What happens in rent reviews? 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 it 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.
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. Therefore, 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
When rent reviews occur is down to negotiation and agreement between the landlord and tenant and must then be reflected in the lease. Common rent review intervals are every 3 or 5 years of the lease but can be any period that the parties agree to.
Types of rent reviews
There are various different types of rent review, such as:
- 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 - this is where the increase in rent is linked to a form of index, such as the Retail Prices Index (RPI).
- Fixed increases - 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 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. 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.
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. Therefore, it is generally accepted that, on calculating the rent for the hypothetical lease, it should be ‘assumed’ that the tenant has complied with its repairing obligations under the lease. Conversely, the tenant may have grown a successful business at the property and garnered goodwill, or it may have carried out improvements to the property, both of which would make the property more valuable and would increase the rental value of the property on the open market, which would be unfair to the tenant. It would, therefore, be usual for the lease to expressly state that the goodwill and tenant’s improvements will be disregarded on a rent review.
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.
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:
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.
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.
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 a surveyor and a solicitor.
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.