances”. HH Judge Dight looked to strike a balance between the landlord’s need for a reasonable period of certainty and the tenant’s need for flexibility, given the economic and market uncertainty and its need to remain nimble enough to make sudden changes. He decided the appropriate period was to be five years. The existence or frequency of any breaks was a term to be decided under the provisions of section 35. While the previous lease contained annual breaks, the landlord claimed there should be no breaks in the new lease and the tenant’s claim included one break after three years. Following the House of Lords decision in O’May and others v City of London Real Property Co Ltd [1979] 1 EGLR 76, it is for the party seeking the change from the old lease to show justification for that change and, according to the judgment of Lord Wilberforce, the test to be applied is that the term must accord with fairness and justice.  Again, the uncertainty in the retail market was an influencing factor. HHJ Dight decided to afford the tenant the flexibility it wanted by allowing a break after three years, enabling it to withdraw from the premises if needed. The judge was satisfied that if he accepted the landlord’s own expert opinion evidence as to the anticipated speed of recovery of the local retail market, it followed that the landlord would have little difficulty in reletting the premises if the tenant were to exercise the break. Accordingly, there would be no injustice to the landlord in allowing a tenant break option after three years.  Turning lastly to the matter of the rent, one of the issues the court had to decide in HPUT was the treatment of the initial rent-free periods. On a new letting, an ingoing tenant will usually need to fit-out the new premises before they are able to commence trading, so a rent-free period for this is commonly granted. The rent review clause in a modern lease will typically direct the valuer when assessing the market rent to assume that the tenant has already benefited from a fitting-out rent-free period before the rent commencement date. This is to ensure that the tenant does not benefit from a reduced rent at every rent review to reflect the need to fit out. When we analyse an open-market letting as a comparable for rent review purposes, we therefore ignore the fitting-out element of the rent-free period in calculating the net effective rent, discounting the headline rent by the incentive element of rent-free only over the relevant term. The rent payable for a new tenancy under the 1954 Act is less straightforward as section 34(1) contains no explicit assumption that the incoming tenant has had the benefit of a rent-free period for the purposes of fitting-out. The question that the court was to decide was “whether an assumption should be made, as in the market for new lettings, that a three-month rent-free period should be allowed, thereby reducing the rent payable from day one under the new lease”.  The arguments relating to the treatment of the fitting-out rent-free period are not new, the issue having been considered in a series of county court decisions. In HMV Music Ltd v Mount Eden Land Ltd (unreported, Central London County Court, 17 January 2012), HH Judge Bailey decided that the absence of a rent-free period in the renewal lease meant that a downward adjustment should be made in the analysis of the comparables. The effect on the valuation was a reduction in the rent payable. The same approach was followed in the subsequent decisions of Iceland Foods Ltd v Castlebrook Holdings Ltd [2014] PLSCS 100; Britel Fund Trustees Ltd v B&Q plc (unreported, Central London County Court, 11 March 2016) and WH Smith Retail Holdings in 2021. In HPUT, HHJ Dight came to the opposite conclusion, deciding that no rent-free period should be allowed for fitting out. I summarise the six reasons he gave for his decision: The rent payable under section 34(1) is the rent payable from day one and it is assumed the tenant will “hit the ground running”. There is nothing in section 34(1) which specifically requires the hypothetical model to include an assumption of a rent-free period, and it would have been possible for the draftsman to have said that it should be assumed there would be a rent-free period.  There is no theoretical conflict between the hypothetical model (which disregards the fact that the tenant has been in occupation) and taking into account the principle of reality (in respect of the existence of the actual fitting out works in place). The reality is that the tenant, who is seeking to renew its business lease, does not want a rent-free period to fit out its premises. Section 34 requires the rent to be what the premises “might reasonably expect to be let for” and the word “reasonable” drives the reference to reality.  The disregard of section 34(1)(a) of the fact that “the tenant or his predecessors in title have been in occupation of the holding” was aimed at preventing the overbid of the sitting tenant, not the reality of a tenant who is renewing his lease. “…standing back, in the market the requirement for some sort of inducement to the tenant to take the lease depends on all the circumstances. It is a commercial negotiation. The reality here is that the tenant does not need an inducement in this case and specifically does not need a rent-free period and, in my judgment, it would be illogical for one to be built into the calculation.” The decision supports what some believe to be the fair outcome, namely that the tenant should not be afforded a windfall at every lease renewal by way of a reduction in rent. In HPUT, the court decided that the term of the renewal lease was to be for five years only. If the approach of HMV Music had been followed, Boots would have been entitled to a reduced rent on renewal in 2021 and potentially again if it renewed after a further five years. Those who disagree with HPUT would argue that an adjustment at every renewal merely reflects what the landlord would have to offer to a new tenant in the open market. Summing up  Whatever one’s opinion of the merits of the recent decision on the fitting-out rent-free issue, it has increased the uncertainty as to the amount of rent payable on renewal under the 1954 Act. HPUT lends further support to those who disagree with a reduction for a fitting-out rent-free adjustment and, with conflicting decisions in the county courts, arbitrators and experts appointed under PACT have greater flexibility in reaching their own decisions.  For valuers, the uncertainty is more far-reaching owing to the lack of clarity as to how lease renewal settlements in turn are to be analysed as comparables. The valuer may need to decide whether the comparable reflected a reduction for fitting-out, following the HMV Music approach, or whether no adjustment was made, in line with HPUT.  As leases become shorter, with a reduction in the incidence of rent review transactions, there will be greater need to rely on lease renewal evidence where open-market letting evidence is absent. Until we have clarity in the form of legal precedent, I suggest there is need for caution when deciding the weight to be attributed to a negotiated lease renewal as evidence of market rent. Maggie Stobo MRICS MCIArb is a director at MFS Resolution Click here to read the other part of the lecture, presented by Mark Sefton KC Photo © Ray Tang/Shutterstock