Regular updates on relevant case law and legislation - October 2008

CHAPTER 16 LEASEHOLD COVENANTS

The tenant’s express covenant to pay rent (page 397)

The following is an article which was published on the www.linexlegal.com website. It was written by Philippa Aldrich who is a Partner in Real Estate at Shadbolt LLP (www.shadboltlaw.com) looks at the problems associated with rent reviews. Many of the questions that spring to mind when you are reading a standard land law textbook on this subject are answered and it will give you a very useful practical perspective.

Rent review

Most commercial leases contain a mechanism for the rent to be reviewed at regular intervals, usually 3 or 5 years. What should tenants do if hit with a request by a landlord for a significant rent increase, particularly in these straightened times?

What type of rent review?

First, tenants should have a look at the lease to identify the type of rent review being invoked. There are several different types of rent review. Some leases include clauses that provide for set increases in rent. The lease might, for example, provide that the annual rent will be £50, doubling every 10 years. It is unlikely in this case, that the tenant will be able to oppose an increase in year 10 as he has effectively agreed to it in advance.

Alternatively, the lease may contain an "escalation" type of rent review where an index, such as the retail price index, is used as a basis for calculating the rent rise. Again, provided the right index has been used and the maths is correct, there will be little opportunity for the tenant to object to a rent increase.

Other rents, particularly in the retail sector are linked to turnover whereby the landlord will take a set percentage of the income. The parties might also agree a sliding scale of percentages, for example, charging a different percentage for the first year of the lease, to reflect the time the tenant spends getting the business up and running.

Again, whilst it is worth checking the landlord’s calculations, it is difficult for the tenant to object to the percentage increasing in the second year.

The most common type of rent review, however, is to increase the rent to the open market rent for the property at the date of the review. Whilst this sounds straightforward, in practice, the drafting and operation of this type of rent review can be very complicated.

The lease will usually direct the parties to agree the market rent of the property on the basis of a “hypothetical” lease which includes certain “assumptions” and disregards”. These assumptions and disregards are intended to ensure fairness between the parties. For example, a lease often directs the parties to disregard from the valuation any improvements made to the property by the tenant. This is so that the tenant does not end up paying a higher rent solely as a result of its own improvements. The exact wording of this particular provision is important. Works carried out by the tenant before the lease is granted will usually not be considered an improvement for the purposes of rent review and this can even apply where a tenant carried out works during the term of a previous tenancy of the same property.

Much of the wording in a rent review is highly technical. For example, most rent review clauses state that the hypothetical letting is to be assumed to take place between a “willing landlord” and a “willing tenant”. The parties to the hypothetical lease are themselves hypothetical. This is because if the rent review were to take place based on the actual parties to the lease, this could distort the calculation. For example, the actual tenant of the lease would probably pay a higher rent to stay in the property and avoid the cost and disruption of moving.

A major problem for tenants is a “headline rent” clause. A headline rent is the rent that is paid under a lease, after the end of any rent free periods or any period of reduced rent. It creates an artificially inflated rent by ignoring the rent free period, period of reduced rent or any other concessions the landlord may have given to the tenant in return for a higher headline rate. This type of rent review was once a common feature of business leases and some examples can still be found. Pressure from tenants have made it much less prevalent and indeed the Code for Leasing Business Premises in England and Wales 2007 (2007 Code), recommends that landlords do not impose headline rent review clauses.

Rent review clauses should not be read in isolation. Other clauses in the lease can also be relevant. It is fairly common to see lease clauses to the effect that the premises are to be used only for a specified purpose, such as for retail or for any other purpose to which the landlord gives its written consent. However, tenants should note that if the landlord consents to a wider use or a different one, this may affect the valuation for rent review purposes. Generally, the more uses to which a property may be put, the higher the rental value.

Upwards only rent reviews (UORR)

Open market rent reviews are upwards only, that is, the rent can stay the same or be increased but it cannot go down. UORRs are a major source of controversy in today’s property market. In a falling market, a tenant may end up paying rent that no longer reflects the market value of the property and depending on the date of the rent review be paying the higher rent for a number of years. The 2007 Code encourages landlords to consider alternatives to UORRs but for now they remain the norm.

Rent review procedure

Having established what sort of rent review is being implemented, the next step is to work out what procedure needs to be followed. Now would be a good time to get expert help.

Some leases have long, detailed requirements, such as obligations to serve notices triggering the review and counter-notices in response from the other party. Both sorts of notice may be subject to strict time limits. The content, or even the precise form, of notices may be prescribed in the lease. Complicated procedures such as these can be problematical, not least because mistakes can be expensive. At worst a tenant who fails to deliver a counter-notice in the right way may lose its right to challenge the revised rent proposed by the landlord, however high. (Sometimes a landlord failing properly to serve a trigger notice, may lose its right to review the rent – but although it is worth checking the lease, this is rare!).

Modern leases tend not to include detailed provisions relating to notices and simply provide that the parties should try to agree a rent within a specified period of time.

Disputes

But what happens if the landlord and tenant cannot agree?

The rent review provisions will normally state that, if no agreement is reached, the parties may refer the dispute to a third party for resolution, who will act as either an expert or an arbitrator. An expert is usually a surveyor and is appointed as an ‘expert’ in property and possibly even in local property in particular. An arbitrator is bound by the Arbitration Act and is more like a judge, assessing the merits of arguments and evidence put to him by each side.

In each case, “comparable” rent reviews of similar properties will be considered in order to ascertain market value. Rent reviews are therefore essentially backward looking which means that where rents are likely to fall in the future, landlords will be keen to expedite the agreement of rent reviews so that they can use as comparables, rents agreed before the rental market began to dip. Equally, it may pay tenants to wait.

Once the new rent has been agreed, it will generally be backdated to the date of the review and the tenant will need to pay the landlord the arrears together with interest.

Opportunities?

Rent reviews, whilst mechanical in nature, can be used as opportunities to renegotiate with the landlord, particularly where the tenant has the benefit of a right to break the lease. In a falling property market where the landlord is keen to keep the tenant, the threat to break the lease might persuade the landlord to agree a lower rent.

If there is no break clause but the proposed rent will make continuing with the business difficult a landlord may be prepared to negotiate to avoid being left with an empty building.

However, landlords are always concerned with headline rates - they can use these as comparables to agree rent reviews on other of their properties and they are also key measures for valuing the property for investment purposes. Sometimes landlords whilst insisting on a full market rent, may give the tenant other concessions such as agreeing to upgrade the air conditioning or giving a rent holiday.

Rent reviews are complicated and it is always worthwhile seeking expert advice from a surveyor or property lawyer. When appointing a surveyor, choose an individual or firm with specific rent review experience and also knowledge of not only the local area but also the type of property under review. For every rent review it is important to carry out thorough preparation and research to decide on likely outcomes and the best tactics to employ in negotiations. So tenants receiving a landlord’s rental proposals should not panic but nor should they delay. It is essential to first work out the nature of the rent review and then if necessary seek expert advice.

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