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Rent Review of Commercial Property Leases

Leases of commercial buildings are complex documents, governing the relationship between landlord and tenant for terms which commonly extend to 25 years.  Arguably, the most complex provisions of the lease are those relating to rent review. It is an area that unfortunately often results in costly litigation.

 

To minimise the risk of delay and expense when the rent is being reviewed, landlords and tenants should ensure that they are fully aware of the rent review provisions and take time to negotiate those provisions on the grant of a new lease.  The terms that are negotiated at the outset will depend upon the bargaining positions of the parties.

 

Why include rent review provisions in a commercial lease?

 

Rent review enables the rent to be varied at intervals during the period of the lease.  Depending on the type of mechanism used, it may allow the landlord to benefit from an increase in market rental values or, to stipulate at the outset stepped increases that are to take place throughout the term of the lease, irrespective of market conditions.

 

Tenants will also have a keen interest in these provisions.  The introduction of The Code for Leasing Business Premises (“The Code”) does appear to mark a shift towards more flexible, shorter term leases.  The Code encourages landlords to avoid insisting on provisions that allow upwards-only rent reviews and attempts to allow both the landlord and tenant the ability to start the review process.  In modern leases and with the introduction of The Code, it may be that tenants are becoming better placed to negotiate more favourable terms.

  

How does rent review take place and how often?

 

Rent reviews can take place in various ways.  It is for each individual lease to determine the mechanism used.  Common forms of rent review include stepped increases, those linked to a tenant’s turnover or a rent set in accordance with a prices index.  While these methods may prove to be less cumbersome, the most common form still remains an open market rent review.  Although complex, this type of review does allow the rent to be set at a level that is in-line with market conditions at the time of the review.  That said, despite The Code, it is common for open market rent review provisions to be drafted to provide for upwards only reviews meaning that on review, the landlord will either retain the level of rent payable or benefit from an uplift.

 

The formal rent review process is started when a notice is served by one of the parties.  It is common for a lease to stipulate that a rent review will take place every five years.  However, a trend towards more flexible, shorter leases has seen rent reviews increasingly taking place at three-year intervals.  Again, this remains a matter for negotiation between the landlord and tenant but it should be borne in mind that the more frequent the rent reviews, the greater the costs, especially where agreement cannot be reached.  Consideration will need to be given to whether more regular rent reviews are cost-effective.

 

What if the parties cannot agree?

 

If the rent cannot be agreed, the matter will be referred to a third party expert or arbitrator, resulting in further costs and delay for both parties.

 

The third party will have regard to comparable properties in the area when arriving at a valuation for that particular lease.  However, the ultimate determination of the rent will be decided by reference to the abstract concept of the “hypothetical lease”.  The hypothetical lease can be viewed as an instruction manual for the valuer in how to carry out the valuation.  It is a mirror of the actual lease with certain assumptions and disregards being made regarding the lease in question.

 

If the valuer is asked to determine the rental based on the actual property, it may lead to unfair consequences either for the landlord or for the tenant.  For example, where the tenant has failed to comply with its repairing covenants, the poor condition of the property would lead to a reduction in the open market rental value.  The tenant would therefore be benefiting from its own failure to adhere to its obligations. In this scenario, a landlord would wish to ensure that on review the rent review provisions are drafted to ensure that the valuer assumes that the tenant has complied with the covenants.

 

Similarly, the tenant will be keen to ensure that the rent review provisions are drafted carefully.  If the tenant moves into premises and builds up substantial goodwill in the area, then this could lead to the market value of the premises being inflated.  The tenant however, would not wish to be penalised due to the goodwill it has managed to generate during its occupation and the tenant’s advisers must therefore ensure that the tenant’s goodwill is disregarded at review.  This would be the same where the tenant has made improvements to the premises.  The tenant would firstly have to pay for the cost of making the improvements and then suffer an inflated rental increase on review, leading to an unfair over-valuation.

 

Drafting should always be clear and tailored to the specific landlord and tenant in order to achieve a review procedure that is agreed, workable and fair.

 

The parties must be especially wary of provisions relating to the timing of a review.  Parties should ensure that time is not “of the essence”.  Where time is of the essence, even a slight delay by one party can deprive it of the right of review altogether. 

 

When entering into a lease therefore, it is important that the parties have in mind the future of the letting.  Neglecting to consider the rent review provisions of a new lease or those contained in a lease being assigned at the outset could cause considerable delay and expense. 

 

 

For more information please contact:
Bells Solicitors Limited.   Registered in England and Wales no. 07827988.   Authorised and regulated by the Solicitors Regulation Authority.   SRA number 569030.   VAT registration number 137595285