Commercial leases can range from a few months to years in length. The longer the lease is, the more likely the landlord will want to ensure provisions are included which allow them the right to increase the level of rent - this is known as a rent review clause. In this article, our commercial property solicitors consider the different types of rent review clauses and the key elements of such clauses.
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What is a rent review clause used for?
A rent review clause is used to provide the landlord with an opportunity to review the level of rent payable by a tenant during the term of a lease. For example, a landlord may grant a 15-year lease to a tenant for an annual rent of £15,000. However, in those 15 years the market may change substantially and there is a chance that the level of rents may have dramatically increased, without a rent review clause, the landlord would essentially be letting out the property at below the market rates. A rent review clause allows the landlord to re-assess the rent at certain points in the lease.
Most review clauses are drafted to allow the tenant to instigate the rent review as well, but they also generally state that the review can only result in the rent staying the same or increasing, they rarely allow the rent to decrease (although this is possible) so the clauses are not generally something a tenant will want to include in a lease.
Rent review intervals
Rent reviews can take place at any time the landlord and tenant agree to. Generally, a rent review takes place every 3 or 5 years (the longer the lease, the longer the gap between rent reviews tends to be). To be effective the dates of the reviews or at least the mechanism for setting them must then be included in the lease. As a rule, a lease of less than 7 years should not need to include a rent review.
Tenants will need to consider the potential increases of a rent review during negotiations or heads of terms stage before committing to a lease agreement. This is to ensure the rent will not jump to an unsustainable amount in the future.
What is the commercial rent review process?
The lease agreement itself will contain guidance on how rent reviews are to be conducted.
- The process is usually kick started by one party (most likely the landlord) giving the tenant notice of the upcoming rent review, proposed rates and the date on which it is to commence – often termed the “trigger notice”. The trigger notice should be provided within plenty of time, usually three months, although it may vary from lease to lease.
- The other party should respond to the notice within any time periods specified in the lease and serve a counter-notice providing their own proposals if they do not accept what is being put forward.
- If the revised rent amount is contested, then parties will need to move on to negotiations to try and reach an agreement. Ideally, if the parties can arrive at a common ground, then the matter goes no further. Parties may wish to instruct a professional legal team to make submissions and representations on their behalf in negotiations.
- If an agreement can’t be reached, the lease typically sets out mechanisms for getting an independent expert/third-party involved to decide. Modern leases commonly provide that the matter is referred to the President of the Royal Institute of Chartered Surveyors, who will appoint an Arbitrator. The Arbitrator’s decision will be binding and can be enforced through the court.
- The agreed rent (whether by negotiation or independent determination) will commence, and usually, any backdated rent will be applied.
Types of rent reviews
There are various different types of rent review, such as:
- Index linked - this is where the increase in rent is linked to a form of index, such as the Retail Prices Index (RPI).
- Stepped rent - this is where the parties agree to a fixed increase of rent at pre-agreed times (for example, a £1,000 increase each year).
- Turnover rent - this is not technically a rent review, but a mechanism whereby all or part of the rent payable by the tenant is linked to the tenant’s turnover.
- Open market rent review - this is where the rent is based on what the open market would consider the rent to be for a new lease on the same terms as the existing lease if it were to be granted on the date of the review.
Index-linked rent reviews
Retail Price Index (RPI) reviews are the most common types of index linked reviews, but any other form of index could be used. RPI review clauses essentially increase the rent by the same percentage as the RPI has increased over the rent review interval. Index linked clauses must be read very carefully though as simple mathematical errors can result in unintended, onerous review provisions. A common error is where a lease has more than one rent review date and the lease states that, at each rent review date, the rent is increased by the same percentage of increase in the RPI from the start of the lease until the respective rent review date (rather than resetting the base RPI figure at each subsequent review date). Where there is only one rent review date this is fine, but where there are subsequent review dates this would be problematic as shown in the example below:
Example:
Let’s assume for this example that a lease had an annual rent of £10,000 and there were rent reviews at year 5 and year 10. The RPI figure at the start of the lease was 1.0 then increased to 1.5 at year 5 and to 2.0 at year 10.
If the lease simply made reference to the rent increasing in line with RPI as from the start of the lease the calculations would be as follows:
Rent review at year 5 - (1.5/1.0) x £10,000 = £15,000
Rent review at year 10 - (2.0/1.0) x £15,000 = £30,000
The result is problematic as it has not ‘reset’ the base from which the RPI increase is measured, meaning that the tenant is getting penalised on the second review. The review at year 10 should be by reference to the RPI increase from year 5, not from the commencement of the lease (as this has already been used at the first rent review). If the review clause does ‘reset’ the RPI base figure, then the calculation at year 10 would be as follows:
Rent review at year 10 - (2.0/1.5) x £15,000 = £20,000
As you can see from the examples above, failure to draft the index linked clause properly can be very costly for a tenant and can result in unintended catastrophic increases in rent.
Stepped rent reviews
Stepped rents are the easiest and cheapest type of rent review, the rent is not so much reviewed as increased by a pre-agreed amount on set dates during the lease term. It has no relationship to the actual value of money and almost inevitably one party will be paying too much or receiving too little for the lease by the time it ends, so it is best used for short leases of no more than 2 or 3 years.
Stepped rents can have unintended effects. For example, if a rent at £1.00 a year were to double every year, then within 20 years the annual rent would be over £1 million, far above any likely rate of inflation. Although the courts have shown some willingness to try to limit these types of clauses, they will not intervene just because a tenant has struck a bad bargain. When offered a stepped rent it is always worth working through the figures to calculate just what the clause will do in practice.
Turnover rent reviews
Turnover rent allow a landlord to benefit from the tenant’s success. It is rare that a tenant occupies purely under a turnover rent. Generally, the landlord will agree to lower basic rent on the basis that they will then also be entitled to part of the turnover of the tenant.
From a landlord’s perspective, it will want to ensure that all of the turnover the tenant receives is included in the calculation. This means it is important that the landlord considers all of the different means of turnover that the tenant receives (such as online bookings) to ensure that they are included in the calculations. There should also be provisions in the lease allowing the landlord to insist on all receipts and accounts are provided by the tenant to the landlord so it can check for itself what the turnover is. The landlord will also want to make sure that provisions are included to prevent the tenant from simply not operating for long periods, which would result in a low rent being paid.
From a tenant’s perspective, if it operates from more than one property, it will need to ensure that the turnover from the particular property in question is easily ascertainable. Otherwise, the landlord may seek to inflate the turnover figures based on other sites. The tenant will also want to consider what will happen if it can’t trade or use the property for prolonged periods of time.
Open market rent reviews
An open market rent review allows the landlord to make sure that the rent under the lease matches the current market at the review date. The review takes place by pretending that a new ‘hypothetical lease’ will be entered into and that the hypothetical lease is based on exactly the same terms as the existing lease, but with some pre-agreed assumptions and matters to be disregarded about the lease (see the section below). The rent will then be reviewed to match what the rent of the hypothetical lease would be as at the date of the review taking into account the pre-agreed assumptions and disregarding the pre-agreed matters.
The problem with basing the review on a ‘hypothetical lease’ for that property at that moment in time is that it can fail to take into account what the parties have done in the meantime or even in some cases the surrounding legal or political landscape. It is usual to include in the lease at the outset certain things that must be assumed or disregarded when valuing the rent at the review date.
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Rent reviews and backdated rents
Whilst most commercial leases expressly state rent review dates, these are often a starting point from when the reviewed rent can commence. Most leases are prepared on the basis that allow the parties to commence the rent review in an agreed period to the review date and state that if they have not agreed to the reviewed rent by the set review date, the same rent will continue to be payable. The leases generally state that review can then be undertaken at any point in the future and, once the review has taken place, the landlord will be entitled to backdate the increased rent to the review date and charge interest.
How to prepare for a rent review
For landlords:
- First, they should carefully review the lease agreement to understand the terms and conditions related to rent reviews. It's important to have a clear understanding of the specific clauses that dictate how rent reviews will be conducted, including timeframes, type and method of review.
- Landlords should prepare for rent reviews by carefully evaluating market conditions and property performance. It's essential to gather relevant market data and comparable evidence to support any proposed rent increase. This often involves consulting with professionals to provide expert insight. Consider any improvements, renovations, upgrades or other changes made to the property that could impact rental value.
- It cannot be stressed enough – but make sure you are aware of any timescales specified in the lease in which to serve the trigger notice to your tenant. It may be the case that a missed deadline means you lose the right to negotiate a rent review until the next interval.
- Ensure the notice is served on the tenant in strict accordance with the service provisions set out in the lease. That way, you can avoid the tenant denying receipt and/or contesting the validity of the review.
- Comply with your obligations and management responsibilities under the lease. Negotiations are more likely to be productive and effective if there are no underlying tensions between parties.
- Be prepared to negotiate with the tenant in good faith, consider reasonable requests and concerns they may have, especially if they have been a consistently good tenant. Souring relations or losing the tenant may not be a good idea commercially even if you can justify higher rates.
For tenants:
- Monitor the local market ahead of any rent review intervals (which should be diarised accordingly). If your lease does not contain an upward only rent review clause, then you could potentially take the opportunity to renegotiate the rent down in line with current market trends and save outgoings or at the very least ensure it stays the same.
- Even where the property market is buoyant, conduct your own research and instruct a professional to determine a fair and reasonable figure in advance of the rent review date so that you know what to expect going into negotiations. This also means you can respond with a counter-notice in good time, and alleviate the pressure of finding out crucial information and engaging professional advisors after the event.
- Ascertain your negotiation strategy and bargaining strength in advance of going into negotiations. If for example, the market has slowed down and it would be difficult for the landlord to find a replacement tenant, then this puts you in a stronger position.
- Although this should apply regardless, try to ensure you are consistent with paying rent on time and complying with your obligations under the lease. Negotiations may be more amenable and the landlord may be more willing to cooperate if he sees you as a good tenant.
- Keep records of any improvements you have made to the property out of your own pocket so that you can try to negotiate on this point if the landlord seeks to factor these to inflate rent.
- It may be worth gauging the position and obtaining confirmation in writing from the landlord if they do not act instead of staying silent and letting the date come and go. This might help in the event of unexpected large backdated bills should the landlord take steps in the future.
For both: The main tip would be not to simply accept what the other party has put forward without considering whether it is acceptable and in accordance with the terms of the lease. Ask for a methodology as to how the figures in the review were achieved. If in doubt, take advice from one of our commercial lease solicitors.
What if you can’t agree
Most rent review clauses will allow the parties a certain period of time to agree on the reviewed rent but will then allow either party to refer the matter to a third-party expert or arbitrator to determine if no agreement can be made. The parties should initially try to agree on which third party to appoint, but it should also include provisions allowing the President of the Royal Institute of Chartered Surveyors (RICS) to make an appointment in the absence of agreement.
The lease should state what level of expertise the third-party must have and who will be responsible for their fees. The third party will then determine the revised rent in accordance with the provisions of the lease and the finding will be binding on both parties.
Summary
Whether you are the landlord or tenant, a rent review is something you will need to deal with at some point, especially for leases of 5 or more years. Thinking about rent reviews should start at the outset of the lease at heads of term stage when the interval and type of rent review is agreed upon. To achieve the best possible outcome from a rent review, it is wise to prepare well in advance, stay informed on market trends (or get advice from a property agent), and go into negotiations armed with a strategy.
