In our latest Building Blocks article, Millie Wakefield and Jack Lightburn discuss rent review clauses in commercial leases and consider some of the different options available.
Simply put, the rent review provisions in a commercial lease set out how and when the rent is to be re-assessed throughout the term. For example, in a 10-year lease, there may be provision for the rent to be reviewed after five years to the then open market level. The purpose of a rent review is to try to ensure that the landlord continues to receive a rent which reflects the true value of the property on the open market. Accordingly, if the term of the lease is short, say three or five years, there is less need for a rent review because the initial rent is less likely to vary significantly with the open market rent during and by the end of the term.
Types of rent review
There are various rent review methods which the parties can choose to adopt:
Open market
This is the most common form of rent review mechanism used in commercial leases. An open market rent review sets the new rent based on what could reasonably be achieved in the open market on the relevant review date if the property were let to a willing tenant on (usually) the same terms as the existing lease, save for the rent (which is, of course, the subject of the review).
The valuer looks at the rents achieved for other properties of a similar type, on similar lease terms and within the same locality (known as "comparables"), making adjustments for any differences, in order to reach an assessment of the rental value of the property. Subject to any directions to the contrary in the lease, the valuer takes into consideration the actual premises and the existing terms of the lease in determining the rent.
However, the valuer will also be directed to make certain "assumptions" and "disregards" when carrying out the valuation exercise. Common assumptions are that the property is in good repair and the hypothetical tenant has had the benefit of a rent-free period for fitting out. Factors which are usually disregarded include the actual tenant’s occupation of the property and any increase in value as a result of the actual tenant's improvements made to the property. The assumptions and disregards are generally in market standard form and are intended to ensure that the reviewed rent is not distorted by any facts or circumstances which, if not assumed or disregarded, would have the effect of unfairly inflating or deflating the rent.
Stepped
This is where the level of rent throughout the whole term is specified in the lease at the outset. For example, a five-year lease may have a starting annual rent of £10,000 which is stated to increase to £12,500 after three years for the remainder of the term. In reality, this isn’t a review at all because the outcome is known from the beginning, but it is generally described as a form of rent review.
Index linked
An index linked rent review links the amount of rent to a form of inflation index, such as the Retail Prices Index (RPI) or the Consumer Price Index (CPI). This type of rent review has the benefit of being cheap and more straightforward to operate throughout the term, as the revised rent is calculated by reference to a formula without needing to instruct a surveyor to carry out a valuation exercise. It is imperative that the drafting is checked carefully as mistakes in the formula can result in unfair and even irrational outcomes, to the disadvantage of one of the parties and the benefit of the other (although it will invariably be the tenant who suffers from bad drafting).
A potential drawback to this method is that inflation does not necessary mirror changes in property prices. For example, in the last couple of years a retail tenant with an RPI linked rent review may have seen rental increases of over 10% annually whereas the open market rent of their property may have been stagnant or even falling, given the struggles the retail sector experienced during, and since, the COVID-19 pandemic. Theoretically this disconnect between inflation and property prices could work out to the benefit of either the landlord or the tenant, depending on the circumstances.
Turnover rent
Turnover rent is an umbrella term used to describe any rent which is linked in some way to the tenant’s turnover. A turnover rent is attractive to tenants because it can ease the cost burden in periods of downturn in performance by lowering rents. Because this type of rent only really works (from a landlord's perspective, at least) where there is a connection between the occupation of the premises and the tenant's turnover, these rents are most often seen in the retail, leisure and hospitality sectors where, generally speaking, there is a link between footfall and the success of the business. There has been an increase in the prevalence of turnover rent leases since the COVID-19 pandemic, as many landlords have responded to widespread tenant struggles by offering a turnover rent as a way of accepting some of the risk of fluctuations in the market.
Most turnover rents are not based solely on the tenant’s turnover, although fully turnover based arrangements are becoming more common. Typically, the tenant will pay a discounted market rate as a base rent, for example 80% of the open market figure. The turnover element of the rent will be calculated using a formula based on the tenant's gross turnover arising from the premises. Turnover rent provisions are usually lengthy and complicated which means that a great deal of thought needs to be put into them. For that reason, they are most often seen in leases involving sophisticated parties, for example shopping centre landlords or large multiple retailers.
Geared/side-by-side
This is where the rent payable for a property is directly linked to the rent payable under another lease. For example, the rent payable for an underlease may be 50% of the rent payable under the headlease. If the headlease rent is reviewed, the underlease rent will be adjusted accordingly to take account of the outcome of that review.
Other considerations
Upwards only
A typical rent review clause will provide that the rent will either increase or remain the same following a review. In other words, the rent can never go down. This is known as an "upwards only" rent review. Whereas many other aspects of leasing practice have become more favourable to tenants over the years, upwards only rent reviews are one area where landlords have been very successful in maintaining the status quo. However, there is some indication that this may be slowly starting to change, particularly after the experience of the COVD-19 pandemic where market rents in many sectors fell dramatically. Where leases in these sectors contained upwards only rent reviews, tenants were stuck paying over market rate for their premises unless they could exercise a break option or otherwise negotiate an exit from the lease. This experience may embolden tenants to push harder for upwards/downwards reviews in future.
Cap and collar
This is where the parties agree a set minimum and/or maximum increase of the rent on each review. A cap and collar mechanism is most commonly found in index linked rent reviews, to guard against high volatility. The cap provides the tenant with the comfort of a maximum increase on each review and the collar ensures that the landlord will benefit from at least some increase on each review. Parties agreeing to a capped and collared review need to understand that this introduces an element of distortion into the review. If the cap or collar is applied, the revised rent won’t accurately reflect the true position following the review exercise, to the benefit of one party and detriment of the other.
Time limits
Whilst it is less common these days, rent review provisions can require certain acts to be carried out by a specified deadline, with the possible result that a right to do something is lost if the deadline isn't met. For example, the lease may provide that the tenant must respond to a landlord’s notice of the new rent within a certain period otherwise it loses the right to challenge the proposed figure, or there may be a deadline for the landlord to commence the review procedure otherwise it will lose the right to trigger the review.
Depending on the wording of the lease, failure to abide by these timeframes can have dire consequences. If the lease, either expressly or by implication, provides that "time is of the essence", then the time limits must be strictly complied with. It is now generally accepted as onerous for rent review provisions to include strict deadlines and therefore, more often than not, a modern rent review clause will include an express provision stating that time is not of the essence.
Dispute resolution
Most modern rent review clauses provide that, in the absence of agreement over the level of the new rent, either party can refer the matter to an independent third-party to determine. Provisions restricting this right to the landlord only are onerous and should be resisted by tenants. The third party will be appointed to act either as an expert or an arbitrator. Each has a different function and which is more appropriate in any given scenario will be circumstance and fact dependent. If the parties are unable to agree on who to appoint, there is often scope for either party to apply to the President of the Royal Institution of Chartered Surveyors (RICS) to make the appointment on their behalf.
The above is intended as a general overview of rent review provisions in commercial leases. If you have any questions on the above or require advice in this area, please contact our real estate team.
Jack Lightburn
Millie Wakefield