What are rent review clauses? Well, 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. Here we consider the different types of rent review clauses and 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 and 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 (although it's a little known fact that they can be useful for a tenant, especially when it comes to backdated rents).
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
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 as 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 bears 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 really 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 reviews 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 a 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 within 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 ensure 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.
In theory this allows both parties to be confident that at the review date the rent under the lease is neither more nor less than that payable in the current market but in reality the figure will almost inevitably be somewhere in a “range” and need to be negotiated by expert valuers.
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 outset certain things that must be assumed or disregarded when valuing the rent at the review date.
Assumptions and disregards
As mentioned above, when a lease is reviewed using the open market review method, the review is carried out on a ‘hypothetical lease’. The starting point is that the hypothetical lease is based on exactly the same terms as the existing lease and on the property in its current state. However, as a result, the rent under the hypothetical lease may be artificially high or low. For example, if the tenant had let the property fall into disrepair, the rent achievable for the property on the open market would be lower.
To be calculated fairly, the rent for the hypothetical lease has to ‘assume’ or “disregard” (as appropriate) certain things that may or may not have happened under the lease. These would include:
- that the tenant has complied with its repairing obligations under the lease.
- that the tenant has not carried out any improvements to the property.
- that the tenant has not increased the value of the property by having grown a successful business there.
- the length of the lease term (should it be the whole of the lease term or only that remaining?).
The lease may state various other ‘assumptions’ and ‘disregards’ should be made at a rent review and should property specific assumptions or disregards be required it would be prudent to take advice from a surveyor as to the implications they would have on any rent review before including them in a lease.
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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 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 the reviewed rent by the set review date, the same rent will continue to be payable. The leases generally then 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.
For example, a lease could have an annual rent of £12,000 and state that the rent review date was to be 1 January 2015. The 1 January 2015 could come and go and the rent review may not be implemented at that point, which would mean the rent of £15,000 would continue to be payable. The landlord then may decide on 1 July 2018 that they would like to implement the rent review that should have taken place in 2015 and the review resulted in an increase of rent to £15,000. The landlord would then be entitled to recover the difference of the rent backdated to 1 January 2015 (which would equate to £250 per month and would be for a total of 42 months, giving a rental arrears of £10,500 plus interest). Such a demand could be catastrophic for a tenant. Therefore, from a tenant’s perspective, it is essential that the lease includes an ability for the tenant, as well as the landlord, to also ask for the rent to be reviewed. It may seem counterintuitive for a tenant to want the rent to be reviewed, but by doing so it can ensure that the landlord doesn’t hold off on implementing the review and then seek to make a huge backdated rent claim.
Tips for a rent review
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 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 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.
